As part of the employee stock purchase plan, your employer grants you an option to buy 100 shares of the company’s stock at $20 per share, when the market value was $22 per share.
You later exercise this option, when the market price was $23 per share.
After meeting the holding period requirements (1 year holding the stock and 2 years since the option was first granted), you sold the stock for $30 per share.
Your sales proceeds would be $3,000 (100 shares x $30 per share)
Your purchase price is $2,000 (100 shares x $20 option price per share)
Your gain is $1,000 ($3,000 proceeds minus $2,000 cost)
You would report $200 as ordinary income: fair market value of $2,200 ($22 x 100 shares) at time option was granted, since this is the lesser difference, minus your option price of $2,000 ($20 x 100 shares)
The $800 balance of your gain would be reported as a capital gain
Holding Period Requirement Not Met
If you do not meet the holding period requirements, your ordinary income is the amount by which the fair market value of the share at the time you exercised the option exceeded the option price. The amount of ordinary income you have to report is not limited to the amount of your gain on the sale. In this case, you increase your basis in the stock by the amount of ordinary income you have to report, and then figure the amount of gain or loss on the sale of the stock that is to be reported as capital gain or loss.
Example – Capital Gain
As part of the employee stock purchase plan, your employer grants you an option to buy 100 shares of the company’s stock at $20 per share, when the market value was $22 per share.
You later exercise this option, when the market price was $23 per share.
After meeting the holding period requirements (1 year holding the stock and 2 years since the option was first granted), you sold the stock for $30 per share.
Your sales proceeds would be $3,000 (100 shares x $30 per share)
Your purchase price is $2,000 (100 shares x $20 option price per share)
Your gain is $1,000 ($3,000 proceeds minus $2,000 cost)
You would report $300 as ordinary income in this case: fair market value of $2,300 ($23 x 100 shares) at time option was exercised, less your option price of $2,000 ($20 x 100 shares)
The capital gain to be reported would be $700: selling price of $3,000 minus $2,300 (cost of $2,000 increased by ordinary income of $300)