First of all, you have no income from merely receiving an option (the right) to buy employer stock under the plan. This is the case even though the option is part of your compensation package for working for your employer.

Second, no income tax applies when you “exercise” the option, i.e., buy stock in your employer company under the terms of the option. Presumably, you will be buying the stock for a price below its market value. Still, you won’t be subject to income tax at this point.

You will be subject to income tax on your gain on the stock only when you sell it. At this point, unless one of the exceptions discussed below applies, this gain will be capital gain, and not ordinary income like your other compensation income. As with regular investments, your gain will simply be the difference between the proceeds of sale and your original cost of the stock. Although the sale is taxable, no tax will be withheld from your paycheck. And FICA and FUTA taxes do not apply on any income arising when stock is transferred under the plan or when it is later disposed of.

Once the option has been exercised, any dividends paid on the stock will be taxable to you, regardless of whether you have received the stock certificate or automatically reinvest the dividends in the stock purchase plan.

Option price below market value at receipt. Your employer must fix the option price so that it is not below the lesser of:

 (1) an amount equal to 85% of the fair market value of the option stock as of the time the option is granted, or

 (2) an amount equal to 85% of the fair market value of the option stock as of the time the option is exercised.

If the price for which you can buy the stock is set below the stock’s fair market value when you receive the option, then when you sell the stock, your gain up to the amount of this difference per share is taxed as ordinary income.

Example: Under an employee stock purchase plan, Phil receives an option to buy 100 shares for $90 a share and the per share value when he gets the option is $100. Thus, the option price is $10 a share below value. Phil eventually exercises the option, buys 100 shares for $9,000, and sells them several years later for $10,500. His total gain on the stock is $1,500 ($10,500 − $9,000). Phil will have ordinary income of $1,000 ($10 per share times 100 shares) and capital gain of $500.

Disqualifying dispositions. You may also have ordinary income on the sale of the stock under the plan if you fail to hold it long enough. To avoid ordinary income, you cannot sell the stock before the later of the following dates: (1) the date two years after you receive the option, and (2) the date one year after you receive the stock.

If you sell the stock too early, then the amount of your gain will be ordinary income to the extent the price you paid for the stock was less than market value when you bought the stock.

Example: