Breakdown of ESPP Taxation for MSFT, and discussion of possible problems with Fidelity-provided information

http://www.ericlawrence.com/eric/show.asp?entry=4/2/2010%2012:20:00%20PM

Doing your own taxes isn't that hard if you have all of the
paperwork. However, I've recently discovered that it's easy to do your
taxes incorrectly if you're not aware of how screwy the rules are for
Employee Stock purchase programs.

First, a bit of contrast.  Your Stock Awards (part of your annual
review) are pretty easy to deal with tax-wise. The vested award's value
appears on your W2 in Box 1, and shows on your paystub as "Stock Award
Spread". Taxes on the award are automatically withheld, and those also
appear on your W2 in the appropriate Federal, Social Security, and
Medicare tax boxes. They're listed on your paystub as "Stock Award
taxes."  Easy enough.

Of course, you still have to figure your Capital Gains (or losses)
when you sell the awarded stock. We'll get to that in a minute.

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ESPP COMPENSATION VALUE
-----------------------

Compared to Stock Awards, the tax rules for ESPP are quite
complicated. They're also hard to follow because of how Fidelity and
your W2 do recordkeeping.

When you actually "buy" ESPP at the end of the offering period, there
are no taxes to pay. Great!

Unfortunately, when you sell, the world gets very complicated. The
first thing to understand is that, depending on when you sell, you
either have made a "Qualifying" or "Disqualifying" Disposition. For
Microsoft ESPP, if you sell the ESPP shares within 21 months of buying
them, it's a "Disqualifying" Disposition.

Now, "Disqualifying" sounds bad, but it isn't necessarily a problem
and actually makes your taxes a fair bit simpler.

When you make a DQDSP sale, you have to account for the "Compensation
value" of your ESPP DISCOUNT as "ORDINARY INCOME". For Microsoft, that
discount is 10% of the purchase price of the shares. Microsoft keeps
track of the DQDSP "Compensation value" on your W2; it appears alone in
Box #14, and the value is also added to Box #1.

Being in Box #1 means that DQDSP's "Compensation Value" is counted as
a part of your taxable income automatically, which is good. The bad
part is that Microsoft doesn't withhold taxes on that taxable income,
however, which can lead to unpleasant surprises come tax season.

In contrast, when you make a Qualifying sale (QDSP), your
"Compensation value" / ORDINARY INCOME is the lower of:

 1> The Discount you *would have gotten* on the stock, AS IF it
would have bought at the *start* of the offering period (aka 3 months
before it actually DID buy)
 2> The gain you made when you sold
the stock (e.g. Proceeds minus what you paid.)

Depending on how the stock price has moved between the start of the
offering period and when you sell it, a QDSP could provide tax
advantages OR disadvantages over a DQDSP.

Surprising, eh? It gets worse...

 ** WARNING **
The BIG problem is that Microsoft doesn't keep
track of a QDSP's "Compensation value" / "ORDINARY INCOME" for you, and
it's not super-easy to go back and calculate it. Once you do calculate
it, you have to add it to your W2 Box #1 yourself.

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CAPITAL GAINS / LOSSES
-----------------------

The "Qualifying" or "Disqualifying" nature of the Disposition
controls how much "ordinary" income you have received from the ESPP
discount. But when you buy or sell stock, you also have to report the
Capital Gain or Loss. To do that, you calculate the proceeds of the sale
minus your BASIS cost. Critically for ESPP sales, your BASIS cost IS
NOT what you *actually* paid for the stock-- it's what you paid for the
stock PLUS the "ordinary" income you reported for the discount. This
means your Capital Gain on ESPP shares is smaller (or your Capital Loss
larger) than what Fidelity reports on your year-end statement.

 ** WARNING **
Fidelity *does not* add this "ordinary income" to
the basis cost, meaning that if you just blindly accept Fidelity's
numbers for the Gain/Loss on the sale, you're getting double-taxed on
the Compensation value: once as ORDINARY INCOME, and once as CAPITAL
GAIN/LOSS.

To calculate the CAPITAL GAIN OR LOSS for DQDSP:

 1> Use the FAIR MARKET VALUE of the shares purchased (e.g. what
you paid PLUS the $ discount) as your BASIS COST
 2> Calculate
your GAIN or LOSS (PROCEEDS less BASIS)

To calculate the CAPITAL GAIN or LOSS for a QDSP:

 1> Determine how much ORDINARY INCOME you paid on the QDSP sale
 2>
Add that value to your BASIS COST
 3> Calculate your GAIN or LOSS
(PROCEEDS less BASIS)

At this point the record keeping is getting pretty hard, huh? Because
you cannot trust the BASIS information reported to you (because it
doesn't account for the "Compensation Value" treated as ORDINARY INCOME)
you must understand which specific shares were sold as a part of each
sale, so that you can properly compute the BASIS.

It gets worse.

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TAX LOTS
-----------------------
When
you go to sell stock, Fidelity shows a checkbox that allows you to
choose "specific lots". This checkbox is unticked by default-- unless
you tick it, Fidelity chooses which shares to sell (I'm pretty sure it
sells FIFO by default). The problem is that your future reporting
statements will not necessarily tell you WHICH tax lots were sold, and
if you hold any shares throughout the year, the accounting gets quite
hard.

For instance, say you buy 212 shares on March 31st, and sell 212
shares on April 5th. You might logically think that your April 5th sale
represents the shares that you bought on March 31st. But if you didn't
pick specific shares to sell, and already held any shares before March
31st, it's likely that some or all of those other, earlier shares are
what actually sold. So, your order to sell 212 shares might actually be
selling shares you bought last year, or whatever.

If you sold shares at a loss, it gets worse.

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WASH SALES
-----------------------
Normally,
if you sell shares at a loss, you get to claim a CAPITAL LOSS on your
taxes (or shrink your CAPITAL GAINS). But there's a rule called the
"Wash Sale Rule" which says that if you buy "substantially identical"
stock within 30 days (before/after) of a losing sale, you don't get to
directly claim the loss.

In the example above, you failed to specify the exact shares to sell
in your April 5th sale. You're not selling the March 31st shares, and
hence your March 31st ESPP purchase means that you've acquired
"substantially identical" stock (http://www.fairmark.com/capgain/wash/wsreplac.htm).
So if your sale of those older shares results in a loss, you don't get
to claim that loss directly due to the Wash Sale rule.

Now, it's not the end of the world because the Wash Sale rule says
that you get to use your loss to adjust the BASIS (price and date) of
the new stock that you've acquired. But this means yet more accounting
on your part.

But it gets worse.

-----------------------
"IMPOSSIBLE" ACCOUNTING
-----------------------
Fidelity
will try to keep track of your wash sales and adjust the basis of your
future sales accordingly. Unfortunately, that makes the record-keeping
almost impossible. Firstly, adjusting the BASIS doesn't just change the
basis price, it also changes the "effective" DATE of the purchase. So
when you go to sell that March 31st stock, may get statements from
Fidelity showing that you sold stock bought on "12/31/2009w" -- it's
really your 3/31 stock but the basis has been adjusted due to your wash
sale on April 5th. This can get extraordinarily confusing, because it
means that neither the BASIS price nor purchase DATE for this set of
shares corresponds to what was actually sold.

And that's a freakin' disaster, because as mentioned 3 sections ago,
Fidelity fails to properly adjust the BASIS price of shares ESPP sales,
meaning that you have to do it yourself. But since Fidelity has already
"helpfully" changed the BASIS price and DATE to account for the WASH
SALE, it can be virtually impossible to figure out WHICH shares were
actually sold, meaning it's virtually impossible for you to properly
adjust the BASIS to take into account the ORDINARY INCOME you
recognized.

Oh, and keep in mind that the change of the BASIS DATE means that
your later sale may be changed from a SHORT-TERM transaction to a
LONG-TERM transaction. Confusing.
Oh, and keep in mind that because
you often will be buying and selling different-sized blocks of shares, a
given sale will likely be split up into multiple transactions, each
tracking a different wash sale.

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CONCLUSIONS
----------------

Now, the easy answer for all of this is to just give an accountant
$300 bucks and a binder full of your documents and submit whatever tax
return they prepare for you. But given the utter insanity of the math
and the "lossy" record-keeping on Fidelity's statements and the W2, it's
hard to imagine that a professional accountant would get this all done
correctly either.

It's enough to make me wish for a flat tax even if I were to end up
paying a lot more.

Thoughts for the future:

1> Always specify which tax lots to sell.
2> Always record
myself what shares specifically were sold.

Even if I choose "wrong" and don't have the best tax outcome, at
least I won't spend 9 hours trying to figure out which shares correspond
to which transactions.