Employee stock purchase plans (ESPPs) have emerged as a powerful tool for aligning the interests of employees and employers, fostering a culture of ownership, and driving long-term organizational success. By allowing employees to purchase company stock at a discount through payroll deductions, ESPPs offer a unique blend of financial benefits and motivational incentives. Is an ESPP right for you?
What is an ESPP?
An ESPP is a stock plan that enables employees to buy company shares at a discounted price using after-tax payroll deductions. The plans are classified into two categories: qualified and nonqualified. Qualified ESPPs, governed by Internal Revenue Code (IRC) Section 423, offer significant tax advantages but come with certain restrictions. Nonqualified plans, while more flexible, don’t provide the same tax benefits. This article focuses on qualified plans.
How ESPPs work
The operation of an ESPP involves four key steps:
1. Enrollment
Participation is voluntary. Once you enroll in the plan, you’ll be eligible to participate in the upcoming offering period and purchase company shares at an agreed discount for the length of that offering period. The maximum discount is 15%, but it can vary based on the plan.
2. Payroll deductions
Within an offering period, accumulated contributions from your paychecks (post-tax) are set aside to purchase shares at the purchase date.
3. Purchase of shares
Typically at the end of the purchase period (i.e., on the purchase date), you’ll officially purchase the shares. Shares that are purchased through this program are immediately “vested,” and you’re free to do as you please with them after they’re acquired. These shares also receive dividends and voting rights, similar to if the shares were purchased on the open market.
4. Sell or hold shares
You can choose to sell your shares immediately to take advantage of the discount. Alternatively, you can wait until after certain holding period requirements are met to receive more favorable tax treatment.
Key terms and features
There are several terms you need to understand when evaluating your company’s ESPP.
- Offering period: This is the time frame during which you can enroll and contribute to the ESPP.
- Stock purchase caps: This cap — set by the IRS — limits your maximum amount of stock purchases to $25,000 per calendar year. Plans can be more restrictive if they so choose. This amount is measured using the stock price at the time of the grant.
- Lookback: Plans often allow you to purchase shares at the lesser of the stock price at the offering date and the purchase date. This difference is referred to as the “lookback” and will come into play when examining the potential tax benefits.
- Purchase period: Within an offering period, there can be a series of purchase periods in which you set aside money to purchase the shares. The length of a purchase period is usually six months, as illustrated below.
- Purchase price: The price at which shares are bought, often based on the lower of the stock price at the offering date or the purchase date.
Taxation of ESPP shares
ESPP shares are taxed at the time the stock is sold. The applicable tax rate is dependent on whether the disposition is qualified or nonqualified.
- Qualified disposition: A qualified disposition occurs when shares are sold at least two years after the grant date and one year after the purchase date. The discount (difference between what the stock is purchased for and its current market value) is taxed as ordinary income, while the appreciation is taxed as a long-term capital gain.
- Nonqualified disposition: A nonqualified disposition occurs when shares are sold before meeting the plan’s holding period requirements. In this scenario, the discount and the appreciation up to the fair market value at purchase are taxed as ordinary income, with any additional gain taxed as a capital gain. The following example illustrates how qualifying and disqualifying dispositions work within a six-month offering period.
To summarize, the discount is always treated as ordinary income and the gain after the stock has been purchased is taxed at capital gains rates. The tax treatment on the lookback value is determined by whether a qualified disposition occurs. Additionally, keep in mind that in the event the stock goes down after it’s purchased, you will have a capital loss position in the stock but must still pay ordinary income on the discount benefit.
While it could be more beneficial to sell shares through a qualified disposition, the tax advantages should be balanced against other considerations such as diversification and the outlook for the stock. The taxation of stock plans can be complex, so confirm the tax consequences of participating and selling stock with your CPA before you enroll.
Benefits of ESPPs
ESPPs offer significant benefits to both employees and employers. For employees, the benefits include:
- Financial growth: ESPPs provide an opportunity to increase net worth and save for retirement through the appreciation of company stock.
- Tax advantages: Qualified ESPPs offer favorable tax treatment, including long-term capital gains on qualified dispositions.
- Discounted purchase: You can buy shares at a discount, enhancing the potential for financial gain.
- Low/no cost: You typically don’t need to pay brokerage fees, commissions, or other costs on the purchase of the company stock.
Benefits for employers include:
- Employee engagement: By providing a stake in the company’s success, ESPPs align employee financial interests with those of the organization, fostering a sense of ownership and loyalty.
- Talent attraction and retention: ESPPs are an attractive benefit that help companies attract and retain top talent.
- Performance incentive: ESPPs motivate employees to contribute to the company’s success.
Strategic considerations
When contemplating participating in an ESPP, you should consider several factors.
- Personal cash flow management: Can you afford to divert up to $25,000 away from your current cash flows, or is that cash needed for something else? What other expenses are coming up in your life?
- Diversification: Be cautious about putting “too many eggs in one basket.” If you rely on your company salary to save for retirement and/or meet your financial independence goals, overreliance on company stock or deferred compensation could create pressure if your company fails to perform. Work with your financial advisor to review your personal balance sheet and create a personalized plan that mitigates risk, such as reinvesting ESPP share proceeds into mutual funds or ETFs. If you intend to hold your ESPP shares for a longer term, this should be considered alongside your targets for stocks, bonds, and alternative investments for your portfolio.
- Compliance: If your job gives you access to material nonpublic information, you may be subject to restrictions on when you can sell the stock after it’s been acquired. In this case, a 10b5-1 plan could be utilized for diversifying shares at predetermined intervals and price points. If your role requires you to maintain a certain amount of stock exposure, an ESPP can help you reach your threshold, but you should be cautious of your minimums when contemplating sales. When in doubt, review the plan document with your advisors and consult with your HR/benefits department with specific questions on the plan.
- Loss recovery: Stock that’s obtained through an ESPP is treated the same as stock that’s purchased through the open market. Therefore, if you sell your company stock at a loss within a 30-day window before or after the ESPP shares have been obtained, it will cause a wash-sale violation, and the loss will be disallowed. If you receive stock compensation, such as vesting restricted stock units or exercising options, this should be considered when contemplating sales of shares obtained through an ESPP.
- Potential complications: If you’re considering leaving your employer while participating in an ESPP, be aware that shares could end up being purchased with deductions from final pay checks. Also, if the plan allows for it, remember to add beneficiary elections.
Summing it all up
ESPPs offer substantial advantages but require strategic planning to make sure your company’s offering is right for you. Work with your financial advisor and tax professionals to understand the intricacies of your ESPP, understand the risks, and address potential challenges upfront to maximize the benefits when it’s time to sell.