Employee Stock Purchase Plans (ESPP) – What Are They And Should You Participate?

Employee Stock Purchase Plans (ESPP) are a program that allows participating employees to purchase their employer’s stock at a discounted price. ESPPs are one benefit many large employers offer that many employees don’t fully participate in. Which is too bad as they can be fairly lucrative. These are sometimes called employee stock ownership plans (ESOP).

Luckily, ~1/2 of the companies in this survey offered an employee stock purchase plan and many sectors have higher rates.

When you enroll, you contribute to the plan through payroll deductions that build up over the offering period. The accumulated money is then used to purchase shares of the company.

Learn all about employee stock purchase plans, if you should participate, and how to best maximize their value.

What Is An Employee Stock Purchase Plan (ESPP)?

Employee stock purchase plans (ESPP) are a company-run program that allows employees to purchase stocks at a discount. Employees opt in to the program and contribute money through payroll deductions. Between the offering date and the purchase date funds accumulate and then shares are bought on the purchase date.

Each plan can be a different, but most plans offer 10-15% discounts to the market price for participating employees.

Many ESPPs have a ‘look back’ provision as well. This takes the lowest price of multiple points over the period and then applies the discounted rate. A common look back provision is to use the lower of the price of the offering date (beginning of the period) and purchase date (end of the period). This means if the stock price increases over the period, you can get an even larger discount.

Qualified Vs. Non-qualified Employee Stock purchase Plans

Employee stock purchase plans are categorized into 2 groups: qualified and non-qualified. The differences in the 2 plans are laid out in section 423 of the IRS code.

Qualified ESPPs require shareholder approval before being implemented. After the program is put in place, qualified plan participants have equal rights. Additionally, there are restrictions around the offering period length (3 year max) and the price discount (15% max).

Non-qualified ESPPs have less restrictions, however they don’t have as many tax advantages.

How Do Employee Stock Purchase Plans Work?

ESPPs are typically open to all employees at the company who have been employed for a specified duration. This is usually 1-year of employment. Additionally, individuals who own a large amount of the company’s shares may be excluded. This is usually set at 5% of the company’s stock.

When you opt-in to your company’s ESPP, you elect a contribution amount to be payroll deducted. Many company’s have a 10% max contribution rate, though the number may be higher or lower. However, there is a max annual cap of $25,000 set by the IRS.

[Professor B.T. Effer Note – many resources misrepresent the $25,000 limit. The $25,000 isn’t the amount you can contribute, but the value of the undiscounted stock price on the first day of the offering period. If you get a 15% discount, that means you can contribute 85% of the $25,000 or $21,250 in a given year.]

Participation in the company ESPP starts after the offering period begins. The offering period begins with the offering date, which is also the grant date for the stock purchase plans. The offering period ends on the purchase date. At this point all the accumulated funds are used to purchase shares of the company stock.

Example of Look-Back Provision

The look-back provision is a popular feature on ESPP plans. The most common version takes the lower of the stock price on the offering date and purchase date (ie- the beginning and end of the period).

For example, assume your company has an ESPP with a 15% discount and a look-back provision. At the beginning of the offer period the stock price is $100 and it increases to $120 by the purchase date. With a look-back provision, you get the 15% discount off the lower price of the 2 dates. This means your purchase price would be $85 (15% discount to $100 price). Since the stock is now worth $120, that means the actual discount to the current market is well over 15%.

Employee Stock Purchase Plan Key Dates

There are many different dates involved with the ESPP process. Some of the key dates are:

1. Enrollment Period: The enrollment period is the period where the employee can choose to enroll into the program or not
2. Offering Date: Offering date is the period when your payroll deductions start
3. Offering Period: This is the period between the offering date and the purchase date where you make contributions. This period can be a maximum of 27 months.
4. Purchase Period: The purchase period is a sub-period within the offering period. In general, this occurs every 3 or 6 months.
5. Purchase Date: The purchase date is the last day of the purchase period and when all the previous contributions are used to buy stock.

Tax Rules of ESPPs

The taxation of ESPPs can be complex. In general, you are taxed during the year you sell the stock. You don’t pay taxes on the discount the year you purchase the stock. If you hold the shares long enough to be considered a ‘qualifying disposition’, then you receive more beneficial tax treatment.

Tax-qualified ESPPs get beneficial tax treatment (qualified disposition) if held:

• 2 years from the start of the offering and
• 1 year from purchase

Most plans have offering periods 1 year or less, so 2 years from the start of the offering period will be more than 1 year from your purchase and the binding clause. But since the max offering period can be up to 3 years, this isn’t always the case.

There are 3 tax rates to be aware of with employee stock purchase plans:

1. Ordinary Tax Rate: Tax you pay on your income / earnings
2. Short-Term Capital Gains: Tax rate on short-term holdings, less than 1 year from purchase date
3. Long-Term Capital Gains: Tax rate on long-term holdings, more than 1 year from purchase date

Currently, the long-term capital gain rate is likely the lowest and most beneficial rate. Additionally, capital gains can be offset by realized losses in other investments as part of a tax-loss harvesting strategy. It is generally true that the less ordinary income tax you pay on your ESPP the better it is from a tax perspective.

Tax Treatment of ESPP – Example

[Note – Nothing here is considered tax advice, nor are we tax advisors. Work with your own tax expert. The below example is for informational purposes only.]

Depending on if your sale is considered a qualifying or disqualifying disposition will greatly impact your tax situation.

Qualifying dispositions get beneficial tax treatment. You will only pay ordinary taxes on the discounted amount. Any other gain or loss will be treated as a capital gain. Additionally, since you held the shares for 1 year since purchase to qualify, the capital gains are taxed at the preferential long-term capital gains rate.

A disqualifying disposition you have a higher proportion of the sale being taxed as ordinary income and less as a capital gain.

It is important to note, that if you sell for a loss, the ordinary tax amounts don’t change, but the capital gains become capital losses. This is one of the downsides of an ESPP, you can sell at a loss and still owe taxes on the discount you received when you purchased the shares.

Example Qualifying Disposition

If you to meet the holding-period requirement of 2 years from the offering/grant date and 1 year from the purchase, it is called a “qualifying disposition”. (A disposition is any sale, transfer or gift of the stock, but not including transfers to a spouse, broker, for a divorce, or death.)

In the above example you purchased the shares at a $100 pre-discounted price, due to the look back. Therefor, the price you paid was $85.

If you make a qualifying disposition, you are only taxed at the ordinary income rate for the $15 discount. The $40 capital gain is based on the sale price of $140 and the pre-discounted purchase price of $100.

If you sold the shares at a loss, say $80. Then your ordinary income is still $15 and you have a $20 long-term capital loss ($100 pre-discounted price and $80 sale price).

Example Disqualifying Disposition (Sell Too Soon)

If you fail to meet the holding-period requirement of 2 years from the offering/grant date and 1 year from the purchase, it is called a “disqualifying disposition”.

[Professor B.T. Effer Note – Many ESPP participants get tripped up here due to the 2 clauses and that a 1 year holding period is required for long-term capital gain treatment. For most plans, you need to hold the shares 2 years from the start of the offering period.]

In the above example, the price of the shares on your purchase date was $120, but since you had a look back provision you only paid on the lower $100 amount. The ordinary income includes the 15% discount and the benefit you received from the look back provision ($20).

Therefore, $15 from the discount and $20 from the look back equates to $35 taxed at your ordinary income rate. The remaining $20 is taxed as a capital gain ($140 sale price minus $120 price at purchase date).

But if you sold your shares less than 1 year after the purchase date as part of the early sale, you will get the higher short-term capital gains rate.

Therefore, if you don’t wait the full time to be a qualifying disposition, you still need to wait 1 year from purchase to get a lower tax rate on any capital gains.

Pros and Cons of ESPP

Employee stock purchase plans can be a useful benefit offered by your employer. However, there are also downsides to participating. You should review your personal financial situation and decide if participating is the right decision for you.

Benefits of ESPP Participation

The biggest benefits of participating in your company ESPP are:

1. Easy to do: Since contributions are collected directly through payroll deductions, it typically is a few clicks and selecting an allocation to opt-in.
2. Boosts Your Savings: Easy and cost-efficient way to save & invest. Since the money is already in the market, you can choose to transfer any sales into your brokerage account and reinvest in the market.
3. Free Money: Since you are buying shares at a discount, you are getting free money from your employer.
4. Look-Back Provisions: If your company stock price goes up, you can gain an even bigger discount vs. current market price with a look-back provision.
5. Tax Benefits: Qualifying dispositions allow for you to pay a long-term capital gains tax rate which tends to be preferential.
6. Optional: There is no obligation to participate and you can stop contributing at any time.

Downsides of ESPPs

Despite all the benefits, there are some downsides to ESPPs:

1. Restrictions: There are restrictions on if you can participate (ie- 1 year work experience) and a cap on how much you can contribute each calendar year.
2. Locked Up Funds: During the offering period, your contributions are likely illiquid until after the purchase date.
3. More Employer Exposure: Your financials are already heavily dependent on your employer’s performance. ESPP ties your finances even more to your employer.
4. Complicated Taxes: The taxation of ESPP is more complicated than other investment accounts.
5. Closed Trading Windows: If you are restricted from trading company stock during quiet periods, it increases the risk of the stock going down after earnings and before you can sell.

The Final Word

Employee stock purchase plans can be a tremendous benefit from your employer. Being able to buy stocks at a large discount to market value and sell them almost immediately can result in ‘free’ money.

The large discounts to market value you receive, and potential for look-back provisions, make ESPPs a potentially inexpensive way to accumulate company stock.

However, ESPP have complicated taxes and concentrate even more of your finances in your current employer.

It is important to consider all aspects of the decision around enrolling in your company ESPP.

Frequently Asked Questions (FAQs):