Employee stock purchase plans (ESPPs) can be a great wealth-building tool in your financial plan. Read below to understand how ESPPs work, tax implications, and things to consider before participating in an ESPP.
What is an Employee Stock Purchase Plan (ESPP)?
An employee stock purchase plan (ESPP) is an employee benefit that allows employees to purchase company stock at a discount through payroll deferral. The discount may be as much as 15%.
The IRS restricts contributions to ESPPs to $25,000 per year. And your company may further restrict participation; for example, you may only defer 15% of your salary into the ESPP.
Key features of ESPPs (discounts, offering periods, purchasing periods, lookback provisions, etc.) will also differ by employer.
Key Definitions and Features of Employee Stock Purchase Plans
ESPPs come with their own set of important definitions and tax implications. While the definitions and tax treatment are consistent from plan to plan, each employer may elect different features.
Key definitions to understand your ESPP include:
- Discount – the reduced-price participants are able to purchase employer shares through the ESPP
- Lookback provision – an optional (and highly valuable) feature of ESPPs where the discount is applied to the lower of either (1) the price at the beginning of the offering period or (2) the price on the purchase date
- Enrollment Period – when you may elect to participate in your employer’s ESPP
- Grant Date – typically the first day of the enrollment period and starts the clock for qualifying dispositions
- Offering Period – the beginning of the purchase period and when salary deferrals begin, typically 6-month increments but may be up to 27 months
- Purchase Period – a timeframe within an offering period specifying the frequency of share purchases
- Purchase Date – when your payroll deductions are used to purchase shares
- Sale Date – when you sell your shares obtained through the ESPP
Example of an ESPP Timeline
Below is an illustration of an ESPP timeline. In this example, the enrollment period for the ESPP is the month of December and the grant date (for tax purposes) is December 1st. The offering period is the next calendar year, during which there are two 6-month purchasing periods.
If you were to participate in this ESPP, you would choose to enroll in December and specify your payroll deduction. Payroll deductions would take place during the offering period. On June 30th and December 31st shares would be purchased at the discount specified in the plan.
If your company offered a lookback provision, shares would be purchased at a discount to the price on the purchase date or the price at the beginning of the offering period, whichever is lower. For example, if your company share price was $20 on January 1st and $25 on June 30th, with a lookback provision you would purchase the shares at a discount to the January 1st ($20) price.
Tax Treatment of Employee Stock Purchase Plans
Taxes do not come into play until you sell your shares (meaning the purchase date is not a taxable event).
The tax treatment of your sale depends on how long you held onto the shares after purchase. This holding period determines whether your sale is a qualifying or disqualifying disposition.
A qualifying disposition requires you to hold your shares:
- At least 2 years from the grant date and
- 1 year from the purchase date
A disqualifying disposition is any sale that does not meet both of these criteria.
Although qualifying dispositions receive favorable tax treatment, they require a longer holding period and increase your exposure to your company stock.
Qualifying Disposition Taxation
If you hold shares acquired through an ESPP for two years from the grant date and one year from the purchase date, gains will receive preferential tax treatment. Although the discount you initially received as part of the plan will be taxed as ordinary income, additional gains will be taxed as long-term capital gains (typically a much lower tax rate).
For example, suppose your company stock is trading at $10 on the purchase date and you pay $8.50 per share after the 15% discount is applied. If you meet the holding period requirements for a qualifying disposition and your company’s stock climbs to $12, then you would pay ordinary income tax on the bargain element of $1.50 ($10.00 - $8.50) and long-term capital gains taxes on the gain of $2.00 ($12.00 - $10.00).
Disqualifying Disposition Taxation
If you do not meet the holding period requirements, then your sale is a disqualifying disposition. In this case, the bargain element is taxed as ordinary income (same as a qualifying disposition), and any gains in the stock are also taxed as ordinary income or short-term capital gains (which are the same as ordinary income).
In the previous example, the entire $3.50 difference between the sale price ($12.00) and your cost basis ($8.50) would be taxed at ordinary income rates.
Qualifying vs. Disqualifying Disposition Example
Below is a comparison of the taxation and resulting after-tax value of a qualifying vs. a disqualifying disposition. The example assumes a 30% marginal income tax rate, maximizing ESPP contributions ($25,000), and a 20% gain in the shares from the purchase date to the sale date.
Key takeaways from this example are:
- The bargain element (the discount) is treated as ordinary income regardless of the disposition type
- The main difference is the tax rate on capital gains
- The greater the difference between your ordinary income rate and long-term capital gains rate, the greater the benefit of a qualifying disposition
- The greater the increase in share price, the greater the benefit of a qualifying disposition
- The after-tax gain difference is $750 ($6,875 - $6,125)
Although the qualifying disposition results in a greater after-tax gain, the risks and opportunity costs of this strategy must be considered relative to the potential benefit. Qualifying dispositions require a longer holding period, greater company stock concentration, and you forego opportunities (other investments, spending, savings).
Should you participate in your employer’s ESPP?
Although the guaranteed discount on your employer’s stock may seem like a no-brainer, the following are considerations before deciding whether to participate in your employer’s ESPP.
Cash Flow & Emergency Fund
Participating in an ESPP means additional payroll deductions. Before electing to defer more money from your paycheck, ensure you have the month-to-month cash flow to sustain your lifestyle and firm financial footing.
The guaranteed discount on company stock is great, but not if you’re risking high-interest consumer debt to make it through the next purchasing period.
The discounts offered by ESPPs can range from 0-15%. The greater the discount, the more attractive the plan.
The lookback provision is a powerful feature that makes participating in an ESPP far more attractive. This provision creates far greater potential upside.
For example, suppose your company offers a 15% discount with a lookback provision. If the stock price was $10 on the offering date and climbed to $12 on the purchase date, instead of receiving the 15% discount off the $12 purchase date price, you would receive the 15% discount on the $10 offering date price ($8.50).
Instead of a 15% discount, you effectively receive a 29% discount ($3.50/$12.00).
Company Stock Concentration
Prior to purchasing shares through an ESPP, have a plan for what you will do with the shares and how they fit into your financial plan.
At the time you purchase the shares through your ESPP, you will have received the main benefit of participation: the discount. Choosing to hold onto company shares may allow for a qualifying disposition, but will also increase your individual stock concentration risk.
Reviewing your Company's ESPP
ESPPs have great potential as a tool for your financial plan, but can understandably feel daunting given the terminology that accompanies these plans. Review this post along with your company's ESPP details to better understand your plan and how it may fit into your finances.