If you work at a publicly-traded company, your compensation and benefits offerings may look a little different. Stock options are becoming more popular thanks to a boom in tech start-ups, and employees across all industries are starting to see these perks appear as a part of their compensation packages.
One popular offering is an employee stock purchase plan or ESPP. Before taking advantage of this particular plan, it’s important to understand what exactly an ESPP is, how it will impact your paycheck, and the potential tax obligations. Here’s our assessment and insights on ESPPs for employees.
An Employee Stock Purchase Plan (ESPP) allows employees of publicly traded companies to purchase company stock at a discounted price. This offering is completely voluntary and only offered to employees with less than five percent equity in the company.
Similar to insurance deductibles or 401(k) contributions, you can opt in to have a portion of your paycheck automatically deducted and held in the plan until the purchase date (more on this later). Your ESPP is funded with after-tax dollars, meaning the deductions won’t lower your taxable income for the year.
The company will take the deductions and purchase shares on your behalf at a discounted rate, sometimes as much as 15% off\! The IRS caps yearly contributions to an ESPP at $25,000, although your employer may also have their own contribution limits.
4 Terms to Know
There are a few key concepts to know about ESPPs, which we’ve highlighted below.
The offering period refers to the time when your payroll deductions start accruing. The offering period will consist of purchase periods, which are typically six or twelve months long.
At the end of a purchase period, you will have the opportunity to buy shares at a discounted rate (this is known as the purchase date).
Grant Date or Offering Date
As we mentioned above, it’s totally optional to participate in your company’s ESPP. If you decide to participate, the grant or offering date simply refers to the day the payroll deductions begin.
The purchase date falls on the last day of the purchase period. On this day, the company will purchase stocks on your behalf using the income you deferred during the offering period.
Some ESPPs will include a look-back provision, which can provide an even greater deal on prices, especially when combined with the plan’s discount.
A look-back provision enables you to buy the stock at the best price. With this provision, you can purchase company stock at two points, either,
- At the beginning of the offering period, or
- At the end of the purchase period, whichever is lower.
For example, let’s assume your company gives a 15% discount on stocks you buy via their ESPP, and there’s a look-back provision. Say your company’s stock price is $20 a share on the first day of the offer period. By the purchase day, shares have risen to $30 a share.
In this case, the price was better at the beginning of the offering period. With your discount, you’d pay $17 ($20 minus 15% discount). Compared to the current $30 share price, that’s a deep discount!
Qualified vs. Non-Qualified ESPPs
Your plan will either be a qualified or a non-qualified ESPP.
Qualified ESPPs are also known as section 435 plans. They must meet specific requirements regulated by the U.S. Securities and Exchange Commission (SEC) and may offer preferential tax treatment. Because of this, these plans tend to be more restrictive than non-qualified ESPPs.
The primary tax advantage of a qualified ESPP is that the discount the company gave you to buy the stock isn’t recognized as taxable income, at least until you sell.
Once you sell, the gain will be taxed as ordinary income if there was an increase in stock value. If you’ve held the stock for more than a year, it’d be taxed as capital gains, which is a lower tax rate.
Because non-qualified ESPPs aren’t regulated by the SEC, they tend to offer more flexible requirements but don’t include any tax advantages.
Qualifying vs. Disqualifying Dispositions
Speaking of selling your stock, it’s important to understand the difference between qualifying and disqualifying dispositions.
A qualifying disposition occurs if the sale of your stock is at least one year from the purchase date and at least two years from the grant date. In terms of taxes, you’ll likely pay a combination of ordinary income tax and long-term capital gain tax.
The ordinary income tax rate would apply to either the discount you initially received when purchasing the company stock or the “spread” of the purchase price and final sale price, whichever is lower.
Whichever of the above did not receive ordinary income tax would be subject to capital gains tax.
If you sell your stock less than a year from the purchase date or less than two years from the grant date, the sale will count as a disqualifying disposition.
Again, you can expect a combination of ordinary income tax and capital gains tax in terms of taxes. You’ll be responsible for paying income tax on the difference between the purchase price and the fair market value when you buy the stock.
You’ll also have to pay capital gains tax when you sell the stock, either short- or long-term, depending on how long you held it.
Should You Participate In Your Company’s ESPP?
We like to remind our clients that an ESPP is an investment, not a cash flow fulfillment like a 401(k).
We recommend checking other items off your financial to-do list first, like maxing out retirement savings accounts, paying down debt, contributing to your emergency savings, and addressing other long-term goals. If there’s excess leftover each month, an ESPP could be an excellent next move.
Another important reminder—if you have other stock awards in your portfolio like RSUs, participating in an ESPP may actually make you over concentrated in your company’s stock.
Under the right circumstances, an ESPP can be lucrative for employees with its deep discount and look-back provisions. But before moving money around, we recommend checking in with your financial advisor first.
Our team would be happy to take a look at your current employer offerings, including ESPPs and other stock options. Feel free to schedule a complimentary 45-minute strategy session with us to learn how we may be able to help.