An Employee Stock Purchase Plan (ESPP) is a company sponsored benefit program that allows employees to purchase stock in their employer at a discounted price via after tax salary deferrals. Typically you can contribute up to 15% of your salary in the plan up to the IRS limit of $25K per year.
Salary deferrals build up between the offering date of the plan and the purchase date. On the purchase date, your accumulated funds are used to purchase company stock at the discounted price. The usual discount on your purchase is 15% but can vary from 0-15% depending on the plan.
A typical plan has a 12-18 month offering period with purchase periods occurring every 6 months. The maximum offering period for a qualifying plan is 27 months.
“Lookback” provision
Some ESPPs have a “lookback” provision which allows the plan to use the historical closing price of the stock on the grant date, which is the 1st day of the offering period. This is a great deal for employees as it allows them to purchase stock at the lower price between the grant date and purchase date. For companies whose stock has appreciated a lot this can provide a significant windfall to employees who maximize their purchases in the plan.
Taxation
There are two components to taxation in an ESPP. The first is the discount rate you receive on the purchase date, which will count as ordinary income in the year the shares are sold.
The second component comes from selling your company stock. Sale of stock from a qualifying plan may receive preferential tax treatment so long as two conditions are met:
- Sale of shares is at least 2 years after the grant date
- Sale of shares is at least 1 year after the purchase date
When both of the above conditions are met in a qualifying plan then the difference between the undiscounted purchase price and the sale price will be treated as a capital gain.
Example
Let’s consider the following example. Jane Doe’s company offers an ESPP with a lookback provision and a purchase date 6 months from the grant date with a 15% discount. The plan is considered a qualified plan. On the grant date her employer’s stock trades for $100 per share, and it rises to $120 per share 6 months later on the purchase date.
Thanks to the lookback provision, Jane’s shares will be purchased at a discount to the lower price that existed on the grant date of $100 per share. After applying the discount of 15% she will purchase shares for $85. On the purchase date she will have ordinary income equal to $15 per share based on the 15% discount she received that will be taxable in the year she sells the shares.
- If Jane immediately sold her shares, she’d have additional ordinary income of $20 per share (the difference between the share price of $120 and her $100 undiscounted rate)
- If Jane held her shares for 18 months before selling the difference between the sale price and her undiscounted price of $100 would be treated as a capital gain
- Note that an 18 month holding period would satisfy the requirements of a sale date at least 2 years after the grant date and 1 year after the purchase date.
What I didn’t mention in the second scenario above is what the actual capital gain would be. That would depend on what happened to the stock price in the 18 months after the purchase price. The stock prices of a company can be highly volatile during an 18 month period and this is where some of the planning complexity around ESPPs comes into play.
It’s obviously better to receive preferential tax treatment and pay capital gains tax rates instead of ordinary income rates. However, many people already have too much risk and exposure tied into their employer. Not only does your employer provide you ongoing income and benefits, but many also have too much of their net worth concentrated in their employer via other equity compensation programs like Restricted Stock Units or Employee Stock Ownership Plans.
Thus it’s important to come up with a plan that takes into account your unique financial situation and the attractiveness of your employer’s stock to weigh the tax benefit of holding onto shares vs the risk you take in holding those shares.
Should I participate in my employer’s ESPP?
As long as you have the financial capacity to defer a portion of your salary and your employer offers a discount, absolutely! The discount provides risk free profit if you sell your shares on the purchase date. Thus it’s in your best financial interest to put as much of your salary as you can into your ESPP.
Scott Caufield, CFA, CPA