Many employers offer an employee stock purchase plan, or ESPP, to allow employees to purchase company stock with ease. As an incentive to participate, many ESPPs allow you to purchase stock at a discount from the current market price. ESPP’s may also allow for a lookback provision, adding benefit to the employee.
Each ESPP comes with its own specific set of rules, but that discount might be as much as 15% if you have a qualified plan. That makes the argument for participating in this kind of plan appealing – but that doesn’t mean you should always participate.
Before determining if you should participate or not, you should have a thorough understanding of your plan’s rules and benefits. Read your plan document and ask HR if you have any questions – or work with a financial advisor who can help you sort through the details.
Assuming it does make sense to participate in your plan, you should then consider how to optimize your plan’s benefits best. In this article, we’ll walk through several strategies that you could use when participating in (and eventually selling stock from) an employee stock purchase plan.
An Introduction to Your Employee Stock Purchase Plan
Generally speaking, your plan will follow the following process (again, consult your plan document for specific rules about your program):
Your company establishes an ESPP and sets an offering date and offering period. The offering date is the date the plan starts, and the offering period is how long from the offering date you can purchase shares.
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- You enroll in the ESPP by electing to defer a percentage of income or dollar amount from your paycheck into the plan (subject to certain limits set by the plan document or an annual IRS limit of $25,000).
At predetermined intervals set by the plan, the ESPP uses your deferred dollars to buy shares of company stock. The price you pay for your shares via the ESPP may be the lower of either the fair market value on the offer date or the fair market value on the purchase date. The option to purchase shares at the offer date price is commonly referred to as a look-back provision.
- If your plan offers a discount from the purchase price, that discount will be applied to the purchase price paid.
Often, you’ll find that each purchase period lasts for 6 months. During this 6-month period, the ESPP collects your deferred dollars. Then, at the end of the 6-month period, the ESPP buys the stock.
Once the shares are purchased, you are subject to the normal risk of owning stock, and you should have a strategy in place to manage that risk.
The Strategies You Should Know for Your Employee Stock Purchase Plan
While there are many possible outcomes for how and when you sell your ESPP shares, we can simplify with two ideas:
- Selling your shares as soon as possible.
- Holding your shares for a specific time period.
Choosing one of these two strategies isn’t quite as simple, though. Depending on how when and how you sell your shares, there may be different things to consider regarding income tax, investment risk, plan rules, and concentrated equity – all of which should influence which option you choose.
Let’s explore in a bit more detail assuming that your plan offers a discount and a look-back provision.
Option 1: Sell Your ESPP Shares as Soon as Possible
You could make the argument that selling ASAP is the best strategy because selling your shares immediately allows you to capture any immediate gain thanks to the fact you bought at a discount but can sell at the current fair market value.
For example, let’s assume that your company shares are currently trading at $50 per share and the company offers a 15% discount. If you choose to sell right away, you buy shares for $42.50 and sell for $50. That’s an immediate gain of $7.5 per share, just because you got to buy at a discount.
The thought behind an immediate sale may be to capture your value and eliminate the potential for loss via a falling stock price. The beauty of this immediate sale of your ESPP is that there may be little risk when you participate (but be sure to check with your plan document before deciding to run with this strategy. Not all ESPPs allow you to sell your shares immediately after purchase).
Assuming you can sell ASAP and that you have a lookback provision on your plan, let’s look at the possible outcomes of using your ESPP this way in three different scenarios. We assume the stock price goes up, the stock price stays the same, and the stock price goes down between the offer date and the purchase date. Let us also assume that the offering date price for the stock is $50 per share.
| Scenario w/ Look Back | Stock Price Goes Up | Stock Price Stays the Same | Stock Price Goes Down |
| Offer Date Price | $50 | $50 | $50 |
| Purchase Date Price | $100 | $50 | $25 |
| Discount (15%) | ($7.50) | ($7.50) | ($3.75) |
| Purchase Price | $42.50 | $42.50 | $21.25 |
| Final Sale Price | $100 | $50 | $25 |
| Profit | $57.50 | $7.50 | $3.75 |
In this example, you’ll see that all the scenarios produce a profit.
If the stock price increases between the offer date and the purchase date and you have a lookback provision, you may be able to purchase shares at the better of the purchase date price and the offer date price. This means you can purchase shares via the ESPP at $50, when the current market price (the purchase date price) is $100. (This is a visual example of the value of the “look-back” provision.) On top of all that you get a 15% discount from the $50 offer date price, so your actual purchase price is $42.50 per share.
When you review the down-market scenario, when the purchase date price is lower than the offer date price, you again will see a profit. This is because you are able to purchase shares at the lower of the offer date price of $50 and the purchase date price of $25, less the 15% discounts.
The illustration that you may be able to purchase shares at the better of the two prices means that you may be protected from a down market during the offering period. If the price goes down, shares are purchased at the lowest price. As the example shows, even in a down market, you can buy the shares for $42.50 (purchase date price less a discount) and might be able to immediately sell them for $50.
Option 2: Holding Employee Stock Purchase Plan Stock for a Period of Time
It’s easy to illustrate why an employee stock purchase plan may be a great deal for employees. But in practice, it can be difficult to remain diligent in implementing your personal strategy to sell. Whether out of guilt for selling company stock, not being “part of the team,” or even forgetfulness at best, there are many reasons why someone may not follow through on their goal to sell.
If you elect to hold your employee stock purchase plan shares beyond the point of option 1, you may need to consider market volatility, tax, concentrated equity, and other financial planning issues.
You also should know the difference between a qualifying and disqualifying disposition. If you meet the standard for a qualifying disposition, a portion of the gain (if any) may be subject to preferential long-term capital gains treatment.
A qualifying disposition of ESPP shares is anything that meets the following standards:
- The stock must be held for at least 1 year past the original purchase date
- The stock must be held for at least 2 years after the original offer date
Anything that is not a qualifying disposition is a disqualifying disposition.
The preferential tax treatment of the qualifying disposition comes with a risk: holding potentially volatile company stock. It’s possible that during the time you hold the stock, the stock price could go down and any or all value could be wiped out, including what you paid for the stock (to be fair, it’s also possible that the stock price could go up).
If we make an assumption that the stock does not move and that you hold the stock long enough to make the transaction eligible for a qualifying disposition and we continue our example from above, we can calculate the tax impact to the profit as follows:
| Scenario | Stock Price Goes Up | Stock Price is Flat | Stock Price Goes Down |
| Profit | $57.50 | $7.50 | $3.75 |
| Amount Ordinary Income | $7.50 | $7.50 | $3.75 |
| Ordinary Income (32%) | ($2.40) | ($2.40) | ($1.20) |
| Amount Capital Gains | $50 | $0.00 | $0.00 |
| Capital Gains (15%) | ($7.50) | ($0.00) | ($0.00) |
| Total Tax | ($9.90) | ($2.40) | ($1.20) |
| After-Tax Profit | $47.60 | $5.10 | $2.55 |
The after-tax proceeds in all scenarios assuming a qualifying disposition in our example all result in a profitable outcome.
How Stock Performance May Drive the Final Outcome of your ESPP More than Tax
In our example above, we illustrated a stock price that has the same value on day 1 as it does 1 year later. However, it is more reasonable to assume that the stock price will fluctuate. If the stock price increases, you may benefit from a greater final sales price. If the stock price decreases, you may end up with little to no profit at all. It’s possible, in fact, that any tax benefit you were hoping to capture via a qualifying disposition can be lost as the stock price goes down.
Let’s assume that the price of the stock decreases by 30% from the date the shares are purchased to the date the shares are sold. An updated illustration may look like this.
| Purchase Date Price | $100 | $50 | $25 |
| Discount (15%) | ($7.50) | ($7.50) | ($3.75) |
| Purchase Price | $42.50 | $42.50 | $21.25 |
| Final Sale Price (30% less) | $70.00 | $35.00 | $17.50 |
| Profit /Loss | $27.50 | ($7.50) | ($3.75) |
As you can see, a changing market may change the profitably of your ESPP shares. If the spread between the purchase price and the offering price is big, there is more room for the price to fall before your transaction ends in a loss. The closer the offering price and the purchase price are to one another, the less room for market fluctuations before resulting in a loss.
Therefore, the big question you may want to ask yourself is, is it worth the risk of holding your company stock for at an additional year after purchase with the primary purpose of achieving preferential tax treatment?
What Does This Tell Us About Employee Stock Purchase Plans?
If you are simply looking to cash in the proceeds of your ESPP, an immediate sale of your employee stock purchase plan shares may be a great idea.
As you hold your stock longer in an attempt to pay a potentially preferential tax rate, you may be taking investment risk that might not be worth the corresponding payoff. By holding the company stock, you assume the risk of market fluctuations and you should balance the upside opportunity with downside risk.
The potential tax benefit of a qualifying disposition, as illustrated by the simple example above, is a “nice to have.” It likely should not be the only reason to hold your shares.
Your ESPP is a great way to create wealth if you plan accordingly and execute that plan well. That plan should consider the risk you are willing to take with your employee stock purchase plan and how the company shares fit into your overall financial plan.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.
I think another consideration should be whether or not the ESPP stock pays a quarterly dividend. In my case, my ESPP shares have an annual dividend yield of nearly 3.5%. The share price has been moderately increasing for the past few years, and my discount is 15% on a biweekly purchase. This has led me to maintain a buy and hold strategy, and I hit the annual IRS limit.