What You Should Know about Employee Stock Purchase Plans (ESPP)

An employee stock purchase plan, or ESPP, is an employee benefit that allows employees to purchase company stock via payroll deductions. If you have an ESPP, you can often purchase shares at a discounted price to the fair market value. Some companies offer a discount as high as 15%.

Generally, employee stock purchase plans are offered in an effort to incentivize employees. Over time, with regular and consistent participation, an employee may be able to increase their total compensation by participating in the plan.

That increase is usually due to the combination of receiving a discounted purchase price, a look-back provision, and an appreciating stock price. An increasing stock price is a shared benefit for the employee and the employer.  Simply stated, if the company does well and if the stock price goes up, everyone wins.

Let’s dig further into how an employee stock purchase plan works, what the benefits may be, and what you should think about from a tax perspective.

The Workings of an Employee Stock Purchase Plan

Not all companies offer ESPPs, and employers are under no obligation to do so. If your company happens to provide an employee stock purchase plan as a benefit, you may want to reach out to HR to learn the details of your plan.

The details can often be obtained via a plan document. Once you read the plan document and enroll in the plan, you can begin making contributions to your ESPP through payroll deductions using after-tax dollars.

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The employer typically holds the contributions made from all employees in an escrow account. Then, on a pre-set schedule (often every six months), the company uses the money in the escrow account to purchase company shares for everyone who participates.

When your shares are purchased, they’re usually deposited into a brokerage account that your company chooses. Once in the brokerage account, you can likely treat them like any other investment you own — meaning you can sell them at your leisure (although you should check your plan document to be sure of your plans specific rules regarding what you can do with your shares).

What Price Do I Pay for My Shares?

Employee stock purchase plans can give plan participants an advantage in purchase price compared to buying those same shares on the open market. Specifically, they can offer one or both of the following:

• A discount from fair market value, up to 15%
• A look-back provision

To determine how your ESPP works, check your plan document.

If yours offers a discount, then it might allow you to buy shares at a lower price than what you can on the open market. For example, if you can buy shares at a 15% discount you can buy company stock worth $100 at $85 a share.

If you have a look-back provision, things get a little more complicated. A look-back provision allows the employer to set the purchase price of the plan shares at the lesser of:

1. The fair market value on the offer date OR
2. The fair market value on the purchase date.

To understand how this works, say the fair market value (FMV) of the stock price on the purchase date is $100. We then need to know the FMV on the offer date, a date that often occurs several months or more prior to the purchase date.

The price on the offer date was either higher or lower than the current $100 per share value. For illustrative purposes, let’s just assume the higher value was $120 and the lower value was $80.

On the purchase date of the stock, you can buy shares through your ESPP at the best price — which is the lower of the purchase date price or the offer date price — plus the 15% discount!

The Right Moves to Make Based on the Movement of the Fair Market Value

If the fair market value of the stock goes down in value between the offer date and the purchase date, the plan participants would buy shares at the purchase date price, as illustrated below:

If the fair market value goes up in value from the offer date to the purchase date, the plan participants would buy the shares at the offer date.  With this scenario, it’s possible that the ESPP becomes even more value for the participant.

As you can see from the chart, plan participants would be able to purchase the company stock, currently valued at $100 per share, for $68. This is an immediate value-add of $32 per share (or almost 50%).

What About Taxes on Your ESPP?

When you buy company stock through an employee stock purchase plan, you pay nothing in taxes.  You also use after-tax dollars to make the purchase.

Upon selling the stock, however, you will owe taxes. It’s possible that you will owe ordinary income taxes on the total amount of gain, which is the difference between the discounted purchase price and the fair market value as of the date of sale.

It’s also possible that the discount received on the purchase price will be taxed as ordinary income — but the gain above the discount to the final sale price will receive a lower-rate, long-term capital gains tax treatment.

Ultimately, how much you owe in taxes will depend on whether the stock sale is a qualifying disposition or a disqualifying disposition.

What Is a Qualifying Disposition?

A qualifying disposition of stock from an employee stock purchase plan must meet the following criteria:

1. The stock must have been held for at least one year from the original purchase date.
2. The stock must have been held for at least two years from the original offer date.

If your situation meets these criteria, the discount received will be taxed as ordinary income, and the gain in excess of the discount will be capital gains.

Continuing our example from above, we have added a line for the final sale price:

Assuming that the final sale transaction meets the standards for qualifying disposition, we can calculate the subsequent tax impact as follows:

• The amount taxed as ordinary income:
  • $80 x 15% = $12 per share
• The amount taxed as capital gains:
  • $150 – $80 = $70

If we assume a 33% tax bracket for ordinary income and a 15% tax bracket for capital gains, we can calculate the tax impact to be $14.46 per share.

What Is a Disqualifying Disposition?

A disqualifying disposition is anything that does not meet the criteria for the qualifying disposition discussed above. With a disqualifying disposition, it’s possible that some portion of the gain will be taxed as ordinary income and some portion as a capital gain (either short term or long term).

Following the example above, we can illustrate the tax impact in this situation, too:

• The amount taxed as ordinary income:
  • $150 – $68 = $82 per share

Assuming the same 33% tax bracket as above, the tax impact is $27.06 per share, or nearly twice as much. Clearly, the benefit of a qualifying disposition on an appreciating stock can be meaningful — but keep in mind holding on to the stock long enough to meet the criteria leaves you subject to the risk-reward trade-off and inherent volatility of equity investing.

Should I Participate in My Employee Stock Purchase Plan?

Employee stock purchase plans can be a beneficial way to increase your overall net worth if used appropriately.

However, it’s important to note that all investing carries with it the risk of losing money. Employee stock purchase plans are no different.

It’s easy to run hypothetical examples that illustrate the benefits of owning employee stock, and it’s equally easy to become enamored with purchasing stock at a 15% discount.

Before you decide to participate in your employee stock purchase plan, you should consider a number of things:

• Can I afford to purchase stock?
• Am I saving elsewhere?
• Do I already own company stock through other plans (i.e., options or restricted stock)?
• Am I okay with market volatility?
• Do I already own too much company stock?
• Do I have a strategy in place to hold and/or liquidate my stock?

As always, the decision to participate or not is one that should be made in a vacuum. The decision to participate should be weighed with and against the other pieces of your 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, the 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.