Why Your Employee Stock Purchase Plan May Be a Great Deal

ESPP or employee stock purchase plan

Employee stock purchase plan

Employee stock purchase plans allow for plan participants to purchase company stock at a discounted rate of up to 15% (subject to your specific plan rules, of course).

Based on this simple statement alone, one could argue that an employee stock option plan is something that all eligible employees should consider.

While this argument may hold water, it’s equally fair to assume that such a blanket statement is never that simple.  One reason is that each plan is different, and you should have a thorough understanding of your plan’s benefits before determining if you should participate.

Assuming that it makes sense to participate in your plan, it’s fair to assume that you should consider how to best optimize your plan’s benefits.

In today’s blog post, I will evaluate several strategies that one may employ when participating and subsequently selling the stock of an employee stock purchase plan.

The Simple Answer

Ultimately, the exercise strategies can be categorized into one of the following two options:

  1. Selling your shares as soon as possible.
  2. Holding your shares for any time period in excess of the first option.

Now that we know the exercise options, let’s establish a basic understanding of the mechanics of an employee stock purchase plan.  In short (please keep in mind that every plan is different and you should consult your specific plan to be sure):

  1. Your company offers a plan and sets an offering date and offering period
    1. The share price as of the offering date matters (see below)
    2. During the offering period, you elect to contribute after-tax dollars to the plan
  2. At pre-determined intervals, the plan uses dollars contributed by the employee participants to buy shares of company stock.
  3. The price paid by the plan for shares of company stock is the LOWER of 1) the fair market value on the offer date and2) the fair market value on the purchase date.
  4. Furthermore, you will receive a discount of up to 15% from the price paid in step three.

Now that you understand how to participate in a plan, and what the options are to exercise it, I’m sure that you’re asking yourself this key question.

What’s the best option?  Do I keep them?  Or do I sell them?

Option 1 – Sell The Shares As Soon As Possible

One could argue that the best strategy for participating in an employee stock purchase plan may be to sell your shares immediately after your shares are purchased (keep in mind that all plans may not let you sell your shares immediately after purchase.  Please check your plan details).

This strategy effectively locks in a gain to the plan participant equal to the value of the discount (less market timing and brokerage fees).

For example, let’s assume that the shares are currently trading at a hypothetical $100 per share and the company offers a 15% discount.   If the plan allows for the immediate sale of your shares, you can buy for $85 and sell for $100, locking in a $15 gain!

With this strategy, there is no consideration for holding the stock any longer than necessary.   There is also no consideration for income tax.  The plan participant is not interested in waiting for the stock to further appreciate.   They plan to sell, lock in the gain, and then invest or allocate the dollars elsewhere.

The beauty of this concept is that there is very little risk to the employee stock purchase plan participant.

Let’s explore the possible outcomes of a hypothetical employee stock purchase plan in five different markets.

Big Bull Up Market Flat Down Big Bear
Offer Price $100.00 $100.00 $100.00 $100.00 $100.00
Purchase Date Price $150.00 $125.00 $100.00 $75.00 $50.00
Purchase Price $100.00 $100.00 $100.00 $75.00 $50.00
Discount (15%) ($15.00) ($15.00) ($15.00) ($11.25) ($7.50)
Final Sale Price $85.00 $85.00 $85.00 $63.75 $42.50
Ordinary Income (33%) $21.45 $13.20 $4.95 $3.71 $2.48
After Tax Gain $43.55 $26.80 $10.05 $7.54 $5.03
After Tax Proceeds $128.55 $111.80 $95.05 $71.29 $47.53

 

As you might expect, a big bull market produces the highest net gain for the employee stock plan participant.  This benefit is leveraged by the fact that the plan is able to buy the shares at a discount from the offer price, even though the existing fair market value price is substantially higher.  This is a visual example of the value of the “look-back” provision.

However, even more eye-opening is the big bear market outcome.  Because the plan is allowed to purchase shares at a discounted  price on the offer date and the purchase date, the plan participant may be somewhat insulated from the down market during this time.

In the hypothetical scenario above, the plan buys the shares for $42.5 (purchase date price less a discount) and the plan participant can turn around and sell them for $50 (as compared to the offer date price of $100 per share).

Other Thoughts on Selling Immediately

As you can see from this simple illustration, it’s easy to understand why an employee stock purchase plan can be a great deal for employees.  In fact, one could argue that it’s a no-brainer.

However, 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 simply laziness or forgetfulness, there are many reasons why someone may not follow through on their goal to sell.  It’s often this risk that gets people into trouble, as holding onto company stock that falls in value could lose you a lot of money.

Option 2 – Holding Stock Beyond Option One

If you elect to hold employee stock purchase plan shares beyond the point of option one, you move into an area where you must consider market volatility, taxes, concentrated equity, and other financial planning issues.

You also move into an area that warrants a discussion of qualifying and disqualifying dispositions.

Qualifying vs. Disqualifying Disposition

The discussion of qualifying or disqualifying dispositions of ESPP shares is important, as it highlights a key opportunity – the potential for long-term capital gains tax treatment.

If one meets the standard for a qualifying disposition, a portion of the gain (if any) may be subject to preferential long-term capital gains treatment.

However, this preferential tax treatment comes with a risk, namely the risk of holding potentially volatile company stock.  It’s possible that during this year, the stock price could collapse 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).

Alternatively, a disqualifying disposition leaves all gains subject to ordinary income tax rates.

A Look at the Numbers

If we make an unrealistic assumption that the stock does not move at all AND a shareholder holds the stock long enough to make the transaction eligible for a qualified disposition, we can hypothetically illustrate the potential value of a qualified disposition.

Big Bull Up Market Flat Down Big Bear
Offer Price $100.00 $100.00 $100.00 $100.00 $100.00
Purchase Date Price $150.00 $125.00 $100.00 $75.00 $50.00
Purchase Price $100.00 $100.00 $100.00 $75.00 $50.00
Discount (15%) ($15.00) ($15.00) ($15.00) ($11.25) ($7.50)
Final Sale Price $85.00 $85.00 $85.00 $63.75 $42.50
Ordinary Income (33%) $4.95 $4.95 $4.95 $3.71 $2.48
Capital Gains (15%) $7.50 $3.75 $0.00 $0.00 $0.00
Total Tax $12.45 $8.70 $4.95 $3.71 $2.48
After Tax Gain $52.55 $31.30 $10.05 $7.54 $5.03
After Tax Proceeds $137.55 $116.30 $95.05 $71.29 $47.53

 

As you can see, the after-tax proceeds of a qualifying disposition, assuming a flat stock price, equals $137.50.  To gain a true sense of value, it’s fair to compare this to the after-tax proceeds of an immediate sale – $128.55.

To think about this another way, holding the stock for at least one year beyond the point of possible liquidation created less than $9, or 6.6% increase in value.

Interestingly, as illustrated by the Up market scenario, as the spread between the offer date price and the purchase date price gets smaller, the “benefit” of holding the perceived value gets smaller.  Specifically, the after-tax proceeds for a qualified disposition is $116.30, while for an immediate buy and sell, they are $111.80, so the qualified disposition choice created $4.50, or a 4% value.

What Does this Tell Us?

It appears that the primary benefit of holding company stock from an employee stock purchase plan beyond the point of an immediate buy/sell may be the opportunity for price appreciation.

By holding the company stock, one can participate in the possible upside of the market. However, one is also subject to the downside, and a falling stock price.

The potential tax benefit of a qualifying disposition, as illustrated by the simple example above, is a “nice to have”.  It’s arguably not the sole reason to hold the shares, nor a definite justification.

In addition to participating and strategizing your employee stock purchase plan options, it’s important that you consider how this fits into your larger financial plan.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

 

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