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

An Employee Stock Purchase Plan (ESPP) is an employee benefit that often allows employees to purchase company stock at a discount based on the fair market value. This discount can be 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 stock purchase plan can allow an employee to increase his or her total income.

Simply stated, work hard, if the company does well, if the stock price goes up, and everyone wins!

Before getting overly excited at a seemingly easy answer, however, let’s dig further into how an employee stock purchase plan works, what the benefits may be, and what tax considerations should be considered.

The Workings of an Employee Stock Purchase Plan

First and foremost, your company obviously needs to offer an employee stock purchase plan in order for you to participate in one.  If they do, the first step is to notify the appropriate parties that you wish to participate in the ESPP.  Once enrolled, contributions to an ESPP are made through payroll deductions using after tax dollars.

As you (and other employees) make contributions to the plan via payroll deductions, the employer accrues the contributions in an escrow account. Then, on a pre-set schedule, the company uses the money in the escrow account to purchase company shares for the plan participants.

What Price Do I Pay for My Shares?

Employee stock purchase plans can give plan participants an advantage on 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
  • A look-back provision

First, the employee stock purchase plan can offer a discount from fair market value of up to 15% (check your plan document for your discount, if any).

For example, if the current purchase price is $100, the plan may allow for the purchase of shares at $85 per share.

Second, the employee stock purchase plan may allow for a look-back provision, a concept slightly more confusing than the discount.

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.

Let’s explore this a bit further:

Continuing the assumption above, let’s assume 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 prior to the purchase date.

It’s reasonable to assume that the price on the offer date (a date several months prior to the purchase 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, the employer will have the ability to buy shares for the plan participants at the best price PLUS the 15% discount!

The best price for the plan participants will be the lower of the purchase date price and the offer date price.

Fair Market Value Goes Down From Offer Date to Purchase Date

If the fair market value of the stock goes down in value, the plan participants would want the purchase date price, as illustrated below.

Offer Date Purchase Date ESPP Price ESPP Less 15%
$120 $100 $100 $85

Fair Market Value Goes Up From Offer Date to Purchase Date

If the fair market value goes up from the offer date to the purchase date, it’s possible to create even more value for the participant.

Offer Date Purchase Date ESPP Price ESPP Less 15%
$80 $100 $80 $68

As you can see from the chart, the 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?

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. The worst-case scenario (assuming a gain) is 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.

Best case, the discount received on the purchase price will be taxed as ordinary income, and the gain above the discount to the final sale price will receive 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 plans 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 a person 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 final sale price.

Offer Date Purchase Date ESPP Price ESPP Less 15% Final Sale Price
$80 $100 $80 $68 $150

If we are to assume that the final sale transaction meets the standards for qualifying disposition, we can calculate the subsequent tax impact.

  • 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 that we just discussed. Assuming a disqualifying disposition, the entire gain, from the discounted purchase price to the final sale price, will be taxed as ordinary income. Following the example above, we can determine the tax impact

  • 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!)

As you can see from the illustration, the benefit of a qualifying disposition on an appreciating stock can be huge. However, it’s fair to note that holding on to the stock leaves the shareholder subject to the risk rewards trade-off and the inherent volatility of equity investing.

Should I Participate in My Employee Stock Purchase Plan?

Employee stock purchase plans often allow for additional flexibility compared to their restricted stock and stock option peers. In short, the ability to cash out is often easier.

However, it’s important to note that all investing carries with it the risk of losing money, and 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.

However, 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 not 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.

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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