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Maybe you are fortunate to be recruited by a tech start-up or have worked with an organization for years and are being tapped for higher management roles. In this case, the company will try to woo you with compensation that includes stock options. It will be tied to the company's performance, and if the company does well, you do well.
Known as an Employee Stock Purchase Plan (ESPP), it is a chance to conveniently buy shares of the employer's stock through the after-tax payroll deductions. It is a very simple and straightforward form of the stock purchase plan.
Besides the salary and wages, this is a unique method of compensating the employees today. ESPP allows the employees to participate in the business's profitability with time.
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How does an Employee Stock Purchase Plan work?
ESPP works simply. There is an enrollment period that will come along twice a year. You can enroll during this period and decide the amount you will be able to contribute. The company will open an ESPP account for you and fund it directly from the paycheck. You will reach a purchase date at the end of the purchase period. This is when the account balance will be used to buy company shares.
Let us take an example. You enroll in the company ESPP in the December enrollment period. The payroll deductions will begin on January 1 which is the offering date. The company will buy shares for you on July 1, using the amount accumulated from January to June. The company will automatically re-enroll you for the next cycle and will take the payroll deductions for July 1 to December 31 purchase period.
The discount is usually 15% which makes the employees confident of making a profit by selling the shares at a future date. This is a practice where you buy low and sell high. Plus, it comes with a loopback clause where you pick the most favorable share price during the loopback period, which is six months, and you can base the purchase on that. Now, if the share price on the purchase date is $12, but in the last six months, it was as low as $8, with a lookback clause, you can purchase the shares at $8 minus the 15% discount. This will significantly reduce the purchase price.
If you see the company's long-term growth and hold the stock, you will be able to make a good amount of money. This is why ESPP is attractive to employees.
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Terms and Dates
Those who participate in the company ESPP will only be eligible to do so after the start of the offering period. It will always begin on the offering date, also known as the grant date in case of stock option plans. The payroll deduction will start after that until the date of purchase. The offering period may be overlapping or consecutive. In most cases, the offering period will have different purchase dates at the end of the purchase periods, like a plan with a three-year offering period that includes four purchase periods and ends in four purchase dates.
Enrollment Process
Employees are required to enroll in ESPP on the next offering date. In the process, they will have to mention the dollar amount they are willing to contribute, and it has to be less than 10% of the take-home pay. The contribution is also restricted to $25,000 in a calendar year.
Eligibility
There are specific rules about eligibility that you must be aware of. Qualified ESPPs do not allow any person to own more than 5% of the company's stock for participation in ESPP. Plus, the plan can also disallow specific employees from participation, like those with the company for less than a year. All others are unconditionally eligible. ESPPs are benefits to the employee, and it is not an obligation. Hence, you can choose not to participate in them. Those who meet the requirements cannot be disallowed involvement in the plan.
ESPP Deductions
Those who participate in ESPP should be aware of the allocation of income for ESPP. Here is how the money is contributed to the plan.
- The participating employee will state the amount of money they want to be deducted. It can be deducted monthly or yearly.
- The payroll deduction will accumulate from the offering date to the purchase date.
- After the employee reaches the purchase date, the collected funds will be used to buy the stock.
Types of Employee Stock Purchase Plans
There are two types of ESPP plans, and the key difference between them lies in the tax treatment per the Internal Revenue Section. The term qualified is used to refer to the tax advantage status. A non-qualified ESPP will not meet the IRS criteria but offer more flexibility.
Qualified Plans
The qualified plan is a very common ESPP that is used today. In this plan, you must follow the eligibility criteria as per IRS, and the shareholders should approve the plan before it is implemented. Additionally, all the ESPP participants will have equal rights. Further, the discount on the stock price will not be higher than 15%, and the offering period will not be longer than 27 months.
Here you purchase stock at a discount from the fair market value and do not owe taxes on this discount when you make the purchase. If you hold the stock for a specific period, you will only be charged with long-term capital gains tax at the time of sale.
Non-qualified Plans
Non-qualified plans do not have the same rules as qualified plans. Hence, when you buy the stock, the excess of the stock's fair market value at the time of purchase over the purchase price will be your ordinary income. Further gain or loss at the time of sale will be the capital gain. The tax on discounts is due on purchases, which usually discourages the employees.
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Potential gains of Employee Stock Purchase Plans
Through an ESPP, you can buy the stock at a discount of 10% to 15% from its fair market value. This means you enjoy an immediate capital gain when you sell the stock. Some plans also have a look back feature where you use the company's closing share price of the purchase date or the offering date, whichever is lower. It will have a huge impact on the gains you make. Employers can set their policies about letting the employees withdraw funds from the plan or changing the contribution level.
Employee Stock Purchase Plan Taxes
Understanding the tax treatment of ESPPs is important, and it is complex. The tax treatment will be covered by four aspects:
- The stock holding period
- The purchase price of the stock
- The closing price of the stock on the purchase date
- The stock's closing price on the offering date
Based on the holding period, there is the qualified disposition and non-qualified disposition.
Qualifying disposition
Qualifying disposition is an income tax term that refers to the sale of shares that receive a favorable tax treatment for the individual who disposes of the stock. There is a difference between the regular income tax rate and the long-term capital gain tax rate, where qualifying disposition impacts. It is possible to save dollars on taxes owed with qualifying disposition. Two rules will determine qualifying disposition:
- The stock sale should be at least one year or more after stock purchase.
- The date of stock sale should be at least two years or more after the date when the option to purchase was granted to the employee. For example, the company may give you the chance to buy shares at a 10% discount in May 2015, but you did not purchase the shares until June 2016. Once you purchased it in 2016, you need to hold it for one year to make the most of the benefits.
If these conditions are met, then the stock sale will be deemed a qualifying disposition. The plan's discount will be considered ordinary income, and the balance will be the long-term capital gain. These rules do not apply in case of disqualifying disposition.
Disqualifying disposition
If the shares are not held for the required holding period, a disqualifying disposition will occur, and you will not have preferential tax treatment. This means the incentive stock options sale occurs two years after the grant date, and the final sale occurs at least one year after the incentive stock option was exercised. This does not meet the qualifying disposition and you will be subject to the combination of ordinary income tax and capital gain tax. The seller will consider the difference in the closing price of the stock on the date of purchase and the discounted purchase price as ordinary income. This is a calculation that occurs whenever you file your taxes and it takes place every calendar year.
Pros
- ESPPs motivate the employees to increase productivity and provide an extra means of compensation that does not directly come out of the company’s funds.
- It gets the employees into a saving habit.
- The contributions to the plans are exempt from Medicare Tax and Social Security Tax.
- The plans are easy to enroll in, and the organization's success will be transferred to the employee.
Cons
- If the ESPP shares are a major part of the investment portfolio, you could be taking more risk than necessary. The stock may do well, but there is a chance that its performance could decline, and you could be left with a loss. Even at a discounted price, the shares may not be of value.
- Tax treatment is complex.
- If the share price declines, employee morale will also decrease.
- High administrative cost to handle and manage ESPP for the organization.
Employee Stock Purchase Plans vs. Employee Stock Options Plan
There is a lot of confusion between the employee stock ownership plan (ESOP) and the employee stock purchase plan (ESPP). It helps to understand the difference between the two.
An ESOP is a plan that gives the employees an ownership interest in the company. It is in the form of shares of stock. Through an ESOP, the company and the participants enjoy tax benefits. Organizations across the world use ESOPs as a strategy to meet the interests of the shareholders with the employees.
Consider an employee working with a large tech firm for four years. As per the company's stock ownership plan, this employee can receive 20 shares after the completion of the first year and 100 shares after five years. At retirement, the employee will be paid the share value in cash.
In contrast, ESPP is a stock purchase program in publicly traded companies. It allows the employee to contribute a part of their pay every month to purchase the stock. At the end of the predetermined interval, the balance saved by the employee will be used to buy the stock at a discounted rate.
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The Bottom Line
If you are a business owner and want the employees to purchase company stock, you must consider ESPP. It offers high liquidity, is simple, and has low administrative costs.
It is a good chance for an employee to save money and buy the stock at a discount rate. If your company is performing well and you think that the stock will rise in the future, it is a good idea to participate in ESPP.
Stock options are like a lottery. You have equal chances of winning and losing. Consider the stock's potential a few years down the line and then make a decision.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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