Everyone wants double-digit investment returns but few people can stomach the risk required to achieve them. If your employer offers an Employee Stock Purchase Plan (ESPP), you have the opportunity to generate double-digit returns without the market risk.
What is an Employee Stock Purchase Plan?
An ESPP allows you to buy shares of company stock at a discount from the market price. In other words, you get to buy stock with a built-in gain. It's the definition of a "free lunch," so why do most companies report that less than half of their employees participate?
My guess? Because ESPPs are complicated, you can't figure out how they're taxed, and most of all, you're nervous about losing money. Those are all valid reasons, but after today, you'll be counting the days until your next ESPP enrollment period.
Employee Stock Purchase Plan Basics
First, let's cover basic rules and terminology.
You must enroll in the ESPP and choose a % of your salary or a flat dollar amount to be withheld from each paycheck. You'll do this during the open enrollment period, which typically ends soon before the offering date.
The offering (or grant) date marks the start of the offering period, and the purchase date marks the end. The offering period length is unique to your company's plan, but 6 months is common. Throughout the offering period, your company will set aside your paycheck deferrals.
On the purchase date, your company uses the cash contributed during the offering period to buy company stock at a discount. We'll jump into some examples in a minute, but there are a few important details you need to know first.
The Employee Stock Purchase Plan Discount
The discount applied to shares at purchase depends on the terms of your company plan. Discounts can range from 1% up to 15%. A maximum discount of 15% is common to encourage employee participation. Some plans include a lookback provision that can make your ESPP even more profitable.
Without a lookback provision, your discount is applied to the stock's price on the purchase date. With a lookback provision, your company compares the stock's price on the offering and purchase dates, then applies your discount to the LOWEST price.
How Are Employee Stock Purchase Plans Taxed?
Most ESPPs are considered qualified, so there isn't a taxable event until the shares are sold. To qualify for tax-advantaged status, plans must meet certain rules. One of the most relevant rules is the $25,000 cap on employee purchases in an ESPP per calendar year.
Once sold, you'll report a mix of ordinary income and capital gain (loss).
The amount you report for each depends on whether the sale is a qualifying disposition (QD) or disqualifying disposition (DQD).
I know you want to stop reading now, but we're almost at the good part!
You have a QD if you sell the shares at least 1 year after the purchase date AND 2 years from the offer date. Any other sale is a DQD. Qualifying Dispositions offer a clear tax advantage, but as you'll see in the following examples, they may not always be the most profitable option.
How do Employee Stock Purchase Plans Work?
Next, we'll look at an example of an ESPP would work in real life. Let's assume the following:
You enroll in a qualified ESPP and defer $1,000/paycheck over the 6-month offering period. On the purchase date, your company uses the $12,000 you deferred to buy company stock at a 15% discount from the lower of the offering or purchase date price
The stock's price was $15 on the offering date and $25 on the purchase date.
The 15% discount is applied to the $15 grant price, so your actual purchase price is $12.75. Your $12,000 of ESPP deferrals buy 941 shares worth $23,525 with a built-in gain of $11,525.
Now, let's look at 4 potential scenarios:
1. Sell immediately (disqualifying disposition)
2. Sell <1 year from purchase (disqualifying disposition)
3. Sell >1 year from purchase, BUT <2 years from grant (disqualifying disposition)
4. Sell >1 year from purchase AND >2 years from grant (qualifying disposition)
Pay very close attention to the following paragraphs!
In a disqualifying disposition, you pay ordinary income tax on the difference between your ACTUAL purchase price and the purchase date price.
In a qualifying disposition, you pay ordinary income tax on the LESSER of:
• The discount on the offering price
• The gain between the actual price you paid and the sale price
In both a qualifying disposition and a disqualifying disposition, your basis is the actual cost of the shares + the discount reported as income.
If you sell the shares for more (less) than your basis, you'll have a capital gain (loss). The purchase date is the start of your holding period for determining short or long-term gain (loss) treatment.
Let's say you sell the stock at $25 in every scenario. You can see that the 3 disqualifying disposition scenarios have no gain because the sale value is equal to the basis. You can also see the higher after-tax value in the qualifying disposition scenario.
Say you decide to hold the shares, and the price appreciates to $30 before you sell for either a short-term disqualifying disposition, long-term disqualifying disposition, or long-term qualifying disposition. The price appreciation gives you more money across the board, and the qualifying disposition scenario is still the most lucrative. Here's how it looks:
What if you hold the shares, and the price falls to $20 before you decide to sell? As you can see, selling immediately would have been the best option, even with the qualifying disposition tax advantages.
There are plenty of other ESPP scenarios with varying tax consequences, but don't let that stop you from taking advantage of this huge employee benefit!
Employee Stock Purchase Plan Strategy
The right ESPP strategy for you depends on your situation. Specifically, your cash flow flexibility and other employer equity holdings. However, the built-in gain that comes with newly purchased ESPP shares makes selling the shares immediately a popular approach as it locks in a guaranteed gain. Many participants use the proceeds as a way to give themselves an extra bonus or two throughout the year to replenish cash reserves, spend on lifestyle goals, or allocate to a diversified portfolio.
Conclusion
Employee Stock Purchase Plans (ESPPs) offer employees the opportunity to lock in a double-digit gain with little to no downside. Many employees fail to participate because of the confusing logistics and tax consequences, but understanding how ESPPs work and taking advantage of this benefit can be a lucrative strategy that shouldn't be ignored.
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