Employee stock purchase plans (ESPP) are company-run programs for employees to purchase stock at discounted prices. There are two types of ESPPs: qualified plans and non-qualified plans. The former provides tax benefits but have more administrative requirements while the latter does not have as many restrictions on their operations. The advantage of ESPPs are that they can be an excellent source of profits for employers. The disadvantage of ESPPs are that their tax treatment can be a complicated affair. Have questions about ESPPs? Click here. According to a 2018 survey conducted by consulting firm Deloitte, nearly three-fourths of publicly-traded companies offer ESPPs to, at least, some of their employees. The plans are an opportunity for employees to purchase stock at a discount, generally ranging from 5% to 15%. The IRS has set a pre-discount limit of $25,000 per year for ESPP purchases, meaning employees cannot purchase discounted stock worth more than $25,000 in a given year. ESPPs are a variant of Employee Stock Ownership Plans (ESOP) but the base idea behind both plans – that of providing employees with company stock ownership – remains the same. While ESOPs have a vesting period that culminates into ownership of the stock, ESPPs make periodic payroll deductions that are accumulated over time to purchase stock. The “lookback” provision in ESPPs also ensures that employees can purchase stock at a significant discount to market rates. The two types of ESPPs are as follows: Qualified plans are also known as 423 plans because their terms are governed by section 423 of the Internal Revenue Code (IRC). They offer tax advantages to employees because money to fund stock purchases comes from payroll deductions. Qualified participants are approved by the company’s board of directors and have limits on the maximum discounts that companies can offer to employees. Non-qualified plans use a different mechanism – matching share contributions by employers – instead of discounts. Thus, in a non-qualified plan, the company will match or exceed the number of shares offered to an employee. For example, if the employee buys one share, then the company might contribute two or three shares (depending on the ratio adopted) to the employee’s ESPP account. In most cases, companies attach certain conditions, such as assigning a holding period or requiring that an employee stay with the company for a certain period, to the matching conditions. There are two enrollment periods for ESPP plans in a year. During the enrollment period, employees decide the salary percentage that they will use to fund their purchase and a purchase date for the stock. The company will begin making deductions from your salary based on the date you specified and purchase stock on the date you specified. The purchase price is effected at a discount and uses the “lookback” provision. In the “lookback” provision, you get a discount on the lowest trading price of either the offering date or the purchase date. After purchase, the company deposits stock into the employee’s account. The employee can sell the stock in the open market, whenever he or she wants to. Some employer set conditions on the stock’s sale timings. For example, an employer might require a minimum duration of employment before it allows sale of stock. The “lookback” feature is the most attractive aspect of ESPPs because they ensure that employees get a significant discount on the stock’s market price. When a company provides a lookback discount, then it prices the stock based on the following: The “lookback” period from either one of those two dates is analyzed to determine the lowest price of the stock and a discount is applied to it. The longer the lookback period, the greater the discount. For example, suppose company ABC offers a 10% discount on the price of a company stock trading at $100 on the offering date. During the purchase period, i.e., the period during which the price is tracked to determine its lowest point, ABC’s stock price shoots up to $110. Then ABC’s employees can purchase its stock for $90 (10% of $100, the lowest price during the tracking period). If the price had declined to a low of $70 during the purchase period, then the employees will end up paying $63 for the stock. Either way, the employee gets a significant discount to the trading price. The tax treatment of ESPPs depends on the duration of holdings and can be complicated. You can end up paying taxes on phantom income, or gains that never accrued. It depends on whether ESPPs are qualified dispositions or not. Qualified dispositions are stocks that are sold after more than two years of being held. Their tax calculations consist of two parts: employee discounts taxes and capital gains taxes. ESPP discounts are taxed at ordinary income tax rates and price appreciation is treated as long-term capital gains. Disqualifying disposition are stocks that were offloaded less than 2 years, mostly within a year, after they were purchased. If the price of such stocks is down, then you might end up paying taxes on phantom income. This is because the company discount is treated as income and, even though you did not earn money from it, you are still required to pay taxes on it. Therefore, it is possible that your losses might multiply.Basics of ESPPs
Types of ESPPs
Qualified Plans
Non-Qualified Plans
How Does an ESPP Plan Work?
Understanding the “Lookback” Feature
Tax Treatment of ESPPs
Employee Stock Purchase Plan (ESPP) FAQs
Employee stock purchase plans (ESPP) are company-run programs for employees to purchase stock at discounted prices.
The two types of ESPPs are qualified plans and non-qualified plans. Qualified plans are also known as 423 plans and offer tax advantages. Non-qualified plans have employer share matching instead of employee discounts on shares.
When a company offers a lookback period, it determines the lowest price of the stock in either the offering or purchase period and a discount is applied to it. The longer the lookback period, the greater the discount.
While ESOPs have a vesting period that culminates into ownership of the stock, ESPPs make periodic payroll deductions that are accumulated over time to purchase stock. The “lookback” provision in ESPPs also ensures that employees can purchase stock at a significant discount to market rates.
There are two enrollment periods for ESPP in a year. During the enrollment period, employees decide the salary percentage that they will use to fund their purchase and a purchase date for the stock.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
