If your company offers an employee stock purchase plan (ESPP), it could provide a path to future wealth. Like any investment, however, participating in an ESPP carries risk. Before signing up, you should understand how an ESPP works, the specific provisions of the plan your employer is offering, and how ESPP participation fits into your overall financial plan.
ESPP Basics
In general, an employee stock purchase plan allows employees to make discounted purchases of company stock with after-tax payroll deductions. These payroll deductions begin on the offering date (also the grant date for stock option plans) and accumulate in an escrow account until the purchase date, when the funds are used to purchase discounted stock on the employee’s behalf. The time between the offering date and purchase date is referred to as the offering period.
Lookback Periods
Some plans include lookback provisions, which build flexibility into the discounted price of stock purchased through the ESPP. A lookback provision stipulates that the discount will be applied to either the price at the beginning of the offering period or the price at the end of the purchase period, whichever is lower. This can be a great deal for employees because it can result in deeper discounts.
Rules for Qualified ESPPs
Most ESPPs are “qualified,” which means that they offer certain tax advantages and meet the requirements of Section 423 of the Internal Revenue Code, including approval of shareholders and equal eligibility of all employees who meet certain criteria. In some circumstances, an employer may exclude temporary, part-time, or highly compensated employees as well as those who have been with the company for less than two years. Qualified plans also have limits on how much stock employees may purchase through them, the amount of discount offered, and the length of the offering period.
Taxation of Gains from Qualified ESPPs
Share Discount
If you participate in a qualified ESPP, the discount you receive on your shares, which is commonly up to 15% of the market price, is not taxed at the time your stock is purchased. Instead, this discount is taxed as ordinary income in the year you sell the shares.
Profit on Share Sales
Remaining gains after the discount are taxed as either short- or long-term capital gains, depending on how long you hold your shares. To qualify for long-term capital gains treatment, you must hold shares for at least one year after the purchase date and two years after the grant date. If you do not meet these holding period requirements, the sale is considered a “disqualifying disposition,” making the proceeds short-term capital gains, which are taxable as regular income.
Questions to Consider Before Enrolling in an ESPP
Participating in an ESPP can sometimes bring great financial reward, but this is far from a sure thing. Before you sign up, speak with a trusted financial professional to determine whether it’s the right move for you. Be sure to consider these questions:
- Is your company a good bet or a risky one? If you didn’t work there, would you still be interested in buying the stock?
- How does the investment fit with your overall financial plan? Is it likely to help you meet your goals?
- How will plan participation affect the diversity of your investment portfolio?
- What are the specific terms of the ESPP your company is offering?
Quick-Reference Glossary
- Purchase date—The date on which the funds deducted from an employee’s paycheck are used to purchase company stock
- Grant date—The first day of the offering period
- Offering period—Period during which payroll deductions are made for the ESPP
- Holding period—Amount of time that an employee must hold their stock before the proceeds receive favorable tax treatment
WRP provides expert advice for executives and employees who receive stock options, helping with investment management, tax mitigation, and financial planning. Subscribe to our blog for regular updates on important financial topics.
