Employee Stock Purchase Plans (ESPPs) and How They Work
Employee stock purchase plans (ESPPs) are a form of compensation most public companies use to recruit and/or retain employees. The corresponding benefit? Employees can purchase company stock at a price below its market value. This post discusses how ESPPs work, when to sell shares, tax implications, and other related topics so plan participants can make informed decisions about the same.
Types of employee stock purchase plans
Companies issue two types of ESPPs to employees: qualified (“Section 423”) and non-qualified plans.
While several differences exist between these, the biggest is that the IRS treats qualified plans more favorably with respect to taxation (more on that later). Since qualified types are more common overall (79% of ESPPs fall into this bucket in the U.S., per a recent NASPP Domestic Stock Plan survey), we’ll discuss this specific type moving forward unless otherwise noted.
How ESPPs work
Employee stock purchase plans give you the right to buy shares of company stock at a discounted price, often 5%–15% below market value, so you can make a profit (the overall objective of this benefit).
Much like how you access your 401(k) plan, your employer will offer an initial ESPP program enrollment period during which you can contribute by electing for payroll deductions as either a percentage or fixed amount (up to allowable IRS contribution limits).
Your after-tax deductions then accumulate in your ESPP account during what’s called the “offering period”: the time between your enrollment and purchase dates, the latter indicating when the accumulated money is used to buy stock. Offering periods are typically six months in duration but can extend to a maximum of 27 months. In some cases, enrollment and offering periods are the same.
Your purchase date (also referred to as the “exercise date”) is when plan contributions are used to buy shares of company stock: either at a set discount from their market value or, if your plan offers a “lookback” provision, at a price based on the beginning of the offering period (whichever is lower). The first day (or onset) of the offering period is known as the “grant date.”
To illustrate, let’s assume your offering period begins and your plan includes a 10% discount. The grant date stock price is $20 per share, which eventually increases to $30 per share on your purchase day. In the absence of a lookback feature, the price per share would be $27 (10% off $30). With a lookback feature, meanwhile, your 10% discount would apply to the $20 share price and result in a purchase price of $18 per share.
ESPP eligibility and contribution limits
While many ESPP plans allow you to contribute up to 15% of your gross salary, 2024 federal tax rules dictate you cannot purchase more than $25,000 worth of stock per calendar year.
Regarding eligibility, most plans don’t allow employees who own more than 5% of the company to participate. Some companies may also require employment for a specific amount of time—typically at least a year—as a prerequisite for ESPP participation. Check with your benefits department to learn your specific plan details.
When to sell ESPP shares
If you research the best time to sell ESPP shares, you’ll see many websites recommend selling immediately after purchasing. The most cited reasons why? The ability to lock in your gain, put your funds to better use elsewhere (e.g., to pay off debt or reinvest the money), and/or potentially minimize risk by not holding too much of one company’s stock (often more than 10% of your portfolio’s total value).
Holding on to ESPP shares is perhaps a good idea if you believe your company’s share price will increase, want to minimize taxes (we’ll get into that next), and/or lack the financial discipline to use the proceeds wisely.
There’s ultimately no right or wrong answer in deciding when to sell your ESPP shares.
Employee stock purchase plan tax implications
Keep in mind you aren’t taxed at the time you purchase your ESPP shares—only when you sell them. ESPP tax rules are complex, however, and your tax obligation can be considerable depending on if selling your shares results in a “qualifying” or “disqualifying” disposition.
If you hold your shares for at least two years from the grant date (the first day of your offering period) and one year from the purchase date, your sale will fall under a qualifying disposition; this means any discount offered on the original share price is taxed as ordinary income, and any gain above that price is taxed as a long-term capital gain. If you fail to meet qualifying disposition criteria, your sale is treated as a disqualifying disposition with your entire gain potentially taxed as ordinary income (resulting in more taxes).
To illustrate, let’s assume your ESPP offers a 10% discount with a lookback period, and the price at the beginning of the offering period is $20 per share—which rises to $30 per share on the purchase date. Your contribution is used to purchase 1,000 shares at $18 per share.
If you sell your shares immediately, this is considered a disqualifying disposition and your entire gain of $12 per share ($12,000) is therefore taxed as ordinary income. If you hold on to your shares and meet qualified disposition parameters when you sell, however, you’d receive more favorable tax treatment because long-term capital gains taxes are generally lower than ordinary income tax rates; for example (using the same scenario), a $2-per-share (or $2,000) discount would be taxed as ordinary income, and the remaining gain of $10 per share (or $10,000) would be taxed as a capital gain.
One final detail to know about employee stock purchase plans
While most plans allow you to increase or decrease your payroll deduction amount, it’s not uncommon for many to limit the number of changes per offering period or even suspend you if you reduce your contribution to zero.
The bottom line on ESPPs
Per Aon Consulting, approximately 49% of S&P companies and 38.5% of Russell 3000 companies offer ESPPs to their employees. If you work for a large company, do your homework to learn whether your organization participates in this excellent investment opportunity.
Still have questions about ESPPs? Schedule a FREE Discovery call with one of our CFP® professionals.
FAQs
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If you quit or are terminated by your company, any shares you once purchased are yours to keep. Likewise, your payroll contributions (not used to purchase shares) are also often returned to you.
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Nope! ESPP contributions are made with after-tax dollars, often via payroll deductions.
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Most plans allow you to withdraw accumulated funds before the purchase date, but make sure to check your plan documents to review all rules regarding withdrawals.
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A holding requirement is the amount of time your ESPP shares must be held before you can sell them; check your plan documents to learn if a holding requirement applies to your situation.
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Most plans will automatically re-enroll you for subsequent offering periods (at the same level) after you initially sign on.
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While the IRS outlines $25,000 per year as the maximum, the highest amount you can contribute to buy shares is actually less than this amount because the calculation is based on the non-discounted price at the onset of the purchasing period.
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings.
