Understanding Employee Stock Purchase Plans (ESPPs)

By Zack Gutches, CFP®, CPA | Apr 23, 2024 |

Employee Stock Purchase Plans (ESPP) are a popular employee benefit offered by many large, publicly-traded companies. It allows employees to purchase company stock at a discounted price, typically through after-tax payroll deductions. ESPPs are an excellent way for employees to maximize their compensation from their employer. 

However, it is important to understand the rules and restrictions around selling and cashing out ESPP stock to make informed decisions. 

Let’s level set.  

What is are employee stock purchase plans (ESPP)?

With employee stock purchase plans, employees can purchase company stock at a discount (generally 5% – 15%, with potential greater than 15% in certain instances), resulting in sizeable financial returns. Employees typically contribute up to $25K per calendar year, quarterly or semi-annually.   

Employees can immediately hold onto or sell the stock to realize the potential gains. While less common, certain employers impose a ‘holding period’ restriction after purchasing. 

Types of employee stock purchase plans

ESPPs are either qualified or non-qualified plans. The tax treatment differs. 

Qualified ESPPs (Section 423 Plans) offer potential tax advantages. If you contribute to a Qualified ESPP, you can defer the taxes owed on the discount you receive on the stock purchase until you sell the stock.  

Non-qualified ESPPs (Non-Section 423 Plans) are more flexible but do not offer the same tax advantages as qualified plans. With a non-qualified ESPP, the discount you receive on the stock at purchase is taxed as ordinary income, whether or not you sell the stock in that calendar year. Approximately 20% of ESPPs in the U.S. are non-qualified. While they offer a suite of potential flexibility in their design (because they are not required to comply with IRS Section 423 regulations), this article primarily highlights features of Qualified ESPPs. 

Taxation of employee stock purchase plans (Qualified ESPPs)

Your contributions to the plan are with after-tax dollars — there is no tax deduction for dollars contributed to an ESPP.  

There are no tax triggers upon purchasing the company stock, even though the shares are purchased at a discount. Only when you sell do you generate a potential tax liability for the discount plus any appreciation since the purchase. The timing of the sale will dictate what type of ‘disposition’ the sale is and how the tax is structured.  

Let’s discuss the two main types: 

  • Disqualifying Disposition: You sell the stock within two years of the offering (grant date) or less than one year from the date the stock was purchased. Absent rare circumstances, this will result in a higher proportion of ordinary income tax rates (less favorable) and a smaller proportion of capital gain tax rates (more favorable) 
  • Qualifying Disposition: You sell the stock at least two years after the offering (grant date) and at least one year after your company purchased the stock for you. Most often, this will result in a smaller proportion of your gain on the stock attributable to ordinary income tax rates (less favorable) and a higher portion towards capital gain tax rates (more favorable). 

Consulting with a financial advisor or tax professional can help you navigate the complexities and make informed decisions. 

Maximizing the benefits of ESPPs

ESPPs have contribution limits that determine the maximum amount you can contribute during a specific period. These limits may vary depending on the plan, so it’s crucial to familiarize yourself with your ESPP’s guidelines. Additionally, consider strategies such as contributing the maximum allowable amount, leveraging the potential discounts offered, and carefully timing your stock sales.  

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An example of ESPP in action

A client with a base salary of $250k per year decides to contribute 10% of her compensation towards her employer’s ESPP (to maximize the $25k benefit for the year). The employer puts 10% of the client’s salary towards the ESPP throughout the year. On June 30 and December 31, the employer will use the pool of money the client has contributed to purchase their company stock at a 15% discount, with a look-back provision for the offering period (from January 1 through December 31).  

On January 1, the stock price of the client’s company is trading at $10 per share. On June 30, the stock price is at $14.  

Given the look-back provision, the client gets to purchase the stock on June 30 at a 15% discount from the lower of the January 1 or June 30th stock price, or $8.50 per share in this instance ($10 per share with a 15% discount applied). If the client were to turn around and sell the stock on June 30 at the market price ($14 per share), they would effectively sell at a gain of $5.50 per share, representing a ~65% risk-free return, given they sold immediately upon purchase.  

Given this was a Disqualifying Disposition (did not hold for at least two years from the initial offering period on January 1, nor held for greater than one year from the purchase date on June 30), all of the $5.50 per share of gain would be taxed as Ordinary Income. If this were a Qualifying Disposition (sold at $14 at least two years after the initial offering period of January 1), $1.50 per share of gain would be taxed as Ordinary Income, and the remaining $4.00 per share of gain would be taxed at favorable long-term capital gains rates. 

ESPPs vs. other investment options

One advantage of ESPPs over individual stock trading or mutual funds is the discounted stock price. This immediate discount allows employees to acquire company stock at a lower cost, potentially resulting in higher returns.  

However, ESPPs have disadvantages, too. ESPPs limit the amount of stock an employee can purchase or when the stock can be sold. This lack of flexibility can limit employees’ investment opportunities. Furthermore, the value of company stock can be volatile, which means risk is involved in investing in ESPPs. 

Determining if an ESPP is the right choice depends on your financial goals, risk tolerance, and overall investment strategy. Consult with a financial advisor to assess your circumstances and evaluate whether an ESPP aligns with your investment objectives. 

Remember, an ESPP can be a great way to become a shareholder of your company and potentially benefit from its success. If you have more questions about ESPPs, contact your HR department or consult with a financial advisor. 

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