Welcome to the final article in our stock option series! Over the past several weeks, we’ve been tackling the ins and outs of employee stock options. If you missed it, don’t forget to check out the first three articles in this series:
Today we’ll be going over Employee Stock Purchase Plans (ESPPs). ESPPs are a company-driven program that allows employees to purchase stock in their company at a discounted rate. Employees contribute to this plan through payroll deductions that are subsequently used to purchase company shares on behalf of the employee.
This investment can increase employee engagement and boost morale as the employees have a financial stake in the company and its wellbeing. However, ESPPs have many moving components, and it can be easy to get confused and fail to fully take advantage of them.
The ESPP Process
An employee stock purchase plan can be a great benefit to employees as it allows them to invest in their company at a discounted rate from the fair market value of the company’s shares. Through ESPPs, employees have the choice to enroll by completing a form authorizing payroll deductions to begin before their election or open enrollment period. Contributions aren’t tax deductible.
As an employee, you’re able to choose the amount of money you would like deducted from your payroll. Most companies will put a percentage limitation on your contributions, and the IRS implements a cap of $25,000 per calendar year.
The funds you contribute funnel into a separate holding account where they’ll be stored throughout the offering period – from when you start contributing through the purchase date when you actually buy the company stock. Every company has a different ESPP life cycle. However, you can usually anticipate an offering period of 6, 12, or 24 months, that’s followed by a purchase period. When you reach the purchase period, the funds from your holding account are used to purchase company stock at the predetermined discounted rate (up to 15% for tax-qualified ESPPs).
In some cases, companies also offer a “look back” provision. This means that, when the purchase date rolls around, you have the option to buy company stock at either:
- The price of the stock when the offering period started.
- The current price of the stock.
This protects employees in the event that stock prices fall over the course of the offering period. Let’s look at an example:
On the first day of the offering period, your company stock was $15 per share, and on the last day of the purchase period the stock was $20 per share. Your company is offering a 10% discount on the shares and has a “look-back” provision.
In this case, you’ll be able to purchase stock for the more favorable $15, with your 10% discount, which leaves you with a purchase price of $13.50 per share – even though the fair market value is $20 per share.
Qualified or Non-Qualified
There are two types of ESPPs:
- Qualified. This type of ESPP is in line with IRS Code Section 423, and allows you to purchase stock at a discounted rate without triggering ordinary income tax. There are certain holding provisions, and when those are met, you may be eligible for favorable long-term capital gains taxes.
- Non-qualified. Non-qualified ESPPs don’t meet the IRS Code Section 423 stipulations, and may be subject to ordinary income tax when shares are sold. However, non-qualified plans can offer more flexibility as they don’t have to adhere to all of the rules for qualified plans. Ask your employer about your specific plan.
Qualifying and Disqualifying Positions
As is the case with NQSOs and ISOs, you can either have a qualifying or disqualifying disposition with your ESPPs. These are dependent on the total time you hold your shares.
A qualifying disposition requires that the employee retain their shares for at least two years from the start of the offering period, and at least one year from the date of purchase. If the employee sells the stock less than two years from the start of the offering period, and less than one year from the date of purchase, they will have made a disqualifying disposition. Disqualifying positions can increase the tax burden of the sale (more on this below).
ESPPs and Taxes
ESPPs have complicated tax requirements, and it’s important to consult your tax planning professional throughout this process. However, it can be useful to understand the basics before deciding whether or not ESPPs are right for you.
Remember, tax implications of your ESPP will be dependent on two factors:
- Whether your ESPP is qualified or non-qualified.
- Whether you have met the holding requirements for either a qualifying or disqualifying disposition.
Qualified ESPPs with a Qualifying Disposition
For a qualified ESPP, no tax will be applied until the sale of the shares and you will never pay Social Security or Medicare tax. If you have a qualified ESPP and you have met the holding requirements for a qualifying disposition, you’ll still be facing two types of tax: ordinary income and capital gains.
The ordinary income will either be calculated from the lower of two options: the actual gain (purchase price – sales price) or the purchase price discount. For tax purposes, the purchase price discount is based on the first day of the offering period and also takes into account the price of the look-back provision should there have been one in place. Let’s look at an example to help bring this to life:
Retaining the same numbers from above, on the first day of the offering period the stock is $15. With your 10% discount, you paid $13.50 for your shares. But your ordinary income would only need to be $1.50, as that is 10% of $15. Any additional gain will be taxed at the long-term capital gains rate. So if you sold the stock for $20, you would pay $5 in long-term capital gains.
Qualified ESPPs with a Disqualifying Disposition
If you have a qualified ESPP and you have not met the holding requirements, you will be subject to ordinary income tax at the time of the sale. The ordinary income will be based on the spread (fair market value – purchase price) which, using our example above, would be $6.50 ($20 fair market value – $13.50 purchase price).
Non-qualified ESPPs incur different tax treatment. Ordinary income is applied at the point of sale from the difference between the fair market value and the discount given to the employees. For example, let’s say the company offered a 20% discount for employees and the market price on the purchase date is $35. With the discount, your actual purchase price is $28. This means you would owe $7 in ordinary income at the time of sale (assuming all shares were sold at the same purchase price of $35).
Again, the tax requirements here are nuanced, which is why it is important to be proactive about your tax planning strategy and include your tax professional when making these decisions.
A Word to the Wise
ESPPs can be a fantastic way to leverage the full compensation and benefits your employer offers. However, the tax rules that accompany ESPPs can make them challenging to navigate. It’s also important to remember a few things when deciding whether or not to leverage your ESPPs:
- You don’t necessarily want to be over-concentrated in employer stock. If a portion of your portfolio is already comprised of shares from your employer, and you receive your income from them, you’re putting all of your eggs in one basket. ESPPs can be useful, but you may want to sell more quickly in order to diversify.
- If you do choose to sell before you’d achieve long-term capital gains tax treatment, that’s okay. Many employees choose to do a same-day sale, taking advantage of the gains immediately. Just be aware of the tax implications of selling.
If you ever have questions about your stock options, we’re here to help. Feel free to reach out to the FPC team at any time.