Understanding Your Employee Stock Purchase Plan (ESPPs)
Employee Stock Purchase Plans are one popular way you can invest in the stock of your company. Although they aren’t exactly part of your compensation plan, a lot of the rules surrounding the terminology are like other kinds of stock compensation. ESPPs are usually presented as part of your benefits package and enrollment may be like enrolling in your company retirement plan. In this post, we’ll focus on ESPPs and give you the details you’ll need to know to understand how this type of investment in your company stock works. For an overview of types of company equity plans, refer back to our post Where to Start When You Have Stock Compensation.
The most common ESPPs we deal with are for clients who work for public companies like Facebook, Disney, Microsoft, and Google. These companies offer ESPPs as a benefit to all of their employees and investing in them can be a good way to build wealth. They offer a convenient way for you to invest in the stock of your employer through paycheck deductions. You may also be able to purchase the shares at a discount via the ESPP – which is better than purchasing the stock in a regular brokerage account.
Terminology
If you have the ability to enroll in an ESPP, you’ll want to understand what that means and how the plan can benefit you. There are some special rules that apply to stock purchased this way. Just to be clear, we aren’t talking about an ESOP – that’s a retirement plan that invests in the stock of your employer.
Qualified ESPPs – these are plans that meet special requirements set forth in the tax law. If the plan meets these requirements, they may offer advantageous tax treatment. Another name for these kinds of plans are “Section 423 plans” after the part of the tax code they conform to. A qualified ESPP has to be offered to all employees that meet the eligibility criteria.
Non-Qualified ESPPs – these kinds of plans do not have to conform to any special tax rules and do not offer any special tax treatment to participants.
Plan Details – you will want to understand a couple of different details of your company’s plan.
Amount of paycheck deduction – you may choose an amount to withhold usually between 1%-15%. Each paycheck, that amount will be withheld from your paycheck and deposited into your “account” with the plan administrator.
Offering Period – The amount of time your money accumulates before a purchase is made with your funds. A typical offering period is 3-6 months. You may or may not be able to change your enrollment during the offering period.
Withdrawal Deadline – this is the date by which you must un-enroll in the plan if you change your mind and want to get your money back before the shares are purchased.
Discount Amount – you’ll want to know how much of a discount you will receive on the stock price. The larger the discount, the more of a benefit you get from participating in the program. A typical discount is between 5-15%.
Lookback Period – The dates that the company uses to set the share price to use before applying the discount. Some companies use the lower of the two prices on the first and last days of the offering period. Some companies just use the price on the last day of the offering period.
Special Holding Period – this is the period that refers to how long you have to own your ESPP shares in order to get special tax treatment in a qualified plan. It is satisfied on the later of these two dates – two years from the beginning of the offering period, and one year from the purchase of the share.
Custodian – once your shares are purchase, they are held in an account in your name at a financial institution that your employer has chosen to administer the program. Popular custodians are Fidelity, ComputerShare and Morgan Stanley.
Tax Implications
Compared to other kinds of company stock programs, ESPP taxes can be easier to understand, but that doesn’t mean there aren’t some tricky rules.
Nonqualified ESPP
If you participate in a nonqualified ESPP, there is not a lot to consider from a tax perspective. If you purchase the shares of stock with no discount, it’s like you purchased them on the open market and you only have a tax impact when you sell the shares.
If you purchased the shares at a discount, the amount of the discount is reported by your employer as income to you. You’ll be required to pay taxes on that income. For example, let’s say your company shares are worth $100 each. During the offering period, you accumulated $900 to purchase shares. Your company offers a 10% discount through the ESPP plan. At the end of the offering period, the plan will purchase 10 shares for you ($100 x 10 – 10% discount = $900). The market value is $1,000 so you will pay compensation income taxes on $100 (the value of your discount).
Your company can offer various ways to pay the taxes on this income so make sure you understand how it will happen. Popular ways to pay the tax include withholding cash from your paycheck or selling shares you just bought to cover the taxes.
Regardless of whether you got a discount or not, if you later sell your shares for more than you paid, you’ll pay capital gain taxes on the increase. If you sell them for less, you may be able to deduct that loss on your taxes (or carry it forward). Make sure the custodian handling your transaction has the right amount you “paid” for the shares – $100 per share in both cases even though you got a discount.
Qualified ESPP
Things get more complicated (but can be better for you!) if you have access to a qualified ESPP. If you purchase shares at a discount through a qualified ESPP, you don’t have to report the discount as income, nor pay taxes on it when the shares are purchased. Your company will provide tax Form 3922 by January after the end of the prior year when you’ve participated in the plan. File this form for when you sell later, but you won’t need it right now.
As I mentioned above, there is a special holding period that applies for shares purchased in an ESPP. If you sell your shares before the special holding period has expired, you have made a “disqualifying disposition”. This isn’t necessarily a bad thing, as we’ll discuss below, and sometimes could even be a good thing. You will pay compensation income tax on difference between the price you received including your discount, and the price of the stock on the last day of the offering period. Depending on when you sell, you could also have a capital gain or loss to report.
The benefit of the special holding period is that if you satisfy it and then sell your shares, you could end up reporting less total income than if you sold early. The calculations for how much of your sale proceeds count as compensation income v. capital gain income is complicated, so it’s important you work with an experienced tax professional to help you. So why doesn’t everyone wait to sell their Qualified ESPP shares? We’ll discuss that next.
Planning for ESPPs
Although tax benefits are important, there are several reasons they aren’t the most important factor in making financial planning decisions around ESPPs. Let’s think about the broader picture around an ESPP plan first.
Unlike RSUs, you must pay for shares in an ESPP plan. This means that using your cash flow to invest this way needs to make sense. Sometimes clients come to us and don’t even know they’ve enrolled and don’t understand how an ESPP works. If you want to know if you’ve enrolled, check out your pay stub and see if there’s a deduction shown for ESPP in the After-Tax section. In general, if you have debt you are trying to pay off, or need to work on your emergency fund, we’d recommend a pass on an ESPP. Also, if your employer offers a good 401k plan with a match, you’re better off putting your money there first.
If you’ve done all of that and you’re ready to invest, it still makes sense to think about whether your company stock is a better place to invest than a diversified portfolio. It is more risky to invest in one stock compared to many. Some people like investing in their employer, though. The features of an ESPP plan which make it a good thing despite the investment risk are the discount, the amount of salary you can use, and the offering and look back periods. In general, if you can afford to withhold a larger portion of your salary, and the discount is on the higher end, you may want to fully invest in the ESPP, even if you sell your shares right away and must pay taxes.
Of course, the trajectory of the company stock price and amount of this investment compared to your overall net worth are important considerations too.
In these types of situations, it’s helpful to have a financial planner who understands your situation. For example, with clients who are emotionally attached to their company stock, we help them set up a plan for diversifying their investments. This could mean selling all newly purchased shares but keeping the old ones to get special tax treatment of a qualifying disposition. It could also mean selling old shares in chunks regardless of what the stock price is doing and the tax consequences. Finally, it could mean divesting of the stock completely to fund another important goal like sending your child to college.
We love helping clients understand their company stock benefits. If you have questions about your ESPP, please reach out and schedule a complimentary introductory call!