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What Is an Employee Stock Purchase Plan (ESPP)?
An Employee Stock Purchase Plan (ESPP) allows employees to buy their company’s stock directly at a discounted rate, making it an attractive employee benefit. Through payroll deductions, employees accumulate funds over a specified period, typically between the offering date and the purchase date. Upon the purchase date, these accumulated funds are used to buy company stock, often at a discount of up to 15% from the market price.
Key Takeaways
- Employee Stock Purchase Plans (ESPPs) allow employees to buy their company’s stock at a discount, typically up to 15% below market price, offering a potentially profitable investment opportunity.
- ESPPs can be categorized as qualified or non-qualified, with qualified plans offering tax advantages and requiring shareholder approval.
- Employees contribute to ESPPs through payroll deductions, accumulating funds to purchase stock during specified offering and purchase periods.
- Key restrictions include eligibility based on ownership percentage and employment duration, with a maximum contribution limit of $25,000 per year as stipulated by the IRS.
- Selling ESPP stock immediately after purchase is allowed, but holding it for more than a year can result in lower capital gains tax rates on long-term profits.
How ESPPs Offer Stock at a Discount
With an employee stock purchase plan, employees have the option to buy stock in their employer at a discounted price. Employees are offered ESPPs when they are hired, similar to a 401(k) retirement plan, allowing them to buy company stock below market price and potentially profit. If the company grows and becomes more successful, the stock becomes even more valuable, which then increases the benefit to the employee.
With employee stock purchase plans, the discount rate on company shares depends on the specific plan but can be as much as 15% lower than the market price. An ESPP may have a “look back” provision allowing the plan to use a historical closing price of the stock. This price may be the price of the stock on the offering date or the purchase date—often whichever figure is lower.
Differences Between Qualified and Non-Qualified ESPPs
There are two types of ESPPs: qualified and non-qualified. Qualified plans need shareholder approval, and all participants have equal rights in the plan. The offering period of a qualified ESPP cannot be greater than three years, and there are restrictions on the maximum price discount that is allowable. Non-qualified plans are not subject to as many restrictions as a qualified plan. However, non-qualified plans do not have the tax advantages of after-tax deductions that qualified plans do.
Key ESPP Dates to Understand
You can only join your company’s ESPP after the offering period starts. This period begins on the offering date, and this date corresponds with the grant date for the stock option plans. The purchase date will mark the end of the payroll deduction period. Some offering periods have multiple purchase dates in which stock may be purchased.
Tip
Your employment contract should contain these dates. If you are unsure where to find information about your EESP, contact the HR department at your employer.
Who Can Participate in an ESPP?
ESPPs typically do not allow individuals who own more than 5% of company stock to participate. Employees usually need to work for the company for at least a year to join the ESPP. All other employees typically have the option to participate in the plan, though they are not required to.
ESPP Contribution Limits and Discounts
During the application period, employees state the amount to be deducted from their pay and contributed to the plan. This may be subject to a percentage limitation. The IRS limits contributions to $25,000 per year. Most ESPPs grant employees a price discount of up to 15%.
Understanding ESPP Taxes and Implications
The taxation rules regarding ESPPs are complex. In general, you will be taxed on any stock you purchase through an ESPP during the year you sell it. It can be counted either as taxable income or as a deductible loss.
The difference between your purchase price and selling price is considered a capital gain or loss. Any discount offered to the original stock price is taxed as ordinary income, while the remaining gain is taxed as a long-term capital gain. The entire gain will be taxed as ordinary income if you have not held it for:
- One year after the stock was transferred to you; or
- Two years after the option was granted
Can I Cash Out My Employee Stock Purchase Plan?
Yes. The payroll deductions you have set aside for an ESPP are yours if you have not yet used them to purchase stock. You will need to notify your plan administrator and fill out any paperwork required to make a withdrawal. If you have already purchased stock, you will need to sell your shares.
Can I Sell ESPP Stock Right Away?
Yes, you can sell stock purchased through your ESPP plan immediately if you want to guarantee that you profit from your discount. Otherwise, the value of the stock may go up, which increases your profit, or it may go down, causing you to lose money. However, you will pay a lower tax rate if you hold the stock for more than a year and sell it more than two years after the offering date.
Is an ESPP Income or Capital Gains?
If you sell stock purchased through your ESPP more than 12 months after you purchased it, any gain beyond the discount that you received through the plan is taxed as a capital gain. The discount is taxed as ordinary income. In general, capital gains tax rates are much lower than ordinary income tax rates, ranging from 0% to 20% depending on your income bracket.
The Bottom Line
An employee stock purchase plan (ESPP) is an advantage that lets employees buy company stock at a discount, sometimes up to 15%. Employees can build contributions through payroll deductions until the purchase date specified in their contract is a program in which employees can purchase company stock at a discounted price.
In general, shares purchased through an ESPP are treated like other stock at tax time: you would report a capital gain or loss on your income taxes the year that you sell the stock, though you may have to pay your ordinary tax rate on the difference between what you paid at the market price of the stock.
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