What is an ESPP? #
An employee stock purchase plan, or ESPP, is a benefit some companies offer that allows employees who take part to purchase shares of company stock at a discount, usually 15%.
Employees who choose to participate generally make contributions to the plan via payroll deductions. The deductions are held in the plan until a specified purchase date, at which point they are invested in the company’s stock.
Section 423 ESPPs are the most common type of ESPP. This type of plan is tax-qualified when it meets certain conditions outlined by the IRS, thus offering tax advantages.
Key Dates of an ESPP #
1. Enrollment Period: In this period, you enroll in the plan and decide on what percentage of your salary to contribute, up to a limit the company sets.
2. Grant Date & Offering Period: In ESPPs that are tax-qualified under Section 423, the grant date is critical. The stock price serves as the starting point for tax purposes, for calculating the annual purchase limit of $25,000, and for calculating any lookback price. Payroll deductions start after the grant date.
Look Back Price: “Look Back” provisions are found in certain tax-qualified ESPPs. This provision makes qualified ESPPs more attractive. Typically, a look back provision allows you to apply whatever discount your employer offers to the lower of two numbers: the price on the first date of the offering period or the price on the last day of the purchase period. Most plans use a standard discount of 15% on the minimum of two prices:
1.Price at the beginning of the offering period or
2.Price at the end of the purchase period
Some companies keep their ESPP program open for multiple years, with multiple purchase periods along the way. What this means is that the offering-date price stays the same while the purchase-date price changes.
3. Purchase Period: Payroll deductions start during the purchase period of your paycheck (you decide how much within this range, with a $25,000 annual maximum for tax-qualified plans).In some cases, company ESPPs have a long offering period (e.g. 18 months). There could be several purchase periods during a single long offering period. This implies that there will also be several purchase dates (one at the end of each purchase period). For example, an 18-month offering period that includes three purchase periods will have a purchase date at the end of every 6 months.
4. Purchase Date: The purchase date, sometimes known as the exercise date of your ESPP, is when contributions are used to purchase shares of company stock. The purchase date typically occurs at the end of the purchase period, and always occurs at the end of the offering period.
Discount: Many companies offer a discount on the purchase price of stock acquired through an ESPP in order to encourage participation. A tax-qualified ESPP can offer discounts ranging from 0-15%.
Timeline of a sample ESPP #
By giving written notice to the plan administrator, most ESPPs allow participants to withdraw from the plan at any time before the purchase (or exercise) date. If you withdraw from the plan, either voluntarily or due to termination, you will receive all of the amounts previously withheld from your wages.
Qualified vs. Disqualifying Disposition #
ESPPs are taxed under Section 423 of the Internal Revenue Code if you meet the special holding period requirements:
- Two years from the start of the offering and
- One year from purchase
Stock-price changes between the time you buy and the time you sell can also have an impact on your taxes.
Example Calculation of Tax #
Side by Side Comparison #
Key Calculations:
- Price Used = We take the lesser of the first day and last day price
- Then we apply the discount -> The Price Paid = Price Used x Discount
- Gain = Sale Price – Purchase price
- Ordinary Income = (Price Used x Discount)
- Capital Gain = Gain – Ordinary Income
- Holding period > 1 year –> Long-Term Capital Gain
- Holding period <= 1 year –> Short-Term Capital Gain
