As an employee at a public company, what is keeping us from joining the next UBER in hopes of striking it big? Retaining talent and hiring is a challenge every company faces, and for public companies, the executives understand the need to compensate employees with equity as well. Read more about why equity matters.
Equity ownership for public companies often comes in the form of RSUs and an Employee Stock Purchase Plan (ESPP).
Here's a quick video to explain ESPPs.
How does it work?
When we choose to participate in our company’s ESPP, we need to select how much we want to be deducted from our paychecks. This deduction can be either a specific dollar amount or a % of our take-home pay. The maximum amount we can deduct is $25,000 dedicated to ESPP per year.
Nothing happens until the offering date (the start date). After the start date commences, the company automatically deducts our ESPP election from our paycheck after taxes. The cumulative money is set aside in an account over the offering period. And at the end of the offering period or on the purchase date, the accumulated cash is used to purchase shares at a discount to the market value. Depending on each company’s plan details, the purchase date could happen over multiple intervals throughout a year, e.g., once a quarter or once every two quarters. The company opens a brokerage account on our behalf where we can choose to sell our shares.
The most significant advantage of an ESPP plan is that as an employee we can purchase stock in the company with up to a 15% discount to the current market price! That’s practically free money going into our pockets since we can immediately sell our shares and lock in the 15% profit.
Certain ESPPs have a special provision called a lookback that offers potentially even larger discounts.
Lookback provisions allow the discount to be applied at the most favorable price which can result in more shares purchased for our money. Let's step through an example.
Since we are getting shares at a discount, the immediate gain is taxed as ordinary income.
However, as long as the company’s plan follows certain guidelines, a qualified ESPP allows us to defer the taxes until we sell our shares.
The shares we purchase through an ESPP are our shares, and we can sell them at any time at our discretion unless our company has imposed blackout periods to protect against insider trading. At this point, we'll owe the following taxes on our qualified ESPP:
- The total discount we received on the initial purchase of shares is reported as income. This difference is calculated by taking the stock price on the purchase date and subtracting it from the purchase price (including lookback discounts).
- The difference between the sales price and the purchase date price is subject to capital gains. If we held the shares for more than one year before selling, we would owe long-term capital gains (15%); otherwise, we owe short-term capital gains (same as income tax).
Who can participate?
Most ESPP plans allow all employees to participate unless they already own more than 5% of the company’s stock. This exception prevents most founders and c-suite executives from participating. Some ESPP plans may also have eligibility requirements that require us to work at the company for a minimum of a year before we can participate.
If we are offered an ESPP, it’s almost always a good idea to participate. We should first confirm with the company that the current plan falls under a “qualified ESPP” so that we aren’t surprised by a big tax bill. Secondly, we should ask if there is a lookback provision covered by the plan.
Lastly, we should always prioritize our 401(k) before an ESPP, even with the 15% discount. With an ESPP, our risk is concentrated in the stock of the company, while our 401(k) offers diversification.
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!