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Employee Stock Purchase Plans

Lesson in Course: Finance at work (advanced, 10min)

My company allows me to purchase stock at a discount. Is this too good to be true, and what do I need to know?

Eureka!

What it's about: An equity incentive plan offered by public companies to employees to purchase company stock.

Why it's important: Often these plans offer a discount which serves as free money.

Key takeaway:  A qualified ESPP allows us to purchase shares at a 15% discount. The taxes owed on a sale include income tax on the discount and capital gains on any further appreciation.

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). 

What is Employee Stock Purchase Plan?

An Employee Stock Purchase Plan (ESPP) allows us to buy shares in the company we work for directly through our paychecks with after-tax dollars, often at a discount.

Here's a quick video to explain ESPPs.

ESPP
https://www.youtube.com/embed/ebeNGbl6rWk?start=16&end=177

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.

$25,000 is the most that can go towards an ESPP plan

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 discount

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.

Shares purchased through ESPP are valuable right away

Certain ESPPs have a special provision called a lookback that offers potentially even larger discounts.

What is Lookback provision?

A provision included in some ESPP plans allows us to purchase shares at the better price of the stock at the purchase date or the offering date.

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.

Lookback example

We have contributed to an ESPP a total of $12,500 over 6 months and are on track to maximize the $25,000 per year limit. Our ESPP offers a standard 15% discount with a lookback provision.

Price of shares at the offer date: $100 per share or $85 per share after a 15% discount

Price of shares at the purchase date: $150 per share or $127.50 per share after a 15% discount

Because of the lookback provision, we are able to buy at the $85 per share price and are able to own 147 shares instead of 98 shares.

$12,500 / $85 = 147 Shares purchased vs $12,500 / $127.5 = 98 shares purchased

Taxes owed

Since we are getting shares at a discount, the immediate gain is taxed as ordinary income.

ESPP also create a tax liability

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. 

What is Qualified ESPP?

A specific employee stock purchase plan that allows the income tax owed on all qualified ESPP to be deferred until we sell our shares. Qualification guideline requirements for tax benefits include:

  • Approval by a vote of the shareholders
  • All plan participants have equal rights in the plan
  • Offering periods cannot exceed 27 months
  • The discount on the stock price may not exceed 15%

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:

  1. 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).
  2. 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).
Example of taxes

Following the lookback example above, let’s say we sell all 147 shares 14 months later at $200 per share. What are the taxes we will owe?

Capital gains

$200 - $150 = $50 per share in long-term capital gains

$50 x 147 = $7,350 in total long-term capital gains

$7,350 * 15% = $1,102.50 estimated taxes owed for ltcg

Income

$150-$85 = $65 per share in income

$65 x 147 = $9,555 in income shown on W2

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.

Actionable ideas

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.

Supplementary materials

For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!

Employee Stock Purchase Plans: The Basics & Taxes

Gain the confidence to make investing a bigger part of your life

https://app.getmedes.com/videos/employee-stock-purchase-plans-the-basics-taxes/

Glossary

What is ESPP ?

An equity incentive plan that allows employees to buy shares of the company they work for directly through their paychecks with after-tax dollars. Often these shares can be purchased at a discount of up to 15%.

What is Lookback provision?

A provision included in some ESPP plans allows us to purchase shares at the better price of the stock at the purchase date or the offering date.

Example
Contributed to ESPP: $12,500

Discount: 15%

Offer date price: $100 per share or $85 per share after 15% discount

Purchase date price: $150 per share or $127.50 per share after 15% discount

$12,500 / $85 = 147 Shares purchased compared to $12,500 / $127.5 = 98 shares purchased.

What is Qualified ESPP?

A specific employee stock purchase plan that allows the income tax owed on all qualified ESPP to be deferred until we sell our shares. Qualification guideline requirements for tax benefits include:

  • Approval by a vote of the shareholders
  • All plan participants have equal rights in the plan
  • Offering periods cannot exceed 27 months
  • The discount on the stock price may not exceed 15%