Unraveling Employee Stock Purchase Plans (ESPPs)

December 19th, 2023 by Blake Pinyan

Employee Stock Purchase Plans (ESPPs) serve as effective tools to foster engagement and motivation by offering you an opportunity to partake in the progress of your company. Functioning as a form of Equity Compensation, ESPPs stimulate investment in company stock, typically at a discounted rate compared to the prevailing stock exchange price.

In this article, we’ll explore ESPPs, shedding light on their fundamental workings and their attractiveness as an investment option. We’ll discuss the two primary plan types, review the steps to participate in these programs, delve into the pertinent tax regulations and considerations, and wrap up with a perspective from Anchor Bay.

ESPP Overview

An ESPP can empower you to allocate a portion of your earnings toward purchasing company stock through a voluntary deferral program. This opportunity, akin to contributing to an employer-provided retirement account (such as a 401(k)), involves designating a percentage of your paycheck for payroll deduction into the ESPP plan. Unlike traditional retirement accounts that typically leverage pre-tax contributions, funds directed into your ESPP are usually recognized on an after-tax basis, meaning they don’t immediately reduce tax liabilities.

ESPPs offer an enticing prospect due to potential discounts on company stock purchases. The extent of the discount varies based on the specific plan outlined by the company, necessitating a thorough review of the ESPP plan document to understand its rules and procedures before participation.

Understanding the nuances of ESPPs involves grasping their “lookback” provisions, used in determining the purchase price per share. A “lookback” feature calculates the price you pay based on the lower value between the stock’s price on the grant day and the purchase day, offering a discounted rate per the company’s set percentage.

For instance:

• Emily participates in ABC Company’s ESPP offering a 15% discount and the stock was trading at $40 on the grant day and $50 on the purchase day.
• Her purchase price per share would be $34 ($40 grant day price – $6 discount).
• However, if the grant day price had been $60, the discount would have been applied against the purchase day price ($50), resulting in a different purchase price per share.

Typically, ESPPs feature discounts ranging from 0% to 15%, with the latter being the maximum the IRS permits for tax-qualified plans. Many companies gravitate towards the 15% discount limit as it provides the largest incentive to participate in the plan.

Plan Mechanics

An ESPP can fall into two categories: tax-qualified or non-qualified.

Tax-Qualified

The tax-qualified designation aligns with the requirements outlined in Section 423 of the Internal Revenue Code, which is the chosen route for most companies establishing an ESPP. Opting for the tax-qualified status provides you with a more favorable tax treatment, notably deferring taxes until the eventual sale of the company stock, a detail we’ll explore in more depth later. However, tax-qualified ESPPs enforce a cap on your purchase of the company shares, limiting it to $25,000 within a calendar year, based on the undiscounted share price on the first day of the offering period, known as the grant date.

Non-Qualified

In contrast, non-qualified ESPPs offer greater flexibility in terms of plan specifics, eligibility criteria, and design. These plans can diverge significantly from tax-qualified structures. For instance, non-qualified ESPPs might feature a discount on share prices exceeding the maximum limit allowed in tax-qualified plans (15%). Additionally, companies can opt to match contributions similar to how employers do with 401(k) plans, and they might impose restrictions on access for higher-compensated employees.

ESPPs operate as voluntary deferral programs, with most companies refraining from automatically enrolling you. Individuals interested in participating must complete an agreement or form consenting to paycheck deductions toward the ESPP. This process involves specifying the desired contribution amount as a percentage of your gross annual salary. Similar to strategies advised for 401(k) plans, it’s prudent to begin with conservative salary deferrals and gradually increase contributions to manage cash flow effectively. Typically, you need to submit this form before the applicable enrollment date (grant date), and details on participation procedures can usually be obtained from the employee benefits package or HR department.

The mechanism of purchasing company stock through an ESPP differs from conventional methods. Rather than immediately purchasing stock upon your payroll deductions, your contributions accumulate until the stock is bought on a designated purchase date, which is typically the last business day of the offering or purchase period, as defined by the plan.

Tax Implications

Understanding the tax implications of ESPPs involves consideration of the grant date, purchase date, and eventual sale date, forming the essential timeline for tax assessment. In this ESPP overview, our focus remains on Federal taxation, as each state possesses its distinct tax regulations.

As noted, contributions are typically made on an after-tax basis. In the case of tax qualified ESPPs, taxes are triggered not upon stock purchase but upon its eventual sale.

To understand the tax implications, it’s important to distinguish between a qualifying disposition and a disqualifying disposition.

Qualifying Disposition

A qualifying disposition, according to Section 423 of the Internal Revenue Code governing ESPPs, occurs when stock is sold two years after the start of the offering period (grant date) and at least one year from the date of purchase (exercise date). Compliance with both criteria is necessary. For example, if Emily was offered to contribute to the plan on 10/08/2022 and purchased stock on 12/05/2022, her qualifying disposition date would be 10/9/2024. However, if her purchase date was 11/15/2023, her qualifying disposition date would then shift to 11/16/2024.

The advantage of delaying actions such as selling, gifting, or transferring ESPP stock until meeting the criteria for a qualifying disposition lies in the favorable tax treatment it offers. Notably, part of the transaction can be recognized as long-term capital gain, subject to more preferential tax rates. However, it’s essential to note that there’s an ordinary income component involved as well. This income tax is levied on the lesser of the stock discount granted by the company or the calculated capital gain.

For instance, if Emily purchases 100 shares with a 15% purchase discount, allowing her to buy shares at $34 each, her ordinary income tax would be $600 ($6 discount x 100 shares), as it’s lower than the calculated capital gain of $2,600 ($60 sale price – $34 actual purchase price).

In computing the capital gain for ESPP qualifying dispositions, adjustments are made to the cost basis.

• Emily’s original purchase price was $34 per share after the $6 ESPP discount on 10/8/2022, which increases her adjusted cost basis to $40 per share ($34 original + $6 discount).
• Selling at $60 per share on 10/9/2024, her capital gain amounts to $20 per share or $2,000 ($20 gain x 100 shares).

This qualifies as a long-term capital gain for Federal tax purposes, meeting the criteria of being held for at least one year after purchase and two years from the offering date, thus subject to more favorable Federal tax rates.

Disqualifying Disposition

Conversely, selling company stock held for less than two years from the offering date or one year from the purchase date constitutes a disqualifying disposition, subject to different tax rules.

For disqualifying dispositions:

• Ordinary income tax is levied on the difference between the stock’s price on the purchase day and the discounted purchase price.
• In Emily’s case, where the stock price at purchase was $50 per share and her discounted purchase price was $34 per share, her ordinary income tax for a disqualifying disposition would amount to $16 per share or $1,600 ($16 per share x 100 shares).

The capital gain tax, the second type of taxation, can assume either long-term or short-term status contingent upon the holding period post the stock’s purchase. In the context of a disqualifying ESPP disposition, treatment as a long-term capital gain occurs when the stock is sold within two years from the offering date but over one year from the purchase date. Conversely, treatment as a short-term capital gain happens when the stock is sold within two years from the offering date and one year or less from the purchase date.

Long-term capital gains, as previously mentioned, benefit from more favorable Federal taxation. To determine the capital gain or loss, as we did with the qualifying disposition, we need to adjust the cost basis by the amount of ordinary income tax paid.

For example:

• Emily’s ordinary income tax of $16 per share from the prior disqualifying disposition example added to her original discounted purchase price of $34 per share yields an adjusted cost basis of $50 per share ($34 original + $16 ordinary income tax).
• Selling at $60 per share results in a capital gain of $10 per share ($60 sale price – $50 adjusted cost basis).

The categorization into long-term or short-term hinges on her sale date in relation to the purchase date.

• As Emily purchased her 100 shares on 12/05/2022, if she sold on 03/16/2023, the capital gain would be subject to short-term rates as she held the stock for less than a year from the purchase date.
• Conversely, if she sold on 12/21/2023, the capital gain would be taxed at long-term rates, held for over one year from the purchase date.
• However, both sale examples represent disqualifying positions since they occurred before the two-year mark from the offering date, which would have been 10/09/2024, as Emily was offered the stock on 10/08/2022.

Anchor Bay Perspective

ESPPs offer valuable opportunities but require careful consideration. Participating in these programs involves voluntary paycheck deductions. Factors such as personal cash flow, confidence in the company, discount rates offered, and alternative savings avenues like 401(k)s or savings accounts should be weighed. Starting with lower contributions allows flexibility for adjustments aligned with your individual financial circumstances.

While faith in your company may be significant, investing in a single stock does still present higher risk compared to a diversified portfolio. While potential gains might arise from the company’s stock acceleration, overcommitting a substantial portion of one’s paycheck to an ESPP could significantly impact financial stability if the company’s share price declines.

Moreover, selling stock in your ESPP triggers certain tax implications, depending upon whether qualifying or disqualifying distributions were utilized. Awareness of these tax implications is crucial during decision-making to avoid surprises upon tax filing.

Given these complexities, seeking guidance from a financial professional well-versed in ESPP workings, capable of devising a contribution strategy considering various factors, and knowledgeable about the nuanced tax regulations is essential.

At Anchor Bay, we specialize in assisting clients with their ESPPs, ensuring contribution and disposition plans align with their overall financial and tax strategies. Emphasizing the importance of intentional decision-making, we understand that it’s not just about earnings but also about effectively retaining wealth.