ESPP: What to Know About Employee Stock Purchase Plans
If your employer offers an ESPP, you may be eligible to buy stock at a discount and take advantage of tax benefits.
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An employee stock purchase plan, or ESPP, is a workplace benefit some companies offer that allows employees to purchase shares of company stock at a discount. Employees who participate make contributions to the plan via payroll deductions. The ESPP holds the money until a specified purchase date, at which point it uses the money to purchase shares of the company's stock on behalf of the employees.
» Learn more. See our guide to understanding equity compensation
How ESPPs work
There are four main steps to participating in an ESPP.
Eligible employees enroll in the ESPP. If you meet the plan’s criteria, you can enroll during a specified period and set your contribution level. This may be a percentage of your pay or a flat dollar amount that will be withheld from your paycheck after taxes.
Contributions accumulate until the purchase date. The ESPP typically buys the shares six to 12 months after the “offer date,” or the start of the ESPP offering period. Generally, you can adjust your contributions during this accumulation phase. You also may be able to withdraw contributions if they haven’t yet been used to buy stock.
The ESPP uses the contributions to purchase stock at a discount. The discount rate differs from plan to plan, but it can be as much as 15% below market value.
Employees may sell their stock or hold it. Purchased shares may take a few days to be available in an employee’s account. But once they are, participants typically can sell their stock right away if they choose. Keep in mind you may owe taxes on any gains.
Depending on how the plan is arranged, each ESPP will have different rules and features. A tax professional or financial advisor can help you with the details and assess what's right for you.
Qualified vs. non-qualified ESPPs
Whether your company offers a qualified ESPP will determine the kinds of features or tax benefits that come with it.
Qualified ESPPs
Qualified employee stock purchase plans (also known as section 423 plans) have to meet certain regulatory requirements, so they typically are more restrictive. Some of the regulations imposed on qualified ESPPs include:
Company shareholders must approve qualified plans within 12 months of the date the plan is implemented.
Each plan participant must have equal rights and privileges in the plan, meaning everyone has to follow the same rules and an ESPP can’t favor certain employees, such as highly compensated people.
Depending on plan specifics, there may be limits on how long the offering period lasts.
Employees who participate in qualified ESPPs are typically able to take advantage of some tax benefits (more on that below).
Non-qualified ESPPs
Non-qualified ESPPs often have more flexibility in terms of regulatory requirements, but employees do not get any of the tax advantages.
Most of this article pertains to the rules and regulations surrounding qualified ESPPs. If you’re unsure about the type of plan you have, check with your company's human resources or benefits department.
ESPP lookback feature
Qualified ESPPs may include a lookback feature. Plans that have this feature can set the purchase price of the stock based on the stock price at the beginning of the offer period or the stock price on the day of the purchase — whichever is lower. This provision may help increase your benefit if the stock price changes significantly during the offer period.
For example, say your company has an ESPP with a 15% discount. At the beginning of the offer period, the stock price is $10 per share. If the price increases to $15 per share on the purchase day, your 15% discount would apply to the $10 price at the beginning of the offer period, meaning your purchase price would be $8.50 per share.
» Dive deeper. Is trading employee equity a good idea?
ESPP eligibility and max
Eligibility: Many plans do not allow employees who own more than 5% of the company to participate. Some plans may also prevent employees from participating until they have been employed by the company for a certain amount of time.
Maximum contributions: Tax rules cap the amount of company stock an employee can purchase in a year at $25,000. Most plans allow employees to elect a payroll deduction between 1% and 15%.
How ESPPs are taxed
Taxes on ESPPs depend on a number of factors and can be complicated. Here’s an overview of taxes you may owe if you participate in a qualified plan.
When you’ll be taxed: You don’t owe taxes until you sell your shares.
How discounts are treated: The discount you received when you purchased the stock is recognized as ordinary income when the stock is sold.
How gains are treated: If there has been an increase in stock value, the gain — that is, the profit you earned on top of the discount you received — also will be taxed. But the tax rate depends on how long you’ve held the stock.
Less than a year? The gain also will be taxed as ordinary income.
More than a year? The gain will be taxed at the typically lower capital gains rate.
In a non-qualified plan, you’ll be taxed on the discount you receive when the ESPP purchases stock. You may owe tax on any capital gains if you sell the stock.
