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.
Mar 18, 2022

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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. 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.

How does an ESPP work?

The discount rate offered to employees differs from plan to plan, but it can be as much as 15% below market value. When they enroll, plan participants can elect a percentage or a flat dollar amount to be withheld from their paychecks. These deductions accumulate during the offer period, and on specified purchase dates the company will use the funds to purchase stock for the plan participants.

ESPP lookback feature

Many qualified ESPPs (more on qualified vs. non-qualified ESPP plans below) include a lookback feature, which allows for the purchase price of the stock to be based on the beginning of the offer period, rather than the day the stock is purchased, or whichever is lower. This rule may help increase your benefit if the stock price has gone up during the offer period.

For example, say your company begins an offer period for 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 be applied to the $10 price at the beginning of the offer period, meaning your purchase price would be $8.50 per share.

ESPP eligibility and limits

  • 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, usually one year.

  • Maximum contributions: Tax rules cap the amount of company stock an employee can accrue in an ESPP at $25,000 of the fair market value of the stock per year.  Most plans allow employees to elect a payroll deduction between 1% and 15%.

Qualified vs. non-qualified ESPP plans

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:

  • Qualified plans must be approved by company shareholders within 12 months of the date the plan is implemented.

  • Each plan participant must be afforded equal rights in the plan.

  • Depending on plan specifics, there can also be limits on the term length for an offering period.

Employees who elect to participate in a qualified ESPP are typically able to take advantage of some tax benefits, as the discount is not recognized as taxable income until the stock is sold. When you sell the stock, the discount you received when you bought it may be taxable as income. If there has been an increase in stock value, the gain will also be taxed as ordinary income unless you've held the stock for more than a year, in which case it will be taxed at the typically lower capital gains rate.

Non-qualified ESPPs often have more flexibility in terms of regulatory requirements, but employees do not get any of the tax advantages listed above.

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.

When to consult with an advisor

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.

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