Are you lucky enough to be an employee who receives benefits in the form of equity? There is a mélange of ways companies can incentivize and reward their employees via equity, and employee stock purchase plans (“ESPPs”) are a well-known perk. This discussion will focus on qualified ESPPs, or Section 423 ESPPs, as they must meet regulatory requirements to offer tax advantages. In contrast, non-qualified ESPPs are more flexible regarding regulatory requirements but do not offer tax advantages. It is always prudent to check which type of plan you have before making any investment decisions.
ESPPs are relatively simple as far as contributions go. They are funded by after-tax payroll deductions and there is no withholding, not even for Social Security or Medicare. The deductions are held in the plan until a specified purchase date, at which point they are invested in company stock. Participants state the amount they want to contribute to the plan, which the IRS limits to $25,000 of the stock’s market value per year, and plans generally allow participants to elect deductions between 1% and 15% of a participant’s compensation.
ESPPs offer discounts and lookbacks. Most ESPPs build in a 10-15% stock price discount below market value. Then the lookback provision bases the purchase price not on the stock price at the time of purchase but on the price either at the beginning of the offering period or at the end of the purchase period, whichever is lower.
The tax treatment is a bit more complicated, but stay with me. When you sell the stock, you either pay ordinary income tax (called a disqualifying disposition) or long-term capital gains tax (called a qualifying disposition) on the gain, and you pay ordinary income tax on the discount. To receive the favorable long-term capital gains treatment, you have to hold the shares for more than one year from the purchase date and more than two years from the offering date. If you hold the shares according to these guidelines, you receive a lower percentage of ordinary income taxes and a higher percentage of capital gains taxes, which means you pay less in taxes overall.
Here’s an illustration of the tax treatment for both disqualifying and qualifying dispositions for those who are inclined.
Offering date price $10
Market price on purchase date $12
Purchase price @ 10% discount with lookback = $9
Sell price = $14
< 2 years from offering date and < 1 year from purchase date
Market price on purchase date – purchase price = ordinary income
$12 – $9 = $3 ordinary income
Sell price – tax basis* = short-term capital gain
$14 – $12 = $2 short-term capital gain
> 2 years from offering date and > 1 year from purchase date
Offering date price – purchase price = ordinary income
$10 – $9 = $1 ordinary income
Sell price – tax basis* = long-term capital gain
$14 – $10 = $4 long-term capital gain
*Tax basis = ordinary income + purchase price
In both examples, the tax burden is the same, a total of $5. However, the disqualifying disposition is broken down into $3 taxed at ordinary income rates and $2 taxed at short-term capital gains rates. The qualifying disposition is broken down into $1 taxed at ordinary income rates and $4 taxed at long-term capital gains rates. Therein lies the savings from observing the hold periods.
Let’s not forget about the discount either. While the 10% discount in the above examples may not seem like a significant amount, it can add up with share volume and is basically free money. What would you do if I offered to give you $10 in return for you giving me $9?
Accumulating shares over time through an ESPP can help build wealth. Still, you need to be careful not to end up with a concentrated position that exposes you to unnecessary risk should your company encounter adverse circumstances. You also need to account for your access to other stock-related benefits, including stock awards, restricted stock units, and stock options, and how this might add additional exposure. The key with all investing is diversification, so any ESPP holdings should be appropriately allocated within your global portfolio, which in and of itself should be rebalanced as your company holdings increase over time.