Do you have access to your Company’s Employee Stock Purchase Plan (ESPP)? Beyond your base pay, bonuses, and potential for stock compensation, participating in an ESPP is potentially a great opportunity to enhance your overall compensation package.
Prior to enrolling, it is important to consider your personal financial situation and the terms of the plan. The goal of this article is to outline what an ESPP is, the tax implications of participating, and how this plan may be a beneficial tool in your wealth-building strategy.
What Is an ESPP?
ESPP stands for Employee Stock Purchase Plan and is an employer benefit offered to employees at select publicly traded companies. The plan allows employees to contribute to and purchase the company’s stock, often at a discounted price.
Is Each ESPP the Same?
The terms of each ESPP vary widely, so it is vital to review the terms of your company’s plan prior to enrolling. Several key items will be outlined in the plan terms, including the discount provided, the contribution rate allowed, the length of the offering period, the lookback period, and how long shares must be held once purchased.
- Discount: The primary benefit of an ESPP is your ability to purchase shares of your company’s stock at a reduced price. The discounts we see most commonly fall in the 5-15% range.
- Contribution Rate: During enrollment, you will select the percentage of your pay you would like to contribute to the ESPP. Most commonly, this will be 1-10% of your base pay and can be adjusted during each enrollment period. Note that the maximum annual contribution to an ESPP plan is currently $25,000/yr, but some plans may place a more restrictive limit.
- Length of Offering Period: This will vary by company, most commonly a 6-month period, but often 3 months or one year. Some plans require employees to reenroll for each offering period, while others will automatically reenroll participants at their current contribution rate.
- Lookback Period: Another potential key benefit of an ESPP is the lookback period. Often, plans will allow you to receive a discount on the lower of the company stock price during the lookback period. As an example, consider a company with a 6-month lookback period, and a 15% discount. On June 30th, the stock price is $50/share. On December 31st, the stock price is $60/share. Given the lookback provision included in this company’s ESPP, you would receive a 15% discount on the lower stock price, giving you the opportunity to purchase shares at $42.50/share.
- Holding Period: Some plans allow employees to sell shares within their ESPP immediately upon purchase, while others require the employee to hold the shares for a certain period, like 12 months, for example.
Should I Hold or Sell the Company Shares Once Purchased?
At the end of an offering period, all your contributions will be used to purchase shares in your company’s stock. Continuing the example above, assume you contribute $5,000 to the plan during the 6-month offering period and your discounted purchase price is $42.50/share. You would purchase ~117.65 shares. Note that most plans do not allow for partial share purchases, so it is more likely that you would purchase 117 shares, with a small portion of your contributions refunded as cash.
At this stage, assuming your plan allows you to sell shares immediately, you are faced with a decision to either hold the shares purchased or sell the shares. In addition to considering the benefits of diversifying away from a single stock, consider potential cash flow needs for your household.
Listen to our Podcast Episode: How to Make Decisions About Your Equity Compensation Plans for advice and considerations on which strategy may be best for you.
What Is the Potential Benefit of Participating?
The table below outlines two scenarios, one with the stock price increasing during the offering period while the other shows the price decreasing.
| Stock Price Increase During Offering Period | Stock Price Decrease During Offering Period | |
|---|---|---|
| 6-Month Contribution | $5,000 | $5,000 |
| June 30th Stock Price | $50 | $60 |
| December 31st Stock Price | $60 | $50 |
| Plan Discount | 15% | 15% |
| Purchase Price | $42.50 | $42.50 |
| Shares Purchased | 117 | 117 |
| Stock Sale Price – Price on December 31st | $60 | $60 |
| Gain if Sold | $2,047.50 | $877.50 |
The gain calculation is as follows:
(Shares Purchased x Stock Price at Sale) Minus (Shares Purchased x Discount Purchase Price)
As you can see, even during a stock price decline, participating in an ESPP can potentially be quite beneficial, but your actual benefit will vary depending on the discount received, variance in stock price during the offering period, and your choice of when to sell the shares.
What About Taxes?
Contributions to ESPPs go in after tax, and the purchase of shares at the end of the offering period is not a taxable event. Upon selling shares, however, there will be tax implications.
First, the discount received on the purchase will always be taxed as ordinary income. Upon selling, the discount will be added to your pay.
Additionally, assuming the stock has appreciated from the purchase date to the sale date, you will incur either short-term or long-term capital gains depending on whether certain holding periods have been met.
For shares that are held for at least one year from the purchase date and two years from the offering date, the sale is a qualifying disposition. If met, the gain realized on the ESPP sale will result in preferential long-term capital gain treatment.
If not met, a disqualifying disposition occurs, resulting in the gain being taxed at your ordinary income tax rate.
Is an ESPP Right for Me?
As with many topics, whether participating in the ESPP is right for you will depend on your personal financial circumstances. First and foremost, you will want to review the terms of your company’s ESPP and obtain an answer to each of the key provisions outlined above.
There are also two important questions to ask yourself:
- Can my cash flow needs be met during the offering period, understanding that my take-home pay will be reduced by my ESPP contribution?
- What will my exit strategy be? Will I sell the shares once purchased, assuming the plan allows, or will I hold the shares?
Before enrolling, it is important to consider how participating fits into your financial plan. Our team regularly reviews such opportunities and would love to work together with you to determine if participating in your Company’s ESPP is right for you.
