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Employee Stock Purchase Plan

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What Is An ESPP?

An ESPP, or employee stock purchase plan, is a program run by a company that allows participating employees to purchase company stock at a discounted price. Employees then contribute to their plan via payroll deductions. These deductions build up between the offering date and purchase date. The company will use an employee's accumulated funds at the purchase date to buy stock in the company on behalf of employees who participate in the ESPP.

ESPPs are offered as an employment incentive. They give employees a way to share in the growth potential of a company's stock. They also inspire employees to keep working hard so that the stock price moves up.

Advantages of Employee Stock Purchase Plans

ESPPs have a number of advantages for both employers and employees:

  • Discount to purchase stock: Employees can often purchase stock at a 10% to 15% discount from market value. This creates an immediate capital gain when an employee sells the stock.
  • "Look back" provision: Many plans include a provision that allows them to use the lower closing company share price of either the purchase date or offering date. This can have a positive effect on the amount of gain participants receive.
  • Motivates employees: Employees can receive additional compensation that does not directly come out of the company's pocket.
  • Helps build money-saving habits: ESPPs help get participants in the habit of regularly saving money, and all contributions are exempt from Medicare and Social Security tax.
  • Allows employees to sell stock before retirement: This can prevent portfolios from being heavily weighted in terms of company shares.
  • Simplicity: ESPPs are relatively simple for companies to administer and maintain.

How Do Employee Stock Purchase Plans Work?

ESPPs divide into an enrollment period and an offering period:

Enrollment Period of the Employee Stock Purchase Plan

ESPPs start with an upfront enrollment period. During this period, you get to decide the percentage of your paycheck you want deducted to buy company stock at a discount. Typical plans will allow you to contribute up to the lower 15% of your salary or $25,000 per year.

Whether you contribute pre-tax or after tax will depend on your company. Some stock purchase plans have a minimum contribution of 2% of your salary to participate. With the exception of Roth 401(k) plans, ESPP contributions will be withheld from your income after tax (unlike most 401(k) plans).

Offering Period of the Employee Stock Purchase Plan

Most ESPPs have a 12- or 18-month offering period. The offering period is made up of two or three purchase periods of six months each. Offering periods are divided into shorter purchase periods to maximize the value of the benefit you receive.

After you enroll in your company stock purchase plan, your payroll contributions will accrue. This happens until the last day of each purchase period, when your employer purchases company shares on your behalf using the accumulated funds.

Here's some further reading about the benefits of enrolling in an ESPP if you can afford payroll deductions.

ESPPs and Taxes

When you sell stock that you purchase via your employee stock purchase plan will determine how you pay taxes.

When Do You Owe Taxes If You Enroll in an Employee Stock Purchase Plan?

You do not owe taxes when your company buys shares for you. You're just exercising your rights under your employee stock purchasing plan.

An employer is not required to withhold FICA, or Social Security taxes, when an employee exercises the right to purchase stock through an ESPP. The employer is also not required to withhold income tax when the employee disposes of the stock. However, employees still owe certain income tax on any gain they get from selling the stock.

When you sell this stock, the discount you received when you purchased the stock is typically considered additional compensation. You therefore have to pay taxes on that as regular income. There are two scenarios that affect how you are taxed:

  1. You hold the stock for under a year before selling it: Gains in this scenario are considered compensation and taxed following those rules.
  2. You hold the stock for over a year: In this case, any profit you make will be taxed at the lower capital gains rate. This rate is usually lower than in the above situation.

How much of your stock sale price is considered compensation and how much is considered capital gain will depend on whether the stock sale is a disqualifying or qualifying disposition.

Disqualifying Dispositions

Your stock sale is a disqualifying disposition if you sold your stock within two years following the offering date, or one year or less from the purchase date (also known as the exercise).

Your employer will report the bargain element (the difference between exercise price and market price on the exercise date) in this case on the Form W-2. You will need to pay taxes as ordinary income on that amount.

Any additional profit will be considered capital gain. Whether it is short-term or long-term capital gain will depend on how long you held these shares. This information should be reported on Schedule D.

Qualifying Dispositions

Your stock sale is a qualifying disposition if you sold your stock at least two years following the offering date (also known as grant date), and at least one year following the purchase date (exercise).

If this is the case for you, a portion of your profit will be considered compensation income on the Form 1040. The portion of profit is known as the bargain element. It will be taxed at regular rates.

Then, any additional profit you make will be considered long-term capital gain. Long-term capital gain is taxed at a lower rate than compensation income. You will need to report this on Schedule D, Capital Gains and Losses.

Qualified vs. Non-Qualified Employee Stock Purchase Plans

An ESPP may be categorized in one of two ways: qualified or non-qualified.

Qualified Plans

Qualified ESPPs  are the most common type of employee stock purchase plan. They have a number of requirements, as these plans must adhere to eligibility criteria as established by the IRS. Requirements include:

  • Shareholders must approve qualified plans before they are implemented
  • All plan participants must have equal rights in the ESPP
  • The offering period cannot be greater than 27 months
  • Stock price discounts cannot exceed 15%

Non-Qualified Plans

Non-qualified ESPPs do not have as many restrictions as qualified ESPPs and are much simpler. Non-qualified plans, however, will not have any tax advantages.

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Flexibility in Your Employee Stock Purchase Plan

Your associate stock purchase plan may give you flexibility in a variety of ways. As every plan is unique, it is important to look at your plan document to understand the details specific to you. Some flexible options to look for in your ESPP include:

  • You may be able to modify your contribution during an offering period.
  • You may be able to suspend your enrollment for a certain time period. This means that no further withholdings will be taken out during a suspension. Contributions accrued, however, will still be used to purchase shares when the purchase date arrives.
  • You may be able to withdraw after you enroll. At that time, you would receive your accumulated cash.

Here's an article where you can learn more about employee stock purchase plans, including what questions to ask if you're thinking about enrolling in one.

An employee stock purchase plan can offer great advantages in terms of discounted stocks, tax benefits, and more. If you're an employer considering offering your employees an employee stock purchase plan, you'll have plenty of benefits as well, and it's something to think about if you're starting a business .

ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.

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