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Employee Stock Purchase Plans

Lesson in Course: Finance at work (advanced, 10min )

My company allows me to purchase stock at a discount. Is this too good to be true, and what do I need to know?

As an employee at a public company, what is keeping me from joining the next UBER in hopes of striking it big? Retaining talent and hiring is a challenge every company faces, and for public companies, the executives understand the need to compensate employees with equity, ownership in the company. Read more about why equity matters.

Equity ownership for public companies often comes in the form of RSUs and ESPPs. An Employee Stock Purchase Plan (ESPP) allows us to buy shares in the company we work for directly through our paychecks with after-tax dollars.

Who can participate?

Most ESPP plans allow employees to participate unless they already own more than 5% of the company’s stock. This exception prevents most founders and c-suite executives from participating. Some ESPP plans may also have eligibility requirements that require us to work at the company for a minimum of a year before we can participate.

How does it work?

When we choose to participate in our company’s ESPP, we need to select how much we want deducted from our paychecks. This deduction can be either a specific dollar amount or a % of our take-home pay. The maximum amount we can deduct is $25,000 dedicated to ESPP per year.

Nothing happens until the offering date (the start date). After the start date commences, the company automatically deducts our ESPP election from our paycheck after taxes. The cumulative money is set aside in an account over the offering period. And at the end of the offering period or on the purchase date, the accumulated cash is used to purchase shares at a 15% discount. Depending on each company’s plan details, the purchase date could happen over multiple intervals throughout a year, e.g., once a quarter or once every two quarters. The company opens a brokerage account on our behalf where we can choose to sell our shares.

 

The discount

The most significant advantage of an ESPP plan is that as an employee we can purchase stock in the company with up to a 15% discount to the current market price! That’s practically 15% free money going into our pockets since we can immediately sell our shares and lock in the profit.

Lookback provision

Certain ESPPs have a special provision called a “Lookback,” which allows us to purchase shares at the better price of the stock at the purchase date or the offering date.

Lookback example

We have contributed to an ESPP a total of $12,500 over 6 months and are on track to maximize the $25,000 per year limit.

ESPP Discount: 15%

Offer date price: $100 per share or $85 per share after a 15% discount

Purchase date price: $150 per share or $127.50 per share after a 15% discount

Because of the lookback provision, we are able to buy 147 shares instead of 98 shares.

$12,500 / $85 = 147 Shares purchased

Compared to $12,500 / $127.5 = 98 shares purchased

 

Taxes

Since we are getting shares at a discount, the immediate gain is taxed as ordinary income. However, as long as the company’s plan follows guidelines, the plan can be categorized as a qualified ESPP. We can defer the income tax owed on all qualified ESPP until we sell our shares.

Guideline requirements for tax benefits:

  1. approved by a vote of the shareholders
  2. all plan participants have equal rights in the plan
  3. offering periods cannot exceed 27 months
  4. the discount on the stock price may not exceed 15%

Selling our shares

The shares we purchase through an ESPP are our shares, and we can sell them at any time at our discretion unless our company has imposed blackout periods to protect against insider trading.

Taxes owed while selling:

  1. The total discount we received on the initial purchase of shares is reported as income. This difference is calculated by taking the stock price on the purchase date and subtracting it from the purchase price (including lookback discounts).
  2. The difference between the sales price and the purchase date price is subject to capital gains. If we held the shares for more than one year before selling, we would owe long-term capital gains (15%); otherwise, we owe short-term capital gains (same as income tax).
Example of taxes

Following the Lookback example above:

Contributed to ESPP: $12,500

Discount: 15%

Offer date price: $100 per share or $85 per share after discount

Purchase date price: $150 per share $127.50 per share after discount

$12,500 / $85 = 147 shares purchased.

Let’s say we sell all 147 shares 14 months later at $200 per share. What are the taxes we will owe?

Capital gains

$200 - $150 = $50 per share in long-term capital gains

$50 x 147 = $7,350 in total long-term capital gains

$7,350 * 15% = $1,102.50 estimated taxes owed for ltcg

Income

$150-$85 = $65 per share in income

$65 x 147 = $9,555 in income shown on W2

 

For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!

If we are offered an ESPP, it’s almost always a good idea to participate. We should first confirm with the company that the current plan falls under a “qualified ESPP” so that we aren’t surprised by a big tax bill. Secondly, we should ask if there is a lookback provision covered by the plan.

Lastly, we should always prioritize our 401(k) before an ESPP, even with the 15% discount. With an ESPP, our risk is concentrated in the stock of the company, while our 401(k) offers diversification.

Glossary

What is Employee stock purchase plan (ESPP)?

An equity incentive plan that allows us to buy shares of the company we work for directly through our paychecks with after-tax dollars. Often these shares can be purchased at a discount of up to 15%.

What is lookback provision?

A provision included in some ESPP plans allowing us to purchase shares at the better price of the stock at the purchase date or the offering date.

Example
Contributed to ESPP: $12,500

Discount: 15%

Offer date price: $100 per share or $85 per share after 15% discount

Purchase date price: $150 per share or $127.50 per share after 15% discount

$12,500 / $85 = 147 Shares purchased compared to $12,500 / $127.5 = 98 shares purchased.

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