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Many public companies offer a qualified Section 423 Employee Stock Purchase Plan (ESPP) as a benefit to their employees. This video will simplify everything you need to know about your ESPP.
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While on the surface, that may not seem like a big deal, the two things that make this worthwhile are the possibility of a discount and then also a look back provision.
First, from a discount perspective, what that is saying is that rather than buying the stock at $15 a share instead, you can buy it at a discount of up to 15%. So in our example, we're just going to say that it's a 15% discount and so rather than buying at $15 a share then you can buy it for $12.50 a share.
The other possible benefit is the idea of a look-back provision. What the look-back provision is saying is rather than just looking at the price of the stock on the purchase date, it is also going to look back to the stock price on the offering date too.
If you would combine those two benefits, then the way that this would work is that on this purchase date, it's going to compare these two prices, and it's going to figure out what the lower one is. It's going to use that as the purchase price and then also add in that 15% discount. So in this particular example, on the purchase date, rather than buying it for $15 a share, you can actually get it for $8.50 a share. Using the example numbers, whenever we have set aside $6,000, we are buying this stock at $8.50 a share, but it's actually worth $15 a share. Then immediately on the purchase date, we already have more than a $4,500 gain.
As with a lot of things, I figure the easiest way to describe how an ESPP works is through an example.
So let's talk about how to get into your ESPP. The way that it'll work is really similar to your open enrollment for your employee benefits. Similarly, there'll be an enrollment period that will say, "Hey, if you want to participate in the ESPP for this offering period, then you have to enroll within this window and the decision that you make within this enrollment period is how much of your salary that you want to have put aside for the ESPP stock purchase."
In our example, we have a person, they work for ABC Company, and they make a $120,000 salary. Then let's say they are electing to enroll and put 10% of their income into the ESPP. Then once you've made that election during the enrollment period, there's going to be an offering date which is going to be the start of whenever the actual ESPP is in effect. The way that it gets funded is once the offering date starts. Then with every paycheck that your company will pay you, they'll also withhold an amount, and they're going to basically put it into an escrow account, into a cash account.
The most common length of a window, that is between the offering date and the purchase date, is six months. So in our example, in this six-month period, 10% will put $6,000 into your escrow account. After the end of the six-month period, whenever you get to the purchase date, that is when they use the $6,000 to purchase stock in the company.
The next thing to talk about is the way that it's taxed once you purchase it.
So first, if on the purchase date, if you just decide to sell right away, then the difference between what you actually purchased it at and the value of that stock is going to get taxed as ordinary income. Your cost basis is the value of the stock on the purchase date, so if it goes down, then you can actually take that short-term loss, and it can offset your income. But if it gains any more, then that amount gets taxed as short-term capital gains.
Similar to if you would just buy stock normally, then once you wait a year after you've bought it, that's whenever it switches from short-term capital gains to long-term capital gains.
One thing that is specific as a benefit for qualified ESPPs is the idea of the preferential tax treatment if you can not only hold one year from the purchase date, but then you also are holding it two years from the initial offering date. What happens at that time is that rather than your basis being the price on the purchase date, it will look all the way back to the stock price on the offering date.
So in our example, whenever the stock price has gone up, then you can see that there's a smaller amount that is considered ordinary income, and then there's a larger portion of it that gets taxed at the preferential long-term capital gains rates.
The next question to answer is deciding when you should sell. One of the main things to think about is how much risk you're willing to take because remember that whenever you've bought it, then you own stock in the company that also gives you your paycheck. So there could be that concentration risk that you'd want to think about.
So if you would sell immediately, then this becomes income, and you know you're locking in that discount and that benefit you have.
If you want to try to stick it out and get these long-term capital gains rates, then you could do that. One of the main things to think about for the decision on whether to try to hold for the two-year period is how did the stock actually do during your offering period. For example, the stock price could have gone up a decent amount, and so holding more than that two-year period, the benefit that it has is more money qualifying as long-term capital gains.
But if it would have stayed flat, then really holding more than that two-year period doesn't really have any added benefit.
Then the strange thing is if the stock price actually went down from the offering date to the purchase date, then holding over that two-year period will mean you're actually worse off if you would hold for past this two-year period.