Employee Stock Purchase Plans (ESPP)
Employee stock purchase plans (ESPPs) enable employees to buy company stock at a discounted rate, such as 15 percent. The plans offer a potential financial benefit to employees, encourage them to stay with the company for a certain period of time (otherwise they lose the benefit), and can promote employee loyalty to the business.
Employees pay for the stocks they purchase through regular, after-tax payroll deductions administered by the employer.
An ESPP begins on an Offer Date—say January 1—at which time employees are informed they are eligible to participate; the plan lasts for a set period of time—for example, 18 months. Within that period, employees will be able to purchase stock on one or more dates (known as the Purchase Dates) that are specified by the plan.
Sweetening the Pot
In addition to offering stock at a discounted rate to employees, ESPPs also may offer a look-back option that can further sweeten the deal. Here is how it works: Between the Offer Date and the Purchase Date, the price of the stock likely will change. The look-back option enables employees to purchase the stock at the lower of the two prices—the price at which the stock sold on the Offer Date, or the Purchase Date.
So if the stock traded at $20 per share on the Offer Date, then rose to $40 per share at the Purchase Date, employees would pay only $20 per share. Coupled with a stock discount of, say, 15 percent, employees would spend only $17 for a share that is immediately worth $40.
Tax Implications
How much tax employees pay on that gain is determined by the way an ESPP is structured. There are two forms of ESPPs—qualified and unqualified. Qualified plans are subject to more restrictions and rules, but enable employees to avoid paying tax immediately on the gains obtained by buying the stock at reduced rates. In the example above, employees would avoid paying an immediate tax on gains of $23 per share. Most employers use qualified ESPPs.
Once employees own shares purchased through an ESPP, they can dispose of them however they wish—including selling them immediately. Doing so, however, has unfavorable tax consequences (the same as any stock holder who sells shares without holding them for at least 12 months after purchase).
To reduce their potential tax liability, employees typically should hold their shares for a certain amount of time. How long? At least one year after the Purchase Date, or at least two years after the Offer Date—whichever is longer.