Employee Stock Purchasing Plan (ESPP)

Summary

An employee stock purchasing plan (ESPP) allows employees to purchase company stock at a discounted price. In this company-run program, employees contribute to the ESPP through payroll deductions that accrue between the date at which they’re offered and the purchase date. When the purchase date arrives, the company uses the funds that have accumulated in employees’ plans to buy stock in the company on behalf of the employees.

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What Are Employee Share Purchase Plans (ESPP)?

Plain and simple, an employee share purchase plan (ESPP) allows employees to purchase company stock at a discount, which can range from 5% to 15% off. ESPPs are offered as an added benefit for employees like 401(k)s. 

Employees simply enroll in the ESPP and have a percentage of their paycheck withheld for ESPP contributions. At certain points in the year, the employer uses the contributions employees made to the ESPP to purchase stock in the company at a discount on their behalf.   

ESPPs are meant to incentivize employees to work hard to contribute to the company’s success and thus raise the share price of its stock. Helping to boost the company’s stock while having the ability to purchase the stock at a discount may allow employees to profit all the more from the company’s growth.

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ESOP vs. ESPP

An employee stock ownership plan (ESOP) and an employee share purchase plan (ESPP) are both equity incentive plans that companies offer to their employees. An ESPP lets employees purchase company stock at a discount through paycheck deferrals, whereas an ESOP is a qualified retirement plan that offers shares of stock to employees at no cost.

ESOPs typically require some minimum period of service and full-time status for employees and function as retirement benefit programs. Employees build up shares in their ESOPs over the course of their careers and then sell them back to the company upon retirement for their fair market value. Those gains are then used as part of an employee’s retirement income. ESOPs follow a vesting schedule that determines when employees take ownership of their shares. In addition, ESOPs come with some added tax benefits; until they receive distributions from their ESOP, employees can defer taxes (as with other qualified retirement plans, ESOPs require that participants wait until age 59.5 before taking distributions or get dinged for a 10% penalty).

ESPPs don’t have a vesting schedule, but they typically require that employees be full-time and have served at the company for a certain length of time (six months, for example) in order to be eligible for participation. Unlike the tax deferrals possible with ESOPs, ESPPs pay taxes during the year they sell their stock, with regular income taxes owed on their discount and capital gains taxes owed on their gain.

For additional hands-on guidance with employee stock considerations, schedule a meeting with a financial advisor.

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How Do ESPPs work

You sign up to participate in an ESPP through your employer and elect to have a portion of your paycheck deferred toward your ESPP contribution. 

There are typically some eligibility requirements that stipulate an employee must be full-time at the company for a certain period of time (six months, for instance) before he or she can participate in the ESPP. Payroll deductions for ESPP contributions occur during so-called offering periods, which tend to last anywhere from six months to three years. 

On the purchase date, the end of the offering period, the company uses the funds accrued in employees’ ESPPs to buy stock in the company on behalf of the employees. It’s important to note that ESPPs can either be qualified or non-qualified. With the former, the approval of shareholders (all of whom have equal rights) is obligatory before being implemented. Qualified plans also mean that the offering period cannot exceed three years, and they also introduce a number of restrictions on the maximum discount employees will get on their share price. By contrast, non-qualified ESPPs are a bit more flexible in terms of allowing steeper discounts but lack some of the tax advantages qualified plans have.

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What is the ESPP limit in 2023 & 2024?

For 2023 and 2024, the IRS allows employees participating in an ESPP to buy $25,000 worth of stock in one calendar year.

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What Is an ESPP Disqualifying Disposition?

When you sell your stock within one year of the purchase date (also called the exercise date) or within two years of the offering date, then your stock sale is a disqualifying disposition. This means that your employer will report the discount you received on stock shares as compensation on your W-2. This is called the bargain element and can be calculated by subtracting your discounted exercise price from the standard market price on the purchase date. As such, you’ll be on the hook for paying ordinary income tax on that compensation (the number of shares x the amount in dollars you saved per share). You’ll be liable, of course, for capital gains taxes (either short- or long-term depending on the length of time you’d held the shares) on any other profits and must report those on Schedule D.

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What Are the ESPP Tax Rules?

When your company buys shares for you using your paycheck-deferred ESPP contributions you are not on the hook for any taxes. So far, so good. But when you ultimately sell the stock, the discount you received when you bought the stock is considered income and requires you to pay taxes on it. Holding the stock for a year or less before you sell it will make you liable to pay regular income taxes on it. If you do end up holding the shares for more than a year before selling, you’ll only have to pay capital gains taxes, which is typically at a lower rate than income tax.

To determine just how much of the sale from ESPP will be liable for capital gains tax, it’s important to understand whether your stock sale is a disqualifying disposition, as discussed in the previous section. If you sold the stock at least two years after the grant date of shares and at least one year after the purchase date, the bargain element of the sale (the profit you net from the discounted price of the shares) is a qualifying disposition and taxed at regular income on your 1040. Beyond that, any other profit is taxed as long-term capital gains. If you sold the stock in under two years of the offering date or one year from the exercise date, you’ll have to pay ordinary income tax on the bargain element and capital gains (either short- or long-term) on any other profits.

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Should I Contribute to an ESPP?

Contributing to an ESPP can provide a lucrative scenario in which an employee can reap the benefits of steep discounts on their company stock (up to 15%) and thus have the opportunity to lock in robust gains on selling the stock.

Your decision to participate in an ESPP may depend on your particular cash-flow needs; deferring a portion of your paycheck to ESPP contributions may mean that you’re not allocating as much of your earnings to retirement savings, 529 plans, and other important aspects of your financial life. What’s more, diversification is the name of the game when it comes to an intelligent approach to investing. If the majority of your income is already coming from the salary you earn from one company, tying up more of your funds in investments in that company, may mean you’re overweight in your reliance on the performance of a single company to deliver a stable income and investment returns to you. Whether you choose to participate in an ESPP will depend on a number of factors related to your financial goals and immediate needs.

For additional hands-on guidance with employee stock considerations, schedule a meeting with a financial advisor.

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Conclusion

An employee stock purchasing plan (ESPP) lets employees defer money through their paycheck to purchase company stock at a discounted price, typically anywhere from 5% to 15% off. This is a company-run program that lets employee contributions accumulate over an offering period, and the company periodically uses those funds on a so-called purchase date to buy shares on behalf of the employees. In one calendar year, employees participating in an ESPP can buy up to $25,000 worth of company stock.

Though these plans offer great incentives for employees to be invested in the success of the company and to work hard to help boost the value of shares, it’s also important for employees to consider their own financial scenario and also whether from a diversification perspective they want to put a lot of eggs in one basket by investing further in a company from which they likely already receive the majority of their income. It’s also prudent for employees participating in ESPPs to recognize they’ll be on the hook from a tax liability standpoint for the bargain element of their discounted share prices and will also have to carefully weigh how long they hold their shares before selling based on disqualifying disposition and long-term vs. short-term capital gains on additional profits.

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