Introduction to Employee Stock Purchase Plans – ESPP

Defining Employee Stock Purchase Plan – ESPP

ESPPs allow workers to buy shares of their employers' stock in a simple and convenient manner by using after-tax payroll deductions. They are perhaps the simplest form of stock purchase plan in use today.

Outside of the wages and salaries, one common method of compensating employees in today's corporate environment involves the purchase of company stock. The Employee Stock Purchase Plan (ESPP) offers a very straightforward method of allowing employees to participate in the overall profitability of the employer over time.

Qualified vs. Nonqualified Plans

ESPPs can be divided into two categories: qualified and nonqualified. Qualified ESPPs are the most common type of plan and resemble their qualified cousins in the retirement plan arena in that they must adhere to prescribed eligibility criteria per the IRS. Qualified plans must be approved by a vote of the shareholders before they can be implemented, and all plan participants have equal rights in the plan. Their offering periods cannot exceed 27 months, and the discount on the stock price may not exceed 15%.

Nonqualified plans are much simpler and are not subject to the rules that pertain to qualified plans, but there is no tax advantage of any kind in these plans. The remaining sections of this article, therefore, pertain solely to qualified plans.

Key Dates and Terms

Employees who choose to participate in their company ESPP can only do so after the offering period begins. This period always begins on the offering date, which corresponds to the grant date for stock option plans. Payroll deductions then commence for participants until the purchase date (the day on which the company stock is actually bought). Offering periods can be either consecutive or overlapping; those in the latter category will often have different purchase prices because of their staggered purchase dates.

Most offering periods have several purchase dates that come at the end of several purchase periods, such as a plan with a three-year offering period that is comprised of four purchase periods that end in four purchase dates. Therefore, if the offering period were to begin Jan. 1, then the first purchase period would last for six months and end July 1, and the second purchase period would end Dec. 31, with this pattern continuing for the next two years.

Enrollment Process and Plan Mechanics

Employees must apply to enroll in the plan at the next available offering date. On the application, they will state the amount that they wish to contribute to the plan (which is usually limited to about 10% of their take-home pay). Contributions are also limited to $25,000 per the calendar year by the IRS, regardless of any restrictions imposed by the employer. After each pay period, the employee deferrals are placed in separate accounts until the purchase date. The stock is then held in separate accounts for each employee by a transfer agent or brokerage firm until they sell their shares and collect the proceeds.

Potential Gain

Many ESPPs allow their employees to purchase their stock at a 10 to 15% discount from its market value, thus providing them with an instant capital gain when they sell. Furthermore, many plans also have a "look back" provision that allows the plan to use the closing company share price of either the offering date or the purchase date, whichever is lower. This can have an enormous impact on the amount of gain that participants realize. Employers can set their own policies about allowing employees to withdraw their funds from the plan between purchase dates or change their contribution levels.

Eligibility

Qualified ESPPs prohibit any person who owns more than 5% of the stock in the company from participating in the plan, and the plan is allowed to disallow certain categories of employees from plan participation as well, such as anyone who has worked for the company for less than one year. All other employees must be made unconditionally eligible for the plan.

Tax Treatment

The rules that govern the taxation of proceeds from ESPPs can be quite complex in some cases, and only a simplified version of them is covered here. In general, the tax treatment of the sale of ESPP stock is governed by four factors:

• The length of time the stock is held
• The price the stock is actually purchased at, factoring in the discount
• The closing price of the stock on the offering date
• The closing price of the stock on the purchase date

ESPPs use holding periods that closely resemble those of other stock option plans. For qualified ESPPs, the stock that is not sold until at least a year after the purchase date and two years after the offering date will receive favorable tax treatment. Stock sales that meet these criteria are known as qualifying dispositions, while those that don't meet these criteria are labeled as disqualifying dispositions.

Qualifying Dispositions

Participants who meet the holding requirements for qualifying dispositions will realize two types of taxable income (or losses), but none of it is reported until the year of the sale. The amount of discount allotted in the plan (such as 15%) is reported as ordinary income. The remainder is classified as a long-term capital gain.

Disqualifying Dispositions

This type of disposition counts a great deal more of the sale proceeds as ordinary income. The seller must count the difference between the closing price of the stock as of the purchase date and the discounted purchase price as ordinary income. This is an extremely brief summation of the tax rules pertaining to ESPPs. The mechanics of how these work can be fairly technical in many instances and participants should not hesitate to consult a tax professional for advice on this topic.

Other Advantages of ESPPs

Like all other types of employee stock ownership plans, ESPPs can help to motivate the workforce and provide employees with an additional means of compensation that does not come entirely out of the company's own pocket. ESPPs are also relatively simple to administer and maintain and can get employees in the habit of saving money regularly, especially since all contributions into these plans are exempt from Social Security and Medicare tax. They also allow employees to sell the stock before retirement, which can prevent their portfolios from becoming heavily weighted in company shares.

The Bottom Line

Employers that are looking for a relatively simple way to get their employees to buy company stock should take a close look at ESPPs. These plans offer simplicity and liquidity with minimal administrative costs. For more information on these plans, contact your tax or financial advisor, or your HR representative.