As you progress in your career, especially if you work in corporate America, one of the first changes you see is in your compensation. Instead of simply getting an increase in pay, corporations often incentivize their employees, and attract new hires, by offering equity - or the opportunity to buy equity - in the corporation.
To that end, we're kicking off a series walking you through the different types of equity-based compensation and employee benefits.
If you're needing to read these articles to figure out what's being offered to you, then congratulations, because being offered equity-based pay means you're likely on that right track professionally! Hopefully these posts provide some clarity and allow you to form an action plan.
In Part 1, we covered Restricted Stock Units, or RSUs for short.
In Part 2, we covered Stock Options, both Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).
In Part 3, we're covering Employee Stock Purchase Plans (ESPPs)!
In discussing equity-based pay, we're breaking each form of compensation into one of two types:
- Will Be Yours: equity in the company that you WILL have if you meet certain conditions
- Could Be Yours: equity in the company that could be yours if you meet certain conditions AND have the money to pay for it
The Restricted Stock Units we covered in Part 1 are Will Be Yours benefits; as long as you meet the terms required for them to vest, you will get your shares of stock.
The Stock Options covered in Part 2 are a Could Be Yours benefit. A company gives you the option to buy a certain number of shares at a predetermined price, and those shares could be yours IF you have the money to pay for them within a set period of time.
The subject of today's post, Employee Stock Purchase Plans (ESPPs), are also a Could Be Yours Benefit. To describe ESPPs in one sentence, they are programs that allow employees to purchase company stock at a discount to its Fair Market Value (FMV).
Companies offer employees the abilities to purchase company stock at a discount under ESPPs after they've been employed a certain period of time, typically one year. In addition to employees who have not met their service requirement, ESPPs typically don't allow those owning more than 5% of company stock to participate.
If it seems like that's all there is to it - buying company stock at a discount - trust us, there's much more we need to cover, starting with the process of purchasing the stock.
For reasons that will become clear, employees cannot enroll in an ESPP at any point during the year. They must decide whether or not they would like to participate in the stock purchase plan during the enrollment period, which is typically two to four weeks prior to the offering period (see details of offering period below). Employers will furnish the terms of stock purchases made during the upcoming period to all eligible employees, such as the exact discount, the length of time shares will be offered, and the date shares will be purchased.
While some employers offer exceptions for employees hoping to sign up outside of the enrollment window, such as for an employee who meets the time requirement to participate after enrollment has closed, others only allow workers to sign up during the designated enrollment period.
During enrollment, you must not only decide if you would like to participate, but how much you want to contribute each paycheck. ESPP contributions are deducted from your paycheck post-tax, and do not offer pretax benefits found in 401(k)s, HSAs and other tools.
While an ESPP may allow employees to reduce or stop their contributions after the enrollment period closes, they typically won't allow any increases to contributions during the offering period. Even if the plan does allow requests to stop or reduce contributions, they will likely be denied if they are made too close to the purchase date, which we'll also cover below.
The offering period is the time during which money is accumulated to purchase company stock. Offering periods come in six-month increments (6 months, 12 months, etc.), during which time the company will accumulate your contributions, but not actually buy company stock.
The first day of the offering period is also the Grant Date, and Fair Market Value (FMV) of company stock on the grant date will be very important when we cover the tax impacts of selling shares acquired through ESPPs.
Let's look at the terms at grant of an ESPP offering a 15% discount to employees buying company stock:
The final day of the offering period, known as the Purchase Date, is when the company takes all of the funds you've contributed via payroll deductions and buys company stock.
The price of company stock at the purchase date could be different than what it was at grant, which leads us to two more terms to remember for taxation purposes.
- Discount element (Grant Date Spread): by now you're familiar with the term discount element, which in layman's terms, is the difference between FMV of a stock and what you actually paid for it. For the purposes of explaining ESPP taxation, we'll also refer to the discount element as the Grant Date Spread.
- Purchase date spread: the Purchase Date spread is the difference between the FMV of company stock at the PURCHASE DATE and what you actually paid for it.
The distinction between these two terms is important, because many ESPPs have what's called a lookback provision. In plans with this feature, employers will look at the FMV of company stock on the Grant Date and Purchase Date, and apply the discount to whichever number is lower.
As an example, if the ESPP calls for a 15% discount on company stock valued at $20 at Grant and $25 at Purchase, the discount would be applied to the $20 figure:
Now, let's bring this thing home by covering the difference between qualified ESPPs, nonqualified ESPPs, and the tax consequences of selling shares under each plan
Qualified ESPP (423 Plan)
If you understood and retained the difference between Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs) that we covered in Part 2, the tax treatment of qualified and nonqualified ESPPs are very similar.
A qualified ESPP, also known as a 423 Plan, must be voted on by shareholders, and caps the discount employees can receive on company stock at 15%. These plans also restrict the maximum offering period to three years.
Qualified plans have a number of tax benefits. The holding period required to experience these benefits are the same as that of an Incentive Stock Option: you must wait 2 years from the date of grant and 1 year from the date of purchase to sell shares purchased through an ESPP to have a qualifying disposition. If you want more details on how the holding period works, check out Part 2 here.
If the holding period requirements are met, there are no taxes due at the time of stock purchase. At the time of stock sale, the employee will owe ordinary income taxes on the grand date spread, and long-term capital gains taxes on the difference between the sale price and the grant date price.
Let's look at an example of an employee who took advantage of our stock offering, buying company shares valued $20 at grant, for $17 through the ESPP. After meeting the holding requirements, they then sell their shares for $100 per share:
If the employee sells their stock before meeting the holding period requirements, a disqualifying disposition, the IRS will look at the spread between the price paid by the employee and the FMV of company stock at its grant date and purchase date. Rather than charging ordinary income tax on the spread between the discounted purchase price and the lower price of the grant and purchase date, the spread between discounted purchase price and the higher of the two FMV prices will be treated as ordinary income:
In a qualified ESPP, the discount element received by the employee is taxed as ordinary income upon the sale of the stock. Under a nonqualified plan, the discount element is taxed at ordinary income at the time of purchase.
Since the discount element taxation occurs immediately, there is no requirement to hold the stock a minimum of two years from grant. The employee can then sell the shares whenever they like, and any profits would be treated as a short or long-term capital gain based on how long the stock was held.
Let's look at an example using the same variables as the sale under our qualified ESPP to see the difference in tax treatment:
Nonqualified ESPPs are more flexible in their design than qualified plans, and allow for benefits like discounts exceeding 15%, or offering periods exceeding three years. Some may also prefers them because of the more relaxed holding requirements, but their tax treatment is not as preferable as that of a qualified plan.
In Summary ...
If you're an employee of a company you feel has the potential to grow in the future, being able to purchase discounted company stock through an ESPP is an attractive benefit. Longtime employees of organizations that have steadily grown over the years can see their wealth bolstered by consistent contributions, understanding how these holdings fit with the rest of your portfolio, and exercising caution with taxes when selling shares.
I hope this post gives you clarity on how these plans work, and also that you're enjoying our series on equity compensation. In our next post, we wrap things up with another form of equity compensation, Employee Stock Ownership programs, or ESOPs. I hope you'll check it out!