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What Is an Employee Stock Purchase Plan (ESPP) – Tax Rules

By Mark Cussen

employeesOne of the most powerful benefits that any publicly traded company can offer its employees is the ability to purchase stock in itself. There are several ways this can be done, but perhaps the most straightforward method of employee stock ownership can be found in an employee stock purchase program (ESPP). These plans provide a convenient method for employees to purchase company shares and improve their cash flows or net worths over time.

Employee stock purchase plans are essentially a type of payroll deduction plan that allows employees to buy company stock without having to effect the transactions themselves. Money is automatically taken out of all participants’ paychecks on an after-tax basis every pay period, and accrues in an escrow account until it is used to buy company shares on a periodic basis, such as every six months. These plans are similar to other types of stock option plans in that they promote employee ownership of the company, but do not have many of the restrictions that come with more formal stock option arrangements. Plus, they are designed to be somewhat more liquid in nature.

Qualified vs. Non-Qualified

ESPPs can be either qualified or non-qualified. Qualified plans are more common and must adhere to the rules laid out in Section 423 of the Internal Revenue Code. However, qualified ESPPs should not be confused with qualified retirement plans that grow tax-deferred and are subject to ERISA regulations. Participants can receive the proceeds from these plans as soon as the criteria listed below are satisfied. The key characteristics of qualified ESPPs include:

  • The plan must be voted in by the majority of shareholders sometime during the 12 months preceding the plan’s projected start date.
  • The plan can only be offered to actual employees of the company (consultants and independent contractors do not qualify).
  • Although some categories of workers may be excluded from the plan (such as those who have worked for the company for less than one or two years), any employee who is not specifically excluded in this manner in the plan charter must be allowed the opportunity to participate in the plan.
  • Employees who own more than 5% of the voting stock of the company may not participate in the plan.
  • Equal rights are granted unconditionally to all participants.
  • No employee can purchase more than $25,000 worth of stock in the plan in a calendar year.
  • Offering periods cannot exceed 27 months in length.
  • Discounts on stock purchases cannot exceed 15% of the current price.

Non-qualified plans are not subject to these rules and restrictions, except that they must also be approved by the shareholders and board of directors. Like their non-qualified cousins in the retirement plan arena, such as deferred compensation or executive bonus plans, they can allow participation on a discriminatory basis. However, they also do not receive favorable tax treatment under any circumstances. A 2011 survey taken by the National Association of Stock Plan Professionals showed that 82% of companies that had an ESPP used a qualified plan, while only 24% used a non-qualified plan.

The remaining sections in this article will focus solely on qualified ESPPs except when non-qualified plans are specifically mentioned.

an espp plan can help employees accrue savings

How ESPPs Work

Despite their differences, both qualified and non-qualified ESPPs are fundamentally similar in design. All plans consist of an offering period that begins on a specific day known as the offering date. Within the offering period there are typically several purchase periods that end in purchase dates.

For example, an offering period could start with an offering date of January 1st and then have nine purchase periods that last for three months each. The offering period would then expire at the end of 27 months. During that time, employees would elect to have a certain amount taken out of their paychecks (most employers impose a limit of about 10% of after-tax pay), which would then be used to purchase company shares on every purchase date within the offering period. Therefore, employees who participated in an entire offering period would make nine separate purchases of stock.

Each employer sets its own policy regarding its employees’ ability to withdraw funds during purchase periods and increase or decrease the level of their contributions to the plan. And while most ESPPs offer either the automatic price discount or the look-back feature (or both), there is no IRS requirement for this.

Pricing

ESPPs can provide a price advantage to employees in two different ways:

  • Built-in Discount. Most ESPPs give employees an automatic discount on the share price for all of their purchases, such as 10% or 15%. This creates an instant gain for all participants at the time of purchase.
  • Lookback Provision. This provision permits the plan to purchase the stock on the purchase date at either the closing price of the stock on the purchase date or the original offering date, whichever is lower. Obviously, this can make a huge difference in the amount of profit that employees realize from their plans. If the company stock closed at $15 on the original offering date and is trading at $40 when the market closes on the purchase date, then the plan can purchase the stock at its offering date price – or rather, at the discounted percentage of that price, if the plan offers both benefits (which is usually the case). Therefore an employee could get the stock for $12.75 in this scenario if the plan also offered a 15% built-in discount.

Some plans have more than one offering schedule running concurrently, although employees are generally excluded from participating in more than one schedule at a time.

Number of Shares Available to Participants
There is also a further stipulation to the $25,000 limit on purchases; this amount is divided by the closing share price on the offering date, and the quotient then becomes the maximum number of shares that a participant can buy for that year, regardless of whether the price rises or falls afterwards.

For example, ABC Company creates an ESPP, and the stock closes at $18.42 on the offering date of January 1st. By dividing $18.42 into $25,000, it is deduced that 1,357.22 shares can be bought that year by each participant. This number is now set and cannot be changed, regardless of how the price fluctuates for the rest of the year. This computation also uses the actual market price and not the discounted price, which means that an employee in the plan could buy 1,357.22 shares at $15.66 per share if there was a 15% discount applied, thus giving the participant $21,254 worth of stock. But that would be the limit for the year, even though this is less than the $25,000 limit because the calculation does not factor in the discount.

The look-back feature can effectively reduce the value of the plan for participants when the stock price declines from the offering date, because this feature only pertains to price, not to the number of shares that can be bought. If the price of the stock declines during the year from $18.42 to $7.08, it does not allow the participants to buy more shares factoring in the lower price. Therefore, participants who wait to buy the stock when it is $7.08 can get 1,357.22 shares for only $9,609 ($7.08 x 1,357.22), but they cannot buy $25,000 worth of shares at $7.08 to get 3,531 shares for that year.

extra money

Tax Treatment of ESPPs

There are two types of stock sales that can be made from a qualified ESPP. One is a qualifying disposition, which is accorded favorable tax treatment under the tax code. The other is a disqualifying disposition, which is not.

Qualifying dispositions must meet two key criteria:

  • The stock must have been held at least one year from its purchase date.
  • The stock must have been held at least two years from its offering date.

If these conditions are met, then the discount the participant received off the purchase price is reported as ordinary income, and any excess gain between the purchase price and the sales price is considered a capital gain. Disqualifying dispositions, on the other hand, require that the spread between the closing price of the stock on the purchase date (regardless of whether or not there is a look-back period) and the purchase price, factoring in the discount, be counted as ordinary income.

A Qualifying Disposition
For example, Jeremy purchased stock in his ESPP on March 23, 2012. The stock closed at $11.16 on the offering date of January 1st and $18.65 on the purchase date of June 30th. The plan gives him a 15% discount, thus giving him an actual purchase price of $9.49 (85% of $11.16 via the look-back provision).

He will have to hold his stock at least until March 24, 2014 in order for this to be a qualifying disposition. If he does this and sells the stock in April of 2014 for $22.71, then only the discounted amount of $1.67 per share ($11.16 x 15%) will be reported as ordinary income. The difference between the actual undiscounted market price and the sale price will be counted as a long-term gain or loss. Jeremy will therefore have a long-term gain of $11.55 per share ($22.71 minus $11.16).

A Disqualifying Disposition
On the other hand, if Jeremy were to sell the stock before the holding period expired, he would recognize $9.16 as ordinary income ($18.65 minus the discounted purchase price of $9.49). The market price on the day of purchase ($18.65) then becomes the cost basis for the sale.

In this case, the remaining $4.06 of sale proceeds (sale price of $22.71 minus the market price on day purchase of $18.65) will then be taxed as a long or short-term capital gain, depending upon the length of his holding period. This holds true even if the stock price declines before he can sell it. If he sells the stock for $7.55, he must still recognize $9.16 as ordinary income, even though he can partially offset this with a long- or short-term capital loss of $1.94 ($9.49 minus $7.55).

Reporting

Employers will usually report any ordinary income that is realized from ESPPs on the employee’s W-2 form. However, if the employer does not do this, then the employee must report it separately on Form 1040. The purchase information from ESPPs are reported on Form 3922, which is usually furnished by the employer after the purchase date. Gains and losses are reported on Form 8949 and are then carried to Schedule D.

employees

Advantages of ESPPs

The advantages that ESPPs offer far outweigh the disadvantages in most cases. Some of the key benefits that these plans provide include:

  • Employee motivation and retention
  • Tax write-offs for employers (similar to the deductions that employers get for funding and administrating retirement plans)
  • Relatively cheap and simple administration
  • Ability to increase employee compensation that is to be partially funded by increase in the price of the company stock
  • No Social Security or Medicare tax withholdings for employee contributions into the plan (qualified plans only)
  • No requirement for employees to make complex investment decisions in most cases (although timing can be an issue)

The only real disadvantage that ESPPs can pose is that they can cause employees who participate for long periods of time and hold onto their stock to become overweighted with their company stock in their investment portfolios. This can be avoided by selling shares periodically, and reallocating the proceeds into other investment vehicles or assets.

Final Word

ESPPs can provide employees with a regular means of increasing their income over time, especially when the company’s stock is in an uptrend. ESPPs also appeal to employees because they do not require the stock that is purchased in them to be held until retirement, which allows employees to receive the proceeds from the sales of their stock on at least a semi-regular basis within a relatively short period of time, while taking advantage of long-term capital gains treatment.

For more information on employee stock purchase plans and how they work, consult your broker or human resources department.

Mark Cussen
Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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