Employee stock purchase plans, or ESPPs, are employee benefits programs. ESPPs offer employees the option to purchase company stocks directly at a discount.

What Is an Employee Stock Purchase Plan (ESPP)?

An employee stock purchase plan (ESPP) is an optional employee benefit plan an employer offers. Under this plan, the participating employee can purchase company stocks at a discounted rate. Then, the employee can decide how much money they will set aside from their after-tax paycheck to purchase the company's stock.

Features of ESPP

The essential features of ESPPs include:

• Discount Rate: Most ESPPs allow employees to purchase stocks at a discount of around 15% of the market price.
• Lookback Provision: The stocks are available at a price based on the stock offering date or purchase date, which is lower.
• Number of Purchase Periods per Year: The ESPP may specify the number of purchase periods per year when employees can purchase the shares.
• Ability to Withdraw Before Purchase: Employees can withdraw from the plan and have the cash deducted from their paychecks returned to them anytime before making a stock purchase.
• Share Income/Loss Taxed as Capital Gains/Losses: Any income or loss from the sale of shares will be taxable as capital gain or losses, subject to the holding period requirements.

Types of ESPPs

• Qualified Plans: Qualified ESPPs comply with Internal Revenue Code Section 423, offering employees favorable tax treatment on stock purchases. These plans require shareholder approval before implementation and must provide equal participation rights to all eligible employees. Typically, they allow employees to buy company stock at a discount of up to 15% off the fair market value. A purchase limit also enables employees to acquire up to $25,000 worth of stock (based on its fair market value at the offering date) per calendar year.
• Non-Qualified Plans: Non-qualified ESPPs do not adhere to IRS Section 423 requirements, giving companies more flexibility in plan design. They can be established without shareholder approval, allowing employers to set custom eligibility criteria and discount rates. However, the discount employees receive on stock purchases is taxed as ordinary income in the year of purchase, providing no special tax advantages compared to qualified plans.

How Does an ESPP Work?

A typical lifecycle of an ESPP involves:

• Eligibility: ESPP plans do not allow people who own more than 5% of the company's stock to participate. They also restrict employees the company has employed for a year or less. However, that may vary by plan. The IRS allows companies to require up to two years of employment before participation, but some companies may choose shorter periods or no waiting period.
• Plan Enrollment: When eligible, employees receive an enrollment email explaining the plan's specifics, the discount, and when they can purchase shares.
• Participating in the Plan: The employee opens an account and decides how much funds they want to contribute to the plan from their paycheck. According to the IRS, the maximum contribution limit is $25,000 per calendar year. This limit refers to the maximum fair market value of the stock (determined at the time of the offering) that an employee can purchase under a qualified ESPP in a calendar year, not the amount of money they can contribute.
• Accumulation of Contribution: The company collects the amount contributed from the employee's paycheck.
• Purchase of Company Stock: At the end of the purchase period, the company uses the accumulated contribution to purchase stock at a discount.
• Adjustable Contributions for the Next Purchase Period: Employees can increase or decrease their contribution level if desired during the next purchase period.

The company deposits all purchased shares into the employee's account. Employees can sell the shares at any time, though some plans require them to hold them for at least 3, 6, or 12 months after purchase.

How Is an ESPP Taxed?

ESPP is taxed based on whether the plan is qualified or non-qualified.

• Qualified Plan: U.S. taxpayers with a qualified plan pay taxes when they sell their shares. The sale of ESPP shares after one year of purchase or two years of the offering date has more tax benefits than those sold before the specified period.
• Non-Qualified Plan: Employees with a non-qualified plan must pay tax on the purchased shares. Additional tax may be due at the time of the sale of such shares. Discounts on the stock purchase are considered ordinary income and are taxable in the year of purchase, regardless of when the stock is sold. Any subsequent gain or loss upon sale is treated as capital gain or loss.

Advantages and Risks

Benefits of an ESPP

The benefits of participating in an ESPP are:

• A Convenient Way to Save and Invest: An ESPP plan motivates employees to save money by directly contributing funds from their paychecks, which they would otherwise spend.
• Discounted Stocks: Most ESPP plans offer employees stocks at a discount.
• Participate in Company Success: Holding the company's stock allows employees to benefit when the stock's value increases.

Risks of an ESPP

However, returns are not guaranteed with an ESPP since the stock value can rise or fall. Employees should also understand that investing heavily in one's employer can be risky if the company's performance declines, potentially affecting both employment and investment simultaneously.

Maximizing Benefits

Employees can maximize their ESPP benefits by:

• Evaluating if it is worthwhile to participate in the program.
• Calculating how much they are willing to contribute.
• Assessing how much the value of the stock may rise and fall.
• Analyzing when to sell or hold the shares to reap the maximum benefits.

Takeaway

ESPPs are valuable benefits offered by companies. They allow employees to purchase company stocks at a discount and profit when the company becomes financially successful.