EMPLOYEE STOCK PURCHASE PLANS (ESPPs)

ESPPs can be classified into qualified and nonqualified groups. The most popular kind of plan, qualifying ESPPs are similar to their qualified counterparts in the world of retirement plans in that they are subject to the IRS-mandated eligibility requirements. All participants in qualified plans have the same rights under the plan, and they must have shareholder approval before being put into effect. Their offering periods cannot be more than 27 months, and the stock price discount cannot be greater than 15%.

Nonqualified plans are far easier to set up and are not subject to the same regulations as qualified plans, but they offer no tax benefits of any kind. Therefore, the remainder of this article is limited to eligible plans.

Important Dates and Terms

Only when the offering period starts can employees choose to take part in their employer’s ESPP. This time always starts on the offering date, which is also the date that stock option programs grant stock options. Participants are then subject to payroll deductions up until the purchase date (the day on which the company stock is actually bought). Offering periods can either be sequential or overlap; the latter category frequently has various purchase prices due to its staggered purchasing dates.

The majority of offering periods feature several purchase dates that follow multiple purchase periods, such as a three-year offering period with four purchase periods that conclude with four purchase days. The first purchase period would therefore last for six months and expire on July 1 if the offering period started on January 1 and for another two years if the second buying period ended on December 31.

Process for Enrollment and Plan Mechanics

At the following open enrollment date, employees must submit an application to enroll in the plan. They will include their desired contribution amount to the plan on the application (which is usually limited to about 10 percent of their take-home pay). Regardless of any limitations set by the employer, contributions are also restricted by the IRS to $25,000 each calendar year.

The employee deferrals are kept in separate accounts after each pay period until the purchase date. A transfer agent or brokerage company will then hold the stock in individual accounts for each employee until they sell their shares and get the money.

Potential Gain

Several ESPPs enable their participants to buy their stock at a 10 to 15% discount to the market price, generating an immediate financial gain upon sale. In addition, many plans often include a “look back” clause that permits the use of the closing share price of the company on the purchase date or, if lower, the offering date. The amount of profit realized by the players may significantly change as a result. Employers are free to establish their own rules regarding the withdrawal of cash from a plan between purchase dates or adjustments to employee contribution levels.

Eligibility

Anyone who owns more than 5% of the firm’s shares is not permitted to participate in a qualified ESPP, and the plan may further exclude some employee groups from participation, such as those who have worked for the company for less than a year. The plan must be made unconditionally available to all other employees.

Qualifying Dispositions

Participants will experience two forms of taxable income (or losses) if they satisfy the holding requirements for qualified dispositions, but none of it is reported until the year of the sale. Ordinary income is stated in the amount of the discount allocated in the plan (for example, 15%). The remaining amount is considered a long-term capital gain.

Disqualifying Dispositions

The sale earnings are far more often counted as ordinary income in this kind of disposition. The difference between the discounted purchase price and the stock’s closing price as of the acquisition date must be included in the seller’s calculation of ordinary income. This is a very succinct summary of the tax laws that apply to ESPPs. Participants should not be afraid to ask a tax expert for help on this subject since the mechanics of how these function can often be quite sophisticated.

Just like all the other kinds of employee stock ownership plans, ESPPs can encourage employees and give them a secondary source of income that does not fully originate from the company’s coffers. Additionally, because all contributions to these plans are exempt from Social Security and Medicare tax, ESPPs are easy to administer and maintain and can help employees develop a regular saving habit. Additionally, they permit employees to sell the stock before to retirement, preventing a heavy concentration of corporate stock in their portfolios.

The income is not taxed when you purchase stock through an employee stock purchase plan (ESPP). When you sell the stock, you must recognize the income and pay taxes on it.

The income from selling the shares can be either an ordinary income or a capital gain. If the stock is held for both of these reasons, the sale will be eligible for capital gain treatment.

• At least two years following the issuance of the option
• A minimum of one year after purchasing the stock

Additionally, before exercising the option, you must continue working for the business for at least three months.

Your ordinary income from the sale is based on the option price if you satisfy the holding-period conditions. Price of the option:

• Possibly lower than the stock’s fair market value (FMV) as on the day you received it. If this is the case, you have ordinary income in the amount that FMV exceeds the option price. Put this income on Line 7 of Form 1040 as wages. The ordinary income recognized in the sale year is included in the basis of the shares.
• Possibly not less than the stock’s FMV on the day you received it. If so, the income should be considered a long-term capital gain. Fill out Schedule D to report the capital gain. The option price is the stock basis. The capital gain is calculated above for any income that is higher than the ordinary income.
• It is a disqualifying disposition if the holding period requirement is not met. Only normal income is recognizable. To calculate the amount of ordinary income:
  • Find the stock’s FMV as of the day you received it (exercise date).
  • Subtract the stock’s purchase price (option price).

The gain on the sale might not exceed the usual income. The sum of the two determines the stock’s basis:

• The average income amount
• Price of a stock option

On Line 7 on Form 1040, declare the amount of ordinary gain as wages.

Capital losses apply to ESPP stock sale losses.

ESPP shares can function as a turbo-charged savings account that you can use to advance your financial goals because of the discounted acquisition price.

Let’s examine a few options for doing that.

Increase Your Cash Flow

Given that shares are originally purchased at a 5–15% discount, the program initially reduces monthly cash flow, but after your initial enrollment period, it can actually increase annual cash flow. Imagine that you donate $10,000 every six months to an ESPP and that you utilize that money to purchase about $11,760 worth of shares at a discount of 15%. (assumes no price appreciation; gains would be greater if the share price increases). You still have a $1,055 boost in your cash flow every six months even after income tax (assume a 35 percent overall tax rate).

Fund Short-Term Objectives

You may use your employee stock purchase plan to hasten your savings for immediate objectives.

Boost Your Long-Term Savings

Even if you aren’t saving for short-term purposes, you can use your ESPP earnings to enhance your retirement savings (Traditional IRA, Roth IRA), health savings account (HSA), or taxable account.

Invest ESPP Shares in a Brokerage Account

The ESPP program can be a way to acquire shares of your employer’s stock at a discount if you are attempting to do so. You may wish to do so if you are particularly optimistic about your employer’s future (and risk-seeking) or if you are working towards a minimum holding requirement in company stock (required at many companies for senior executives and directors). Once the shares have been acquired through the ESPP, they can be moved to the brokerage account of your choice

Consider how to integrate an ESPP approach into your overall financial plan and investment strategy.

People frequently inquire, “When should I sell my ESPP shares?” We would respond that it depends on the following factors:

Indicate the level of company shares you wish to own: Furthermore, your salary, bonus, and other equity incentives like RSUs are already based on your employer’s performance, so you are already taking on additional risk by investing in individual equities. Choosing the maximum quantity of employer stock to hold is the first step. A suitable starting point is a percentage of no more than 10%.

Automate your strategy: The simplest method to stick to a plan once you’ve decided how much company stock to hold is to automate it. We advise that once you’ve reached that threshold, you set your ESPP sale strategy to sell immediately so that you don’t need to remember to sell the shares later and unintentionally go over the limit you set. This is true whether you decide to hold 0% or 10% of your liquid net worth in your employer’s stock.