7 Things to Know About Your Employee Stock Purchase Plan

An employee stock purchase plan is a compensation tool that may allow you to purchase shares of company stock through convenient payroll deductions.

Employee stock purchase plans, or ESPPs, can give you the opportunity to buy company stock at a discount or at a favorable price. Through the plan, you could also receive potentially preferential tax treatment on the profits should you meet specific holding period requirements for the shares you buy.

If your employer offers an ESPP but you’re not sure if you should participate, here’s what to know to help you decide whether or not you’d like to take advantage.

1 – You Buy Shares of Company Stock Through an ESPP

An employee stock purchase plan allows you to buy shares of company stock. Owning shares of company stock may be a good thing if you think the company stock price will go up, but it comes with a number of risks.

The most obvious risk is one all investments carry: there’s a risk of loss, as there’s no guarantee your investment will increase in value. There’s a chance you could buy shares, hold them, and see their price fall below what you paid for them.

But there’s another risk that not every other investment carries, and that is concentration risk.

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Before you participate in your ESPP, and especially if you plan to participate and hold the stock you buy (instead of immediately selling the shares to lock in any discount you may receive), you need to know what it means to hold a single stock position.

You also need to consider that not only do you hold company stock, but your employer pays your salary — so if something happens to the business, both your investments and your cash flow could be negatively impacted.

2 – You Usually Fund an Employee Stock Purchase Plan with Payroll Deductions

Most employee stock purchase plans are set up so that enrolling into one allows you to elect to defer a set percentage or amount of your paycheck to the plan.

This makes contributions easy and convenient, which many employees see as an attractive feature of ESPPs. Just keep in mind that the plan comes with an annual contribution maximum of $25,000 per year.

Once you enroll, your employer automatically deducts a portion of your paycheck into the ESPP much like 401(k) contributions are deducted from your pay. But unlike a traditional 401(k) where you fund the plan with pre-tax deferrals, ESPP contributions are made with after-tax money.

Contributions from payroll can be likely be turned on and off at set intervals per the rules of your plan document.

3 – Purchases in an Employee Stock Purchase Plan Are Made at Set Intervals

Many plans provide an “offering period.” During this window, your employer collects your payroll contributions.

Your plan will also have a purchase date. On the purchase date, your employer uses the funds collected during the offering period and held in the trust to buy shares of stock.

For example, your plan may have an offering period of 2 years and a purchase date of every 6 months. This means that you may be eligible to participate in the plan for 2 years. During that 2-year period, there will be 4 times during which shares will actually be purchased:

• At 6 months
• At 12 months
• At 18 months
• At 24 months

From months 0 to 6, your contributions go into a trust until the purchase date at the 6-month mark. At that time, your employer uses the funds to purchase shares for you.

Contributions accumulate in the trust again for another 6 months, until the 12-month purchase date when your employer buys shares. This process will continue until the end of your 2-year offering period.

4 – You May Have a Beneficial “Lookback” Provision

The actual purchase price you pay for the shares you purchase through your ESPP is subject to your plan document.

For some plans, the price you pay will be the fair market value of the stock on the purchase date. For others, you should check to see if your plan allows for a lookback provision.

A lookback provision allows for an ESPP to purchase shares of stock at the purchase date price or the grant date price, whichever is lower. The grant date price is typically the price of the stock when the offering period begins.

For example, say the grant date price for your employee stock purchase plan shares was $100 per share and the purchase date price was something like $150 per share. Over the last 6 months, if you’re set to max out how much you can contribute, you would have put $12,500 into your plan.

If you have a lookback provision, here’s how your ESPP could purchase these shares on your behalf at the offering date price:

Payroll Deductions Collected / Offering Date Price = Shares Purchased

$12,500 / $100 = 125 shares

Shares Purchased x Purchase Date Price = Current Value

125 x $150 = $18,750

In this scenario, you will have contributed and paid $12,500 for something that is immediately worth $18,750.  You will have benefited from “free” stock price appreciation during the 6-month period.

If the stock price went down — let’s say it dropped from $100 to $50 per share — you will be able to buy the same 125 shares at $50 per share purchase date price.

5 – Your Employee Stock Purchase Plan May Allow You to Buy at a Discount

Many employee stock purchase plans will offer a discount of up to 15% on the purchase of company stock. Being able to buy something at a 15% discount that you can immediately sell for full market value means locking in a profit of at least 15%.

Remember to check your plan document to confirm whether or not you receive such a discount. Not all plans are the same, and some don’t offer the ability to buy at a discount (or the percentage of that discount might be something other than 15%).

A 15% discount can be even more beneficial if you can combine it with the lookback provision. In our example above, let’s assume that the stock price has gone up and you paid $100 per share for shares that are currently valued at $150 per share.

If your plan offers a $15 discount, you will actually pay $100 per share less 15%, or $85 dollars per share. In the example when the price drops during the offering period, you will pay $50 per share less 15%, or $42.50 per share.

6 – You May Pay Several Types of Tax When You Sell Your Shares

When you purchase shares of company stock through an employee stock purchase plan, you pay no tax. But when you sell those shares, you create a reportable event for tax purposes.

The type of tax you pay will depend on how long you held the ESPP shares. More specifically, the sale of your ESPP shares will be identified as a qualifying or disqualifying disposition.

A qualifying sale is one that meets the following criteria:

• The final sale occurs at least 2 years after the offer date
• The final sale occurs at least 1 year after the purchase date

Anything that does not meet these criteria is a disqualifying disposition.

The tax rules for an ESPP can be complicated. You’ll likely find yourself reporting a combination of compensation income and short- or long-term capital gains income, depending on the offering period price, purchase date price, and how long you held the shares since the purchase date.

Generally speaking, if you have a qualifying disposition, the discount received from the offering date price will likely be taxed as compensation income and taxed at your regular tax rates.

However, if you have a total realized gain when you sell that is less than the discount received, your compensation income may be lower. Gains, if any, in excess of the offering date price (not including the discount) will likely be taxed as a long-term capital gain.

If you have a disqualifying disposition, you’ll likely report compensation income on the discount received from the actual purchase price paid and short- or long-term capital gain/loss on anything in excess.

7 – Everything You Need to Know Lives in Your Employee Stock Purchase Plan Document

You’ve seen it here a few times, but I encourage you to obtain a copy of your plan document.  This document will tell you the specifics of your plan.

By consulting the plan document, you can find out if you get to buy shares at a discount or not, and if your plan offers additional benefits like a lookback provision. The plan document will also detail when and how to enroll and when and how you can sell your shares.

If you still aren’t sure of the answers to your questions after you read it, it may make sense to talk with a professional who can help you navigate this potentially complex topic.

Your Employee Stock Purchase Plan May Be a Great Deal

As you can see, there are a lot of moving parts with an employee stock purchase plan. It can get complex, but if you have access to this kind of company benefit you may want to take advantage.

You’ll want to be sure this strategy, however, fits into your overall financial plan and investment allocation. It also needs to fit within your cash flow, because the money to fund the ESPP comes directly from your paycheck.

If you can buy shares at a discount, benefit from a lookback period, and sell the shares immediately after purchase — while also managing the change in cash flow as some money from your paycheck will go straight into the plan — an ESPP may allow for you to capture immediate profit with little to no risk.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.