Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

espp

How to Evaluate an ESPP from a Recent IPO Company

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Access to an employee stock purchase plan that offers a lookback provision and a discount is often a great benefit for employees. If you can afford to contribute, these two features may allow you to benefit from an increasing stock price while potentially receiving downside protection (assuming you sell your shares immediately after they are purchased).

If you work for a company that recently went through an initial public offering, or IPO, an employee stock purchase plan, or ESPP, might be a newly-offered benefit from your employer. If it is, you may be wondering if it makes sense to participate.

To help you evaluate, here is a primer on how an ESPP works, what you need to know about your plan, and why it may or may not make sense for your financial planning goals and objectives.

Understanding the Basics of an ESPP If Your Company Just Went Through an IPO

Generally speaking, an ESPP allows you to purchase shares of your company stock via convenient payroll deductions. In addition to offering a convenient way to buy shares, an ESPP may also provide the following benefits:

  1. Some ESPPs give you the ability to purchase shares of company stock at a discounted price. For qualified plans, the discount can be up to 15% off the purchase price of the stock.
  2. Some ESPPs offer a “lookback provision” that lets you buy the stock at the grant date price or the purchase date price, whichever is lower (and therefore less expensive to you).

Your plan document will provide you with all the details on how the particular ESPP your company offers works, including its rules and any limitations. When you review this document, you’ll want to identify and understand the following features of your ESPP:

  • What the offering period is, which can be up to 27 months long in qualified plans.
  • How to enroll and how much you can contribute to the plan, which is often based on a $25,000 calendar year limit for a qualified ESPP.
  • The deals on the purchase periods, which occur within an offering period (and there may be several within a single offering period).
  • What the taxability of your employee stock purchase plan is, which depends on whether or not you do a qualifying or disqualifying disposition (but more on that later).

This is an extremely concise rundown of ESPPs and some important terms. Everyone with access to an employee stock purchase plan should be familiar with these basics — but if your ESPP is a new benefit coming from a company that went through a recent IPO, you also need to understand how that event can impact your plan.

How a Recent IPO Can Impact Your ESPP

When a company goes through an initial public offering, they begin to sell shares of stock to the public. As a shareholder, going public means that you can sell your shares on a public exchange (although you should still check with your company to see if any restrictions apply to shares you own).

Public companies regularly trade, so it is easy to know what your stock is worth. That can make it easier to make a plan for what to do with the proceeds if you turn your company stock into cash that can be used for other needs or to achieve financial goals.

The price at which your company goes public is known as the public offering price. This price, as it relates to an ESPP, is important because it might be the grant date price that is used at the start of an offering period.

This is one price at which you might be able to buy shares of stock in the ESPP for the duration of the offering period. The exact price you pay to purchase shares will be determined by the future stock price and by the rules of your plan.

Regardless, however, of those future price points, participating in your ESPP immediately following an IPO can be a smart strategy. Let’s take a look at why and how this may be true by exploring several potential scenarios.

For the following examples, we’ll assume the following:

  • There are four purchase periods during the offering period.
  • You receive a 15% discount on the purchase price of the stock.
  • The grant date price is $20 per share.
  • You can purchase 625 shares on each purchase date.

Now, let’s explore three separate examples to illustrate outcomes in an up market, a flat market, and a down market to see the potential benefits and drawbacks of participating in an ESPP that coincides with an IPO.

Example 1: The Stock Price Goes Up Consistently (Up Market)

In this example, we will assume that the company stock price doubles each purchase period. As the price goes up through the duration of the offering period, the lookback provision of the ESPP allows ESPP participants the privilege of purchasing shares at the $20 grant price.

You can purchase at the $20 price when the actual purchase date price is $400, which is significant — and immediate profit should you turn around and sell as soon as you buy. On top of that, your actual cost would be just $17 per share, thanks to the 15% discount benefit.

Grant Price Purchase Date Price Actual Purchase Price Shares Purchased Total Cost Total Value (When Sold Immediately After Purchase)
$20.00 $50.00 $17.00 625 $10,625.00 $31,250.00
$20.00 $100.00 $17.00 625 $10,625.00 $62,500.00
$20.00 $200.00 $17.00 625 $10,625.00 $125,000.00
$20.00 $400.00 $17.00 625 $10,625.00 $250,000.00
2500 $42,500.00 $468,750.00

 

On each of the four purchase dates, 625 shares are purchased at the lookback and discounted price of $17 per share, or $10,625 total in each period. The actual stock price at the various times of purchase ranges from $50 in purchase period 1 to $400 in purchase period 4.

Once the shares are purchased, you, as the ESPP participant, can elect to keep or sell them. If we assume that you sell immediately after purchase, then your total proceeds equal $468,750, your total cost is $42,500, and your total pre-tax profit over four purchase periods is $426,250.

If, on the other hand, you decided to wait until the end of the offering period to sell all 2,500 shares at the final purchase date when the share price was $400, the total proceeds would be $1,000,000. That would give you a pre-tax profit of $957,500!

In this example, you not only benefit from an increasing stock price, but you could also benefit from a tax standpoint if you bought and held some of your shares for over a year. Some portion of the shares you eventually sold at the last date could meet the rules for a qualifying disposition and therefore, could receive a more favorable tax rate.

The flipside is that the longer you maintain ownership of shares of stock, the longer you expose yourself to the regular investment risks of holding a single stock position. This may leave you subject to significant price volatility, and this risk may or may not be one you can afford to take.

Example 2: The Stock Price Stays the Same (Flat Market)

An ESPP can drive a significant increase in your wealth if your company stock price goes up while you participate. However, not all stock prices go up after an IPO, and it makes sense to compare that potential scenario to an alternative possibility.

Let’s assume that, instead of the stock price going up, the IPO is priced at $20. The shares “pop” on the first day to $50 per share, but then stay fixed at that price throughout four purchase periods.

Grant Price Purchase Date Price Actual Purchase Price Shares Purchased Total Cost Total Value (When Sold Immediately After Purchase)
$20.00 $50.00 $17.00 625 $10,625.00 $31,250.00
$20.00 $50.00 $17.00 625 $10,625.00 $31,250.00
$20.00 $50.00 $17.00 625 $10,625.00 $31,250.00
$20.00 $50.00 $17.00 625 $10,625.00 $31,250.00
2500 $42,500.00 $125,000.00

 

Just as in the first example, you can purchase shares of your company stock at the grant date price of $17 thanks to a lookback provision and discount.

Over four purchase periods, the same 2,500 total shares will be purchased for the same total cost of $42,500. If we assume the stock price stays fixed at $50 per share and that you sell the shares immediately after purchase, the total proceeds will be $125,000, and your overall profit will be $82,500.

This might not be quite as impressive as the profit gained in a scenario where the stock price only goes up — but it’s still a meaningful increase in wealth.

Because we’re assuming things stay flat here, your profit would still be $82,500 even if you held on to all shares throughout all purchase periods and then sold everything at the end. But, some of the shares may still be sold as qualifying shares and therefore, could get the same preferential tax treatment as discussed above.

In this case, the after-tax outcome of a qualifying disposition could net you a more than selling shares as they’re purchased.

Example 3: The Stock Price Goes Down (Down Market)

Everyone hopes that the stock price of the shares they own goes up. But that doesn’t always happen, and there’s nothing that says the shares you buy through your ESPP can’t drop in value.

While this may mean that much (or all) of the profit shown in the previous two examples would not show up in this scenario, an ESPP with a lookback and a discount may still protect you from the downside risk of declining share prices.

That means that, despite a down market, maximum participation in your ESPP might still be a good idea. This example shows us how, and in it, we’ll assume the company stock IPOs at $20 per share but then drops each purchase date, with the last purchase date price at just $2.50.

Grant Price Purchase Date Price Actual Purchase Price Shares Purchased Total Cost Total Value (When Sold Immediately After Purchase)
$20.00 $15.00 $12.75 625 $7,968.75 $9,375.00
$20.00 $10.00 $8.50 625 $5,312.50 $6,250.00
$20.00 $5.00 $4.25 625 $2,656.25 $3,125.00
$20.00 $2.50 $2.13 625 $1,328.13 $1,562.50
2500 $17,265.63 $20,312.50

 

In this example, you still purchase 625 shares in each purchase period. Instead of buying stock at $17 as above, the lookback provision of an ESPP in our example will allow for the purchase of shares at the better of the grant date price ($20 per share) or the purchase date price ($15, $10, $5, or $2.50) less the discount.

That means for each purchase period in this example; the shares would be purchased at $12.75, $8.50, $4.25, and $2.13, respectively.

Assuming again, you sell shares immediately after purchase; your total cost would be $17,266. The entire proceeds would be $20,313, giving you a pre-tax profit of $3,047 (which is equal to the value of the discount).

Even in a down market scenario, the combination of the lookback and the discount may provide for short-term protection against loss and leave you with some cash in your pocket (although, clearly not nearly as much as you would have in conditions that saw the company’s stock price rise).

But this only holds if you did sell the shares as soon as you purchased them. Unlike the other two scenarios, the outcome is not positive if you keep the stocks until the last date. If you did that, the value of your shares would be just $6,250 — resulting in a loss of $11,016.

While no one likes the idea of a falling share price, the structure of an ESPP may offer additional benefits in a down market. Again, you’ll need to check your company plan document to see how your specific plan works — but if you have “overlapping” offering periods, then you could have even more protections.

An overlapping offering period may mean that if the stock price goes down between the grant date to the purchase date, you may be able to reset from the “old” offering period and enroll in the “new” offering period with a new and lower grant date price.

In our example above, this means that the “old” (or original) grant price is $20 per share, and the “new” grant date price for the new offering period is $15 per share.  You can read more about ESPPs during times of market volatility here.

Should You Still Participate in an ESPP If You Already Own Too Much Company Stock?

If you work for a company that recently went through an IPO, then in addition to gaining access to an ESPP, you might already have other forms of equity compensation. These could include stock options or restricted stock units.

In this case, since you already own a lot of stock, you may question whether it makes sense to participate in an ESPP because that puts you in a position of buying even more stock.

While your thinking regarding buying more stock and increasing your concentration risk associated with a single company stock position may be prudent, remember that participating in an ESPP does not have to be an either/or decision.

It does not need to be “I have other stock and stock options from my employer and should not contribute” or “I do not have company stock and should contribute.”

Many times, the decision to participate in an ESPP, even if you already own a meaningful amount of company stock, is simply a decision to maximize the opportunity to increase your wealth. As seen above, a good ESPP with a lookback and a discount might give you an excellent opportunity to do so.

With that said, the decision to manage concentration risk is one that should be addressed. Depending on your situation, that could mean choosing a disqualifying disposition that leads to ordinary income tax rates over holding onto shares once you purchase them.

Although the tax rate won’t be as advantageous as the lower rate you can secure through a qualifying disposition, the slight increase on how much in taxes you’ll owe could be a worthwhile tradeoff to properly manage concentration risk according to your specific investment strategy and overall financial plan.

Participating in an ESPP at a Company That Just Went Through an IPO

For many of the reasons illustrated above, a good ESPP can be an excellent opportunity to increase your wealth with limited short-term risk. If your company recently went through an IPO or is scheduled to IPO, it may make sense to evaluate if this employee benefit will be offered.

If it is, it may be something to consider, even if you already own a lot of company stock.

If you find yourself in that situation, or if you find yourself wanting to participate, you should consider how this may impact your cash flows, what you plan to do when your shares are purchased, how these decisions may impact your tax return, and how all of this fits in to your overall financial plan and investment profile.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

The information in these articles may change at any time and without notice.  Laws of a specific state or laws relevant to a specific situation may affect the applicability, accuracy, or completeness of this information. The information presented here is not specific to any individual’s personal circumstances. There is no guarantee that any strategies discussed will result in a positive outcome.  The purchase of certain securities may be required to effect some of the strategies.

You should discuss any legal, tax or financial matters with the appropriate professional. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results.

 

A Look at Your Employee Stock Purchase Plan During Times of Market Volatility

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An employee stock purchase plan is a company-sponsored benefit that gives employees a convenient way to purchase company stock.

Typically funded through payroll deductions, an ESPP can be a great way to participate in the success of the business you work for; if the company does well and the stock price increases, employees who participate may reap the benefit of owning shares that appreciate in value.

Of course, there’s a flipside to that. Owning company stock comes with the risk of loss should the share price fall below the price you paid to acquire it.

But after understanding the risks, you may still want to participate in an ESPP, because they’re not just convenient — they may actually provide some unique short-term protection against the risk of loss during periods of market volatility as compared to alternatives like the outright purchase of company stock or other forms of equity compensation.

To understand why, it makes sense to consider how an ESPP works, particularly features that your plan may include such as a lookback provision and a discount to the purchase price.

A Simple Illustration of How an ESPP Works

As always, you want to check your ESPP document to see exactly how your ESPP works — but in general, most plans are very simple in concept. You enroll in the plan offered by your company, you contribute via payroll deductions, and shares of stock are purchased on your behalf (In reality, however, there may be a lot of nuances).

If you participate in an employee stock purchase plan, you likely contribute cash into the plan for a specific period of time. This is known as an offering period.

An offering period begins with an offering date and ends with a purchase date. The time between the offering date and the purchase date is referred to as the purchase period, which is often 6 months. For some plans, the offering period can last as long as 27 months and include multiple purchase periods.

During the purchase period, you contribute payroll deductions to your ESPP. As you contribute to the plan, you’re not actually purchasing shares; your money is held in escrow for the duration of the purchase period.

On the purchase date, your contributions are used to purchase shares on your behalf as a participant of the ESPP.

How the Stretch of Time to the Purchase Date May Offer Downside Protection

On the purchase date of the ESPP, contributions collected during the period purchase are used to buy shares of stock for the plan participants. If you contributed to the ESPP, then your stock shares are deposited into a brokerage account for you.

During the purchase period, the price of the stock price will likely move. It can be up or down, subject to typical market volatility.

If the stock price is up, the ESPP will purchase shares for the plan at a higher price than had you otherwise not participated in the plan and purchased shares on the open market on Day 1.

If the price is down during the purchase period, shares purchased in the ESPP will have benefited from contributions being held in escrow, allowing the purchase of shares to occur at the now-lower purchase date price.

This is a simplified scenario, but it illustrates how an ESPP can offer downside protection on the purchase price during the purchase period. During a period of volatility, particularly when markets lose value, the ESPP purchase process may be seen as an attractive benefit to limit the risk of loss.

Using an ESPP with a Lookback Provision During Times of Market Volatility

A lookback provision is a benefit offered by some employee stock purchase plans. This allows for the purchase of company stock at the offer date price of the ESPP or the purchase date price — whichever is better (in this case, whichever is the lower cost). This can add to the ability to protect against downside risk during periods of market volatility.

Let’s assume that you enroll in an employee stock purchase plan. The company stock’s share price is $20 on the offering date — but the value rises over time and on the purchase date, the price is $50 per share.

A lookback provision allows for the purchase of shares at the better price. In this hypothetical, the ESPP participants benefit from the plan because their shares are being purchased at $20 each even though the stock is worth $50 per share.

Obviously, this is a great deal as you could immediately lock in a gain if you took your shares and sold them on the open market.

If the stock price is down during the purchase period and on the purchase date the stock price is $5 per share, shares will be purchased at the better purchase date price of $5 per share.

This lower purchase date price might provide additional benefit moving forward. As we mentioned, it’s possible that an ESPP can have an offering period, with a lookback provision, for up to 27 months. In this example, it would be possible to buy the stock at the original offer date price of $20 per share.

Some plans, however, may sweeten the deal and offer multiple offering periods at the same time, resulting in offering periods that overlap.  If you have multiple offering periods at the same time, you’ll also have multiple offer dates price. If the volatile markets lead to a lower offering date price than your existing one, it may mean that you can lock in that lower offer date price on future contributions.

For example, let’s assume that following the original offering period and purchase date, the ESPP purchased stock at $5 per share. If the plan includes multiple offering periods, it’s possible that the current $5 per share price may actually occur at the beginning of a new offering period too, with a new offer date price.

If so, “switching” to a new offering period with a lookback price of $5 is certainly more advantageous than one with an offer date price of $20. As this example illustrates, an ESPP with a lookback provision allows a participant to benefit from upside volatility and may offer added benefits on downside volatility.

How the Added Benefit of an ESPP Discount Can Fit into the Plan

Some companies will even offer a discount to the purchase price of company stock acquired through ESPPs. Discounts are usually set between 1-15% of the purchase price. This even more protection against market volatility, as the discount is directly from the actual purchase price of the stock.

If we assume a 15% discount and continue our lookback examples above, we can assume the following:

Offer Date Price Purchase Date Price Purchase Price Discount Actual Price Paid
No Lookback $20 $50 $50 $7.50 $42.50
No Lookback $20 $5 $5 $0.75 $4.25
Lookback Up $20 $50 $20 $3 $17
Lookback Down $20 $5 $5 $0.75 $4.25

 

In all scenarios, the discount offers an additional reason to participate in an ESPP even if the stock price is down.

Employee Stock Purchase Plans During Market Volatility

It’s important to note that while a good ESPP may offer some purchase period protection on downside volatility of a stock price, that shares you own outright are not afforded this same luxury. Shares owned outright, possibly from an earlier purchase of ESPP shares, are subject to the full market volatility.

This means that good financial planning might be required to determine if you should participate in your company offered ESPP, how actively you should participate, and what if anything you should do once your shares are purchased.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

The information in these articles may change at any time and without notice.  Laws of a specific state or laws relevant to a specific situation may affect the applicability, accuracy, or completeness of this information. The information presented here is not specific to any individual’s personal circumstances. There is no guarantee that any strategies discussed will result in a positive outcome.  The purchase of certain securities may be required to effect some of the strategies.

You should discuss any legal, tax or financial matters with the appropriate professional. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results.

4 Factors to Consider Before Participating in Your ESPP

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A good employee stock purchase plan (ESPP) is something that many consider being a no-brainer when it comes to deciding if you should take advantage or not. Contributing to an ESPP is often accomplished through convenient payroll deductions, and many participants benefit from features like lookback provisions or discounts to the purchase price.

At first glance, participating in an ESPP that’s available to you can seem like the obvious “right” choice. But there are other factors that you might want to consider before deciding.

For example, how will a reduced paycheck impact your household cash flow? You may also want to explore the investment risk inherent in purchasing shares of your company’s stock, and if you can truly afford to take on (or want to take on) additional concentration risk. Then, of course, there are the tax planning considerations to keep in mind.

Your plan document can tell you how your employee stock purchase plan works — but there are still details to dig into before you can understand if using your ESPP is the best choice for you. Here’s what to think about before getting started.

1 – How Will Participation in Your ESPP Impact Your Cash Flow?

If you choose to participate in an employee stock purchase plan, one of the first decisions to make is what percentage of your salary you’ll contribute to the ESPP.

ESPPs are usually set up so that you can contribute up to a maximum percentage of salary, like 10 to 15 percent. Some companies may also allow you to contribute a fixed amount. You can contribute at your chosen contribution rate until you reach the maximum allowable annual limit of $25,000 per year (for a qualified plan).

In either case, remember that contributions to a plan come from your paycheck — which means the more you contribute, the less take-home pay you have.

Using an example to illustrate how your contribution may impact your take-home pay, let’s assume that you make $150,000 per year and elect to contribute 15% of your pay to the ESPP, or $22,500.

Unlike pre-tax contributions to a 401(k), contributions to an ESPP are made with after-tax dollars. This means a “true” reduction of $22,500 per year of cash flow from your paycheck. If you get paid 26 times per year, that means taking home about $865 less per paycheck.

Before contributing to an ESPP, you may want to consider how your contribution will impact your take-home paycheck, and how you plan to accommodate for the reduced cash flow at home.

2 – If Cash Flow Is an Issue, Can You Limit It to a One-Time Problem?

If a reduction to your take-home pay doesn’t work for you, it might seem like an ESPP is out of the question — but if the plan offers benefits like a lookback provision and discount on company stock, it might be too good of an opportunity to pass up.

So how do you manage the cash flow problem with the opportunity presented by the plan? Depending on how you manage the ESPP, you could turn a reduction in every paycheck into a one pay period problem.

Continuing with our example from above where you contribute $865 per paycheck to the plan, let’s say your company ESPP has a 6-month purchase period. At the end of that period, your contributions are used to purchase shares of stock.

In total, you’d contribute $11,235 to the plan to buy shares. If your ESPP offers a discount, you may be able to immediately sell your shares at market value and lock in a profit equal to the discount you received when buying them.

You can use these proceeds to supplement your continued reduction of salary due to your ongoing participation in the ESPP. Doing this after every purchase period can mean a hit to your cash flow from reduced take-home pay might reduce take-home pay a one-time problem to plan around.

Moving forward, you can manage cash flow via an immediate sale of stock and still benefit from the potential benefit of a purchase price discount and lookback provision.

3 – What Is Your Strategy to Keep or Sell Your ESPP Shares?

Participating in an ESPP means buying shares of company stock. Before you sign up, you might want to develop a strategy for keeping and holding your shares — or selling them.

The decision to keep your ESPP shares likely needs to include a detailed discussion of investment risk, concentration risk, cash flow, income tax, and other needs. It may also include a conversation regarding your personal opinion of the future value of the stock.

If you don’t set a plan for what to do with the shares you buy, you may default to taking no action. That could lead to an increased position in company stock, which might not align with your overall investment plan.

Concentration in a single stock might not be a problem if you have a good plan for holding shares, or you happen to benefit from an increasing stock price. But accumulating shares could leave you overexposed to company stock and open to the risk of a falling stock price wiping out significant wealth.

4 – How Does Income Tax Impact Your Plans to Purchase, Hold, and Sell Shares in an ESPP?

If you participate in an ESPP, you’ll likely hear the terms qualifying disposition and disqualifying disposition. These terms speak to holding period requirements for your ESPP shares that impact how and when the proceeds of your sale will be taxed.

A qualifying disposition is a final sale of ESPP that meets the following 2 requirements:

  1. The final sale of your shares occurs at least 2 years from the grant date, AND
  2. The final sale of your shares occurs at least 1 year from the purchase date.

Generally speaking, if you meet the qualifying standard and profit from the transaction, the discount from the purchase price received (if any) will be taxed as ordinary income, and all other proceeds will be taxed as a long-term capital gain.

Anything that does not meet this standard is a disqualifying disposition of the stock. With a disqualifying disposition, the gain between the actual purchase price of the stock and the purchase date price of the stock is taxed as ordinary income, and the remainder is taxed as a capital gain (or loss).

While it may seem like it’s easy to argue that better tax treatment is always a better outcome if all else is equal, the reality is that rarely is all else perfectly equal.

To obtain this tax treatment, you must hold your shares for at least 1 year past the purchase date and two years from the grant date. During this requisite holding period, the stock price may fluctuate, and you may end up with less after-tax (even if at a better tax rate) than had you sold the stock immediately after the shares were purchased.

You need to take this possibility into account when considering the best strategy to use for managing shares you buy through an ESPP.

Moving Forward with Your ESPP

In addition to understanding how you ESPP works, understanding key ESPP terms, and knowing what benefits your plan offers in terms of a discount and a lookback provision, you may also want to understand how participating may impact your cash flow, your financial plan, and your risk tolerance or ability to manage concentration risk.

Ultimately, your ESPP might be a great tool to use — but make sure you have a plan for how you’ll manage the opportunity both now and in the future.

The content herein is for illustrative purposes only and does not attempt to predict the actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

8 Key Terms to Know About Your Employee Stock Purchase Plan

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Employee stock purchase plans (ESPP) are a convenient way to purchase company stock. In an ESPP’s simplest form, employees contribute money directly from their paychecks into an employer-offered plan.

At set intervals established by the company, money contributed is used to purchase shares of stock. Those shares are then deposited into an investment account on behalf of each employee who participates.

If you have an ESPP, the ease and convenience of using the plan might be a big benefit — but there are additional reasons you might want to take advantage.

The Benefits of Employee Stock Purchase Plans

To attract employees to participate, many companies offer ESPP features like lookback provisions and discounts on the purchase price of the stock.

This means ESPPs aren’t just convenient. They can also be a great way to generate additional wealth with minimal risk for employees who immediately sell shares after they are purchased.

An immediate sale may generate a quick profit equal to the difference of the final sale price and the discounted price you purchased the shares at through the ESPP.

What You Know Before Getting Started

Still, there are considerations to think through before actively participating in this kind of plan if your employer offers one. Contributing to an ESPP can impact your cash flow, your investment risk, your concentration of employer stock, and your other financial planning needs.

Before jumping in, make sure you fully understand your plan. Start by picking up a little knowledge about a few key terms associated with employee stock purchase plans.

Here is some information on eight key terms to get you started:

Offering Period

Set by the employer, the offering period is the length of time that you may be allowed to contribute after-tax money (usually directly from your paycheck) into your employee stock purchase plan. This money can then be used to purchase shares of company stock.

For a qualified ESPP, the maximum length of the offering period is 27 months. The exact length of an offering period can vary and be as long as that maximum or shorter, depending on the goals and objectives of the company.

Grant Date

The grant date is the first day of the offering period. For some plans, the price on the grant date matters as it may be used to determine what you pay when the ESPP buys shares of stock on your behalf.

Purchase Period

The purchase period is generally a subset of the offering period. At the end of a purchase period, your contributions to the plan are used to purchase shares of stock. These shares are usually deposited into a brokerage account for you.

For example, let’s assume that your company designs an ESPP with a 24-month offering period and 6-month purchase periods. During the offering period, the company will have four 6-month purchase periods. The final purchase coincides with the end of the offering period.

For each 6-month purchase period, the company will collect contributions to the ESPP. At the end of the six months, contributions will be used to purchase shares of stock on the purchase date (or exercise date).

Purchase Date

The purchase date, sometimes known as the exercise date of your ESPP, is when contributions are used to purchase shares of company stock. The purchase date typically occurs at the end of the purchase period, and always occurs at the end of the offering period.

Discount

To encourage participation in an ESPP, many companies chose to offer a discount to the purchase price of stock acquired via an ESPP. For a tax-qualified ESPP, the discount can be from 0-15%.

Lookback Provision

A lookback provision captures the stock price on the grant date of the ESPP. The grant date price and the price of the stock on the purchase date are then used to determine the actual purchase price of the stock.

For plans with longer offering periods, the lookback provision may be an even more appealing benefit of using an ESPP. If the price of the stock increases during the offering period, you’ll be able to continually buy shares at a lower grant date price for a more extended period.

Purchase Price

On the final day of the purchase period, or the final day of the offering period, shares of stock are purchased in an ESPP. The price paid for the stock is as follows:

  • If no discount and no lookback provision is offered, shares of stock are purchased at stock price at the end of the purchase period.
  • If a discount is offered, but there is no lookback provision, shares of stock are purchased at the stock price at the end of the purchase period, less the discount offered.
  • If a discount and a lookback provision are both offered, shares of stock are purchased at the lower of the grant date stock price and the purchase date stock price, less the discount applied.

Qualifying Disposition (or Disqualifying Disposition)

If you participate in an ESPP, you will likely come across the terms qualifying disposition and disqualifying disposition. These terms speak to how profits (or losses) from an ESPP may be reported for income tax purposes.

A qualifying disposition can sometimes provide preferential tax treatment, which may be why people seek to achieve this (although it’s not always the best strategy). You will need to meet the following holding period requirements for your ESPP shares for a qualifying disposition:

  1. The final sale of the shares must occur as least 2 years from the grant date, AND
  2. The final sale of the shares must occur at least 1 year from the purchase date.

Anything that does not meet this standard is considered a disqualifying disposition. Note that what you do after your shares are purchased may have a meaningful impact on income tax, investment risk, and financial planning needs.

The actual tax implications of either scenario go beyond the scope of this article, but you may want to check out the following for more information on what kind of disposition makes the most sense for you:

Your ESPP Can Be a Valuable Wealth-Building Tool — Just Make Sure You Understand It First!

The concept of purchasing shares at a discount to the current price, coupled with a lookback provision, can mean participating in an employee stock purchase plan is a great idea for you — and a great way to add to your wealth.

But as you can see, there are some nuances of ESPPs that can make things a little more complicated.

If you are offered an ESPP, one good place to start is by reading its plan document. This will detail exactly how your specific company plan works, what features it may offer, and explain if any of the other concepts detailed above apply to your ESPP.

Once you understand how your specific plan works, you can couple that information with your overall financial plan to determine if participation is a good idea, at what level, and what your strategy to buy, hold, and sell may be.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

ESPP Tax Rules You Need to Know – And How They’re Affected by Qualifying Dispositions

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An employee stock purchase plan, or ESPP, can provide employees of a company a vehicle through which to purchase that company’s stock.

This is usually done through automated payroll deductions, which makes the system convenient, and employers may offer added benefits like discounts on the market price of the shares and a lookback provision.

These two features alone may make it seem like a no-brainer to participate in an ESPP if you can.  It’s another way to add to your compensation outside of your regular income. But while buying into shares tends to be relatively easy, selling those you own in the ESPP is another story.

When you sell your ESPP shares, you create a reportable tax event — and this is where things may get complicated.

A good strategy for participating in an ESPP is one that not only evaluates when to enroll, how much of your pay to contribute to it, and when to sell the shares you buy but also understands the intricacies of ESPP tax rules and how they impact the after-income tax proceeds that you receive.

A Primer on the ESPP Tax Rules You Should Know

When you enroll, contribute, and/or purchase shares in an employee stock purchase plan, you don’t owe additional income tax from these actions. Only when you sell your shares will you encounter a reportable tax event. You usually use a few documents to do that reporting, including Form 3922 and Form 1099-B.

Exactly how the proceeds of your sold ESPP shares are taxed, however, may be subject to several factors.  Some of the primary determinants are whether your ESPP is a qualified plan or a non-qualified plan and if your ESPP offers a discount on the purchase price.

ESPP tax rules are also influenced by the price of your shares on several key dates. The dates where the price matters are:

  • The offering date
  • The purchase date (for which you’ll want to know the market price and any discount on that price you received)
  • The sale date

The timeline and dates for these events lead to one of two possible scenarios: a qualifying disposition, or a disqualifying disposition.

Understanding the Tax Rules for Qualifying Dispositions

A qualifying disposition (QD) occurs when you sell your shares at least 1 year from the purchase date and at least 2 years from the ESPP offering date.

According to ESPP tax rules, you may be subject to ordinary income tax and/or long-term capital gains (loss) tax if you trigger a qualifying disposition. The rules say that you will pay ordinary income tax on the lesser of:

  1. The discount offered based on the offering date price, or
  2. The gain between the actual purchase price and the final sale price. You will pay long term capital gains on the gain in excess of the discount received, if any.

The allure of qualifying for long-term capital gains may be attractive (because they’re usually lower than your ordinary income tax rate), but this strategy requires you to hold your shares for at least 1 year after you purchase them. That may expose you to concentration and single stock risk.

Holding a single stock may leave you vulnerable to a level of price volatility in your shares that you may or may not be comfortable maintaining — or that you may or may not want to maintain if that position represents far too much of your net worth to risk.

The Differences Between Dispositions: Tax Rules for Disqualifying Dispositions

If you don’t meet the holding period requirements for a qualifying disposition, then by default you end up with a disqualifying disposition (DD).

ESPP tax rules dictate that you may be subject to ordinary income tax and capital gain/loss tax (short term or long term) on the profit/loss in this situation.

That means you will ordinary income tax on the difference between the actual purchase price and the purchase date price, and you’ll pay capital gain (loss) tax rates at the difference between the purchase date price and the final sales price (subject to short-term or long-term holding period requirements).

While paying ordinary income tax may seem less attractive than the qualifying disposition alternative, a disqualifying disposition may allow for you to eliminate single stock risk, reap the proceeds of the sale, and use the money for personal consumption or other long-term savings goals.

How Your ESPP Is Taxed in a Hypothetical Example

ESPP tax rules can be complicated for many reasons, and the nuance of each situation can lead to confusion. To help further explain how your ESPP is taxed and the implications for both a qualifying and disqualifying disposition, it helps to create a hypothetical illustration.

Let’s assume the following:

  • You have a qualified ESPP
  • You get a lookback period that allows you to purchase ESPP shares at the better of the purchase date price or the offer price
  • You receive a 15% discount on the market value of the stock at the time you purchase
  • The offering price of your shares is $10

The final sale price will change the outcomes, even with all the above factors being the same across different scenarios. Specifically, we will evaluate the following scenarios: a final sale price of $50.00, then $9.50, and then $5.00 per share.

These prices lead us to the following three outcomes:

  1. Final Sales Price > Actual Purchase Price and > Offer Price
  2. Final Sales Price > Actual Purchase Price and < Offer Price
  3. Final Sales Price < Actual Purchase Price and < Offer Price

How an ESPP Is Taxed When the Purchase Date Price Is Greater Than the Offering Price

Assume that the purchase date price of the stock is $25 per share. Let’s put this, along with our other key assumption into the chart below, and calculate the profit/loss from the sale of ESPP shares:

Profit/Loss Chart $50.00/share $9.50/share $5.00/share
Offering Price $10.00 $10.00 $10.00
Purchase Date Price $25.00 $25.00 $25.00
Actual Purchase Price (with discount) $8.50 $8.50 $8.50
Final Sale Price $50.00 $9.50 $5.00
Taxable Profit (loss) $41.50 $1.00 ($3.50)

As you would expect, each scenario produces a different profit/loss outcome. As a next step, we can take the calculated profit/loss and model how the ESPP shares are taxed.

For a qualifying disposition, some of the ESPP proceeds may be taxed as ordinary income and some as long-term capital gains. Going back to the ESPP tax rules stated above, we know the following:

  • You pay ordinary income tax on the lesser of (1) the discount offered based on the offering date price or (2) the gain between the actual purchase price and the final sale price.
  • You can pay long-term capital gains on the gain in excess of the discount received, if any.

We can chart the following:

Qualifying Disposition $50.00/share $9.50/share $5.00/share
Total Profit $41.50 $1.00 ($3.50)
Ordinary income $1.50 $1.00 $0.00
Long Term Capital Gain/Loss $40.00 $0.00 ($3.50)

For a disqualifying disposition, ESPP tax rules are different. Here’s what we know:

  • The difference between the actual price paid for the shares and the purchase date price is subject to ordinary income tax rates.
  • Whether you have a capital gain or loss is subject to the difference between the purchase date price and the final sales price.

Following these rules, the tax reporting is:

Disqualifying $50.00/share $9.50/share $5.00/share
Total Profit $41.50 $1.00 ($3.50)
Ordinary income $16.50 $16.50 $16.50
Capital Gain/Loss * $25.00 ($15.50) ($20.00)

*Subject to short/long term holding period requirements

How an ESPP Is Taxed When the Purchase Date Price Is Less Than the Offering Price

In addition to exploring a scenario that the purchase date price is greater than the offering date price, it makes sense to consider the alternative: a scenario that the purchase date price is less than the offering date price.

Keeping all else constant, let’s explore the same example with a purchase date price of $8.00 per share.

If we update the chart accordingly, we see the following:

Profit/Loss Chart $50.00/share $9.50/share $5.00/share
Offering Price $10.00 $10.00 $10.00
Purchase Date Price $8.00 $8.00 $8.00
Actual Purchase Price (with discount) $6.80 $6.80 $6.80
Final Sales Price $50.00 $9.50 $5.00
Taxable Profit (loss) $43.20 $2.70 ($1.80)

We can then model the tax implications. For a qualifying disposition, the income tax reporting is as follows:

Qualifying $50.00/share $9.50/share $5.00/share
Total Profit $43.20 $2.70 ($1.80)
Ordinary income $1.50 $1.50 $0.00
Long Term Capital Gain/Loss $41.70 $1.20 ($1.80)

For a disqualifying disposition, income tax reporting looks slightly different:

Disqualifying $50.00/share $9.50/share $5.00/share
Total Profit $43.20 $2.70 ($1.80)
Ordinary income $1.20 $1.20 $1.20
Capital Gain/Loss * $42.00 $1.50 ($3.00)

How ESPP Tax Rules Impact the Proceeds You Receive from Selling Shares

You need to understand the ESPP tax rules themselves — but it’s just as important that you know how to determine what the after-tax proceeds of your ESPP participation may be. The after-tax amount is the money that you can actually use to do the things you want to do.

To calculate after-tax proceeds, we can easily apply an assumed tax rate to the ordinary income and capital gains portion of the proceeds. We can then subtract the taxes due from the gross sale proceeds to obtain our after-tax proceeds.

In our example, we will assume the following tax rates:

  • Ordinary income tax rate: 32%
  • Long-term capital gain tax rate: 15%

After applying these tax rates to the charts above and adding information for the final sale price of the stock, we can calculate the total after-tax proceeds of each transaction. Next, we can sort the results into a table to determine which scenarios, if any, produce the greatest amount of after-tax proceeds:

Case Number Actual Price Paid Type Sale Price Profit Ordinary Income LTCG Total Tax After-Tax Proceeds
1 8.5 QD 50 $41.50 $1.50 $40.00 $6.48 $43.52
2 6.8 DD 50 $43.20 $1.20 $42.00 $6.68 $43.32
3 6.8 QD 50 $43.20 $1.50 $41.70 $6.74 $43.27
4 8.5 DD 50 $41.50 $16.50 $25.00 $9.03 $40.97
5 8.5 QD 9.5 $1.00 $1.00 $0.00 $0.32 $9.18
6 6.8 DD 9.5 $2.70 $1.20 $1.50 $0.61 $8.89
7 6.8 QD 9.5 $2.70 $1.50 $1.20 $0.66 $8.84
8 8.5 DD 9.5 $1.00 $16.50 ($15.50) $2.96 $6.55
9 8.5 QD 5 ($3.50) $0.00 ($3.50) ($0.53) $5.53
10 6.8 QD 5 ($1.80) $0.00 ($1.80) ($0.27) $5.27
11 6.8 DD 5 ($1.80) $1.20 ($3.00) ($0.07) $5.07
12 8.5 DD 5 ($3.50) $16.50 ($20.00) $2.28 $2.72

From this sorted chart, it’s clear that the final sales price has the greatest impact on your after-tax proceeds. In all scenarios, with all else being equal, a higher sales price will most often lead to a higher after-tax value.

But note that in scenarios where the final sales price is the same, it is not always the case that qualifying disposition (and its presumably better tax rates) is better than a disqualifying disposition (with its tax rates that may appear less attractive at first).

We can see this illustrated when comparing case 2 and case 3, both of which have the same purchase price and final sales price. In this example, case 2 (a disqualifying disposition) produces a higher after-tax outcome than case 3 (a qualifying disposition).

Moving further down the chart, we can see the same when comparing case 6 and case 7.

And when looking at a net loss scenario, in cases 9-12, we can see that a qualifying disposition appears to be preferred as compared to a disqualifying disposition.

What Does This Mean for You (and Your ESPP)?

A good ESPP can provide you with a way to purchase company stock at an attractive price. But using an ESPP wisely is not as easy as simply participating in it.

You need to understand the ESPP tax rules and how they can impact how much money you end up keeping in your pocket if and when you sell the shares in your plan. Don’t simply assume one strategy for selling will always produce the best result for you.

Just because a qualifying disposition may appear to offer a lower tax rate, we’ve seen from our examples that this isn’t always the case.  Things get complicated depending on the final sale price of your shares.

Each case is different, and you should do your own due diligence on each ESPP purchase that you have – then use that information to determine what the best strategy for each may be.

If you aren’t able to make that determination yourself, the use of a good CFP® professional and/or accountant may be the right way to go.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

7 Things to Know About Your Employee Stock Purchase Plan

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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 periods 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.

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 on 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 on 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 this 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 at sale that is less than the discount, 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 in 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 make may 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.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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