Employee stock purchase plan (ESPP): meaning & examples

What is an employee stock purchase plan?

An Employee Stock Purchase Plan (ESPP) is a program that can allow employees to purchase shares of their employer company's stock at a discounted price. 

Qualified vs. non-qualified ESPPs

ESPPs can be categorized into two main types, qualified ESPPs and non-qualified ESPPs. The company decides whether it will offer a qualified or non-qualified ESPP. 

Employees generally don’t have the option to choose between the two.

Let’s get granular and go over each type of ESPP.

Qualified

Qualified ESPPs are the most common type of ESPP in the U.S. These plans may offer tax advantages but come with rules and limitations that are more strict than non-qualified ESPPs. 

Non-qualified ESPPs

Non-qualified ESPPs offer more flexibility in plan design but potentially fewer tax advantages. Non-qualified plans are typically used by companies with a significant number of non-U.S. employees or when the company wants more flexibility in the plan's structure.

Who is eligible for an ESPP, and what are the benefits to employees?

That depends on the type of plan and the specific rules set by the employer. Some possible rules include employment duration or status, compensation level (e.g., must earn less than X dollar amount), and the global location of the employee.

ESPPs can offer employees benefits such as discounted stock purchases (including the lookback provision, which we’ll cover in more detail later), the possibility of growing an investment, and tax advantages.

It's important to note that while ESPPs offer many benefits, they also come with risks for employees, such as potential stock price decline and over-concentration in the company stock. 

Why provide an ESPP to employees?

Companies provide ESPPs to their employees for several reasons: 

• Companies with attractive stocks and ESPPs can gain a competitive advantage for potential hires.
• Employees may be more likely to stay with the company to maximize the financial benefits of their stock purchases, especially if the stock price is appreciating. This in turn increases employee retention rates.
• ESPPs can foster a culture of ownership within the company. Why? Employees who are shareholders may feel a stronger sense of responsibility and commitment to the company's goals and performance.

ESPP vs. ESOP

ESPPs and Employee Stock Ownership Plans (ESOP) each have a different structure and purpose.

With an ESPP, employees can purchase company stock at a discounted price, typically through payroll deductions. 

Employees can participate in ESPPs or opt out. 

In contrast, an ESOP is a qualified retirement plan that grants employees ownership interest in the company at no direct cost to them. The company contributes shares or cash to purchase shares on behalf of employees, who receive allocations based on a formula related to compensation or years of service. 

ESOPs are designed as a retirement benefit and for business succession planning, with shares typically held until retirement or separation from the company.

ESPPs and taxes

What are some ESPP tax benefits?

When employees purchase stock through an ESPP, they generally don’t pay taxes at the time of purchase. 

If the employee holds the stock for at least 12 months from the date the stock was purchased and two years from the date the stock was offered, the sale generally is considered a qualifying disposition. In the case of a qualifying disposition, the discount usually is taxed at ordinary income tax rates. Any gain above that typically is taxed as a long-term capital gain. Generally, a long-term capital gain has a lower tax rate than ordinary income.

Here’s another potential tax benefit. 

Many ESPPs include a "lookback" provision in which the purchase price is the lower stock price, either at the beginning or end of the offering period. This can result in a larger discount and greater potential for capital gains.

Is an ESPP pre-tax or post-tax?

Employees typically pay for ESPPs with after-tax payroll deductions, meaning the payment is removed from their paycheck after taxes.

How am I taxed in my ESPP? Is an ESPP income or capital gains?

Among other things, it may depend on whether the sale of the shares is considered a qualifying or disqualifying disposition. 

Qualifying dispositions generally offer more favorable tax treatment, with part of the gain taxed as long-term capital gains. 

Disqualifying dispositions generally result in the discount being taxed as ordinary income, which may be at a higher rate. 

Will the company withhold taxes upon sale of stock purchased under the employee stock purchase plan?

Generally, companies do not withhold taxes. Employees are responsible for reporting and paying their own ESPP taxes. 

That’s why understanding the tax implications and consulting with a tax professional can help employees manage their tax liabilities and avoid unexpected tax bills. 

How an employee stock purchase plan works

Important features of an ESPP

ESPPs have several important features that may make them attractive to both employers and employees. 

Here are key features to consider.

Discount rate

One of the primary benefits of an ESPP is the ability to purchase company shares at a discount, which generally ranges from 5% to 15% off the stock's fair market value. This discount allows employees to buy shares lower than the market rate.

Lookback provision

The lookback provision allows employees to purchase stock at a lower price, either the price from the offering date or the purchase date. This provision generally acts as a hedge against market volatility, ensuring that employees can benefit from a lower purchase price if the stock price has increased since the offering date. 

Offering periods

The offering period is the timeframe during which employees can make contributions through payroll deductions. Within this offering period, there can be one or multiple purchase periods. 

Purchase periods per year

ESPPs typically have defined purchase periods within an offering period. 

For example, a 12-month offering period might have two six-month purchase periods. At the end of each purchase period, the accumulated contributions are used to buy shares. This setup can help employees manage their contributions and stock purchases effectively.

Eligibility and limits

Eligibility and limits for ESPPs can vary, but there are common rules and regulations that usually apply, particularly for qualified ESPPs. 

Let’s go over them. 

Eligibility criteria

Ownership restrictions: Employees who own more than 5% of the company's stock are generally not eligible to participate in qualified ESPPs.

Employment duration: Some plans require employees to have been with the company for a certain period, such as one or two years, before they are eligible to participate.

Employment status: Part-time, seasonal, or temporary employees may be excluded from participation, especially if they work less than 20 hours per week or less than five months per year.

Highly compensated employees: Some plans may exclude highly compensated employees, as defined by IRS regulations.

Contribution limits

IRS limit: For qualified ESPPs, the IRS limits the purchase to $25,000 worth of stock per calendar year based on the stock's FMV at the start of the offering period.

Plan-specific limits: Companies may impose additional restrictions, such as capping contributions at a certain percentage of an employee's salary or setting a maximum number of shares that can be purchased.

Employee stock purchase plan example

An example of an employee in the U.S.

Let's consider a hypothetical example of how an ESPP might work for an employee in the U.S.:

Rodrigo is an employee at a tech company that offers a qualified ESPP with a 15% discount and a lookback provision. Rodrigo earns an annual salary of $100,000 and decides to allocate 5% of his salary to the ESPP.

The company has a 12-month offering period with two 6-month purchase periods. The stock price at the beginning of the offering period is $50, and at the end of the first purchase period, it is $60.

Rodrigo contributes $5,000 annually, which is $2,500 per purchase period. This is deducted from his paycheck and set aside for purchasing stock.

With the lookback provision, the purchase price is calculated as 85% of the lower of the stock price at the beginning of the offering period ($50) or the end of the purchase period ($60). Thus, the purchase price is 85% of $50, which is $42.50.

At the end of the first purchase period, Rodrigo's $2,500 contribution is used to purchase approximately 58.82 shares ($2,500 / $42.50 per share).

If Rodrigo sells the shares immediately at the market price of $60, he realizes a gain of $17.50 per share, resulting in a total gain of approximately $1,029.41 (117.65 shares x $17.50 gain per share), before taxes.

Employee stock purchase plan FAQs

How much can I contribute to my ESPP?

The amount you can contribute to an ESPP is limited by the IRS to a maximum of $25,000 worth of stock per calendar year, based on the stock's fair market value at the start of the offering period. 

Companies may impose additional restrictions, such as capping contributions to a percentage of your salary or setting a flat dollar amount. It's important to check your specific plan's rules, as they may vary.

How often can I change my payroll deductions?

The ability to change payroll deductions for an ESPP depends on the specific rules set by your employer. Typically, changes can be made during designated enrollment or election periods, which often happen at the beginning of each offering period. 

These periods may be every six months or annually, depending on the plan. It's important to check the specific guidelines of your company's ESPP to understand when and how you can adjust your contribution amounts.

Can I cash out my employee stock purchase plan?

Yes, if you have not yet used your payroll deductions to purchase stock, you generally can withdraw the accumulated funds by notifying your plan administrator and completing any required paperwork. If you have already purchased stock, you can sell your shares at any time, as ESPP stock is considered a liquid investment. 

When may I sell my stock in an ESPP?

You typically can sell your ESPP shares anytime after purchasing them, depending on your company's policy and your position within the company. However, the timing of the sale can have tax implications and you should consult a tax professional. If you sell the shares immediately after purchase, it may be considered a disqualifying disposition, and the discount may be taxed as ordinary income. 

Can I sell ESPP stock right away?

Yes, you generally can sell ESPP stock immediately after purchasing it if you want to lock in the profit from the discount. Selling right away allows you to capture any immediate gain due to the discounted purchase price compared to the current market value. 

However, doing so may result in a disqualifying disposition, meaning the discount is taxed as ordinary income. If you hold the stock for more than one year from the date of purchase and two years from the offering date, the sale generally qualifies for preferential tax treatment on any additional gains. Make sure to check with a tax professional. 

What happens to my ESPP when I quit?

Any shares you have already purchased through the ESPP are yours to keep, even after you quit. But, you cannot buy additional shares at a discount once you leave the company. If you quit midway through the purchase period, many companies will refund your contributions that have not yet been used to buy shares.

Is it possible to lose money on an ESPP?

Yes. ESPPs offer the advantage of purchasing company stock at a discount. However, the stock price can still decline after purchase, potentially resulting in a loss.

Does ESPP show up on W-2?

If an employee sells the ESPP shares soon after purchasing them, the discount received on the stock price generally is considered extra income and will show up on the W-2 form. The employee typically will pay regular income tax on that discount amount.

What happens if you need your money back before the ESPP purchase date?

Most plans allow you to withdraw your accumulated contributions at any time before the purchase date. To withdraw contributions, employees need to complete paperwork. Withdrawing contributions will return the exact amount the employee has contributed up to that point.

Conclusion: Experience a better business banking platform with Rho

For employees, ESPPs offer a financial incentive to invest in their employer, potentially benefiting from the company's growth. For employers, these plans can enhance employee retention and motivation, especially during significant company milestones like an IPO. 

By aligning employee interests with company success, ESPPs create a mutually beneficial relationship that supports long-term organizational goals.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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