US Companies offer all sorts of benefits and incentives to motivate and retain employees. You may be most familiar with 401(k) and 403(b) plans.
There are also:
- Incentive stock options
- Restricted stock programs
- Long term incentive plans (LTIPs)
- Deferred compensation programs in many variations.
Some of these programs are “qualified”. Meaning they that there may be associated tax benefits if the program meets the criteria of Section 401(a) of the Internal Revenue Code (“IRC”) including stipulations relating to plan documentation, coverage, eligibility, vesting and non-discrimination rules.
The IRC also provides special rules for specific programs like the aforementioned 401(k) or 403(b) cash balance pension programs that we are so familiar with (the names of these programs actually refer to the IRC section for which they are named).
What is an Employee Stock Purchase Plan (ESPP)?
An ESPP is a broad-brush benefit offered by many public companies to their employees. ESPPs are outlined in Section 423 of the IRC. Employees who are eligible to participate in the program are given an opportunity to invest beneficially in their company’s stock during a set period. During that period they can have a set amount of post-tax dollars deducted each pay cycle from their paychecks.
The accumulating proceeds of this deduction are put in a trust. At a defined date, the trust proceeds are used to purchase company stock at the fair market value (“FMV”) as defined in the program.
What is a Qualifying Disposition?
If the program is “qualified”, and the employee has held the stock for the statutorily mandated period, and they have been an employee of the company up to 90 days before the sale of the ESPP stock, then the gain on the sale of the stock is called a “Qualifying Disposition” and it is treated in a special way as follows:
- The discount is treated as ordinary compensation.
- Any gain over and above the discount is treated as a capital gain.
For example, let’s say you invest in your company’s stock via an ESPP. The FMV of the stock is $100 when you bought it and the ESPP offers you a 15% discount on the purchase date. The share price to you then is $85. If in this example, you had $850 in paycheck deductions then you were able to purchase 10 shares of company stock at the purchase date.
If you hold these shares long enough for a qualifying disposition and the share price on the date of sale is $125, then your gain is $400 ($1,250 less the $850 purchase price). The first $150 of the gain (the 15% discount) is treated as additional compensation for tax purposes and the next $250 is treated as a capital gain which for most taxpayers would be 15% in 2018.
In order for a tax effective Qualifying Disposition to take place:
- At least two years pass after the option to purchase stock through an ESPP has been granted, and
- One year has elapsed since the employee actually purchased the stock through the program.
If the employee sells the stock before the mandated holding period ends, then all of the gain is treated as ordinary compensation and taxed like any other regular earnings you have.
This is referred to as a “Disqualifying Disposition”.
Are there differences in ESPPs?
There is some flexibility in the design of ESPPs. Some important common variables include:
- What percentage of a discount the company offers (15% is the maximum allowed and the most common discount),
- Period of time within which employees can purchase the stock via an ESPP.
- How is the FMV (purchase price per share of stock) determined? There is a lot of flexibility here such as it could be the lesser of the FMV of the stock on the first day of the plan purchase period or the last day of the defined purchase period. It could be the average of the stock price during that period. Or it could just be the FMV on the last day of the purchase period.
- How long an employee has to have been employed by the company to be eligible (0 – 2 years)
- How part time, temporary and highly compensated employees are treated under the plan.
3 ESPP fast facts:
- No employees are allowed to purchase more than $25,000 of company stock via an ESPP.
- For companies with global operations, you may be able to include your international employees in the program as well.
- There are other relevant rules around ESPPs, but the point of the program is to offer employees a really great benefit that encourages employee stock ownership. It also ties a potential, tax advantaged reward to the success of the company.