Employee stock purchase plans are a benefit available for employees of public companies. I see people missing out on this potential opportunity, so I wanted to explain how this works more in depth.
Before we start, I want to give a heads up that I will be referring to the employee stock purchase plan as an “ESPP” for the remainder of the article.
An ESPP is a program that allows employees to buy company stock at a discount and is frequently offered by publicly traded companies. When you enroll in the ESPP, you then have money deducted from your paycheck on an after-tax basis and it goes into a “pool” where it's then used to buy stock at the end of the period. Typically, there are two purchase periods each year but some company ESPP’s provide either quarterly or annual purchases. On top of this, you're usually allowed to buy up to a limit of around $25,000 of company stock in any given year.
The ESPP discount is typically 10 - 15% from fair market value. For example, if you get a 15% discount, this means you can purchase company stock at $85/share when the market price is $100/share.
Another feature of the ESPP is that they often provide a lookback provision. The lookback provision allows you to purchase the stock at the lower of either the price at the beginning of the period or the price at the purchase date (end of the purchase period).
The taxation of the ESPP depends on when you choose to sell the shares. There are two different tax scenarios: a “qualifying disposition” and a "disqualifying disposition” which determine whether you pay favorable long-term capital gains tax rates or short-term capital gains tax rates. Short-term capital gains tax rates are just taxed as ordinary income.
Here are the differences:
A qualifying disposition:
- When the shares are held for at least 1 year from the purchase date and 2 years from the start of the offering period. If both of those are met, then you receive long-term capital gains tax rates instead of ordinary income tax rates on the gain.
- The discount you receive is still taxed as ordinary income independent of how long you hold the shares for.
A disqualifying disposition:
- When the shares do not meet the 1-year holding period from the purchase date and 2-year time frame from the start of the offering period.
- If you sell before BOTH of those dates are met, your entire gain AND discount will be taxed as ordinary income.
With that being said, it isn’t always best to hold until you meet the requirements for a qualifying disposition. For example, if the stock continues to go down, you are better off (from a return standpoint) selling immediately after the purchase date. Holding until you receive a qualifying disposition runs the risk of the stock price continuing to go down.
But, if the stock continues to rise, you are better off (from a return standpoint) holding until you meet the requirements for a qualifying disposition.
The right decision for each person differs. You need to consider personal cash flow needs, your tax situation, and company outlook.
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