A qualified (Section 423) Employee Stock Purchase Plan can be a great way for eligible employees of public companies to build their financial assets with minimal risk. For example, the plan may be structured to allow you to make more than a 15% return on your investment in just six months.
Sounds worth considering, right? Yet many employees don't understand these plans and so don't take advantage of them. Below is an explanation of how an Employee Stock Purchase Plan (ESPP) works and why participation can be a wise move.
A "qualified" ESPP is one that meets the criteria in Internal Revenue Code § 423. These plans enable an employee to purchase discounted shares of company stock from their employer through accumulated payroll deductions, as long as the employee meets certain IRS eligibility requirements.
The payroll deductions accumulate during the purchase period, and at the end of that time the funds are used to purchase stock at a discounted price. You can then turn around and sell the stock for an immediate profit or hold on to it and sell later (this involves some risk).
How does this discount work? ESPPs offer shares to purchase at a fixed price. Depending on the plan, participants purchase shares at a discount to the lower of the stock price at the time when the offer period began (known as a lookback feature) or when the period ends. Some plans do not have a lookback feature and simply offer the discount on the ending price.
The majority of ESPPs give participants a 10% to 15% discount on the stock. The maximum the IRS allows is 15%, but some companies offer as low as a 5% discount. For plans with a lookback feature, a rising market can provide a return on investment even greater than 15%.
The plans encourage broad employee ownership of company stock. By participating in the ESPP, you can share in the financial success of your company.
For example, say your company's share price on the offering date is $8, the share price on the purchase date is $6, and your company offers a 15% discount. Your purchase price is $5.10 because of the "lower of" price stipulation or because your plan does not offer a lookback feature. If your payroll deduction over a six-month purchase period totaled $1,000, then the total number of shares purchased is 196. With a current market price of $6, the value of your investment is $1,176. That's a gain of $176 or 17.6% over a six-month period. Thus, whether you have a lookback provision with more potential upside or not, you can still achieve approximately a 17% return. This gain would be subject to W-2 reporting and ordinary income tax rates whether or not you sell or hold the shares.
Now consider the reverse scenario. The share price on the offering date is $8 and the share price on the purchase date is $13. Your purchase price of the stock is $6.80 with the discount applied to the $8 share price from the beginning. Your $1,000 of payroll deductions now buys you 147 shares. With the market price of $13 on the purchase date, the total value of your investment is $1,911. That is a net gain on your investment of $911 or 91% over a six-month period. You can realize your gains by selling your stock, in which case the entire gain is subject to W-2 reporting and ordinary income tax rates. Or you can hold out for further tax benefits but will be subject to the risks in the stock price going up or down.
Additionally, most plans allow you to withdraw from the ESPP within a time period specified in your individual plan. In this case, your contribution is refunded, but you won't capitalize on any interest. (Thus, you have just given your company an interest-free loan, without getting any return...)
ESPPs enjoy special tax treatment.If participants hold the shares for at least one year from the purchase date and two years from the offering date, any sale of the shares will be considered a "qualified disposition" under IRS code. This means that a smaller portion of your total gain, the 15% discount, is reported by your company on your W-2 as ordinary income in the disposition year. Any remaining gains will be considered long-term capital gains and taxed at a lower percentage. In addition, ordinary income incurred from a qualified disposition is exempt from FICA taxes (Social Security and Medicare).
If you have the opportunity, consider taking advantage of a qualified Employee Stock Purchase Plan. It allows you to build your financial assets in the long term while minimizing risks, especially if shares are sold on the same day as they were purchased.
Armanino's CFO Advisory team has 30+ years' experience providing audit, tax and consulting solutions to a wide array of clients concerning ESPP and other equity incentive plans. If you have questions, please reach out to Scott Schwartz, Hung Tran or Laura Verri.
Note: This blog is just for informational purposes. Armanino is not providing any personal financial advice. We encourage you to reach out to your financial advisor for more information. If you do not have one, email us at the contacts above, and we can refer you to someone who may be able to help.
