Everyone wants double-digit investment returns but few people can stomach the risk required to achieve them.
If your employer offers an Employee Stock Purchase Plan (ESPP), you have the opportunity to generate double-digit returns without the market risk.
After reading this post, you'll be counting the days until your next ESPP enrollment period.
What is an Employee Stock Purchase Plan?
An ESPP allows you to buy shares of company stock at a discount from the market price. In other words, you get to buy stock with a built-in gain.
It's the definition of a "free lunch," so why do most companies report that less than half of their employees participate?
My guess? Because ESPPs are complicated, you can't figure out how they're taxed, and most of all, you're nervous about losing money.
Those are all valid reasons. The rest of this post will help ease your concerns so you can start taking advantage of the free money your ESPP offers.
ESPP Basics
You must enroll in the ESPP and choose a % of your salary or a flat dollar amount to be withheld from each paycheck.
You'll do this during the open enrollment period, which typically ends soon before the offering date.
The offering (or grant) date marks the start of the offering period, and the purchase date marks the end.
The offering period length is unique to your company's plan, but 6 months is common. Throughout the offering period, your company will set aside your paycheck deferrals.
On the purchase date, your company uses the cash contributed during the offering period to buy company stock at a discount.
We'll jump into some examples in a minute, but there are a few important details you need to know first.
The ESPP Discount
The discount applied to shares at purchase depends on the terms of your company's ESPP. Discounts can range from 1% up to 15%. A maximum discount of 15% is common to encourage employee participation.
Some plans include a lookback provision that can make your ESPP even more profitable.
Without a lookback provision, your discount is applied to the stock's price on the purchase date.
With a lookback provision, your company compares the stock's price on the offering and purchase dates, then applies your discount to the LOWEST price.
Qualified ESPP Plans
Most ESPPs are considered qualified, so there isn't a taxable event until the shares are sold.
To qualify for tax-advantaged status, plans must meet certain rules.
One of the most relevant rules is that each employee is limited to buying $25,000 worth of company shares (based on the offering date price) in the ESPP per calendar year.
How are ESPPs Taxed?
Once sold, you'll report a mix of ordinary income and capital gain (loss).
The amount you report for each depends on whether the sale is a qualifying disposition (QD) or disqualifying disposition (DQD).
I'll be honest, this part is tough to read, but it will make much more sense in the examples below.
ESPP Qualifying Disposition
You have a QD if you sell the shares:
More than 1 year after the purchase date AND;
More than 2 years after the offer date
In a qualifying disposition, you pay ordinary income tax on the LESSER of:
• The discount on the offering price
• The gain between the actual price you paid and the sale price
ESPP Disqualifying Disposition
Any other combination of sale circumstances results in a disqualifying disposition.
In a disqualifying disposition, you pay ordinary income tax on the difference between your ACTUAL purchase price and the stock's price on the purchase date.
ESPP Capital Gains
In both a qualifying and disqualifying disposition, your basis in the shares is the actual cost of the shares + the discount reported as income.
If you sell the shares for more (less) than your basis, you'll have a capital gain (loss).
The purchase date is the start of your holding period for determining short or long-term gain (loss) treatment.
Qualifying Dispositions offer a clear tax advantage, but as you'll see in the following examples, they may not always be the most profitable option.
ESPP Examples
You enroll in a qualified ESPP and defer $1,000/paycheck over the 6-month offering period.
On the purchase date, your company uses the $12,000 you deferred to buy company stock at a 15% discount from the lower of the offering or purchase date price (lookback provision).
The stock's price was $15 on the offering date and $25 on the purchase date.
The 15% discount is applied to the $15 grant price, so your actual purchase price is $12.75. Your $12,000 of ESPP deferrals buy 941 shares worth $23,525 with a built-in gain of $11,525.
Now, let's look at 4 potential scenarios:
1. Sell immediately (disqualifying disposition)
2. Sell <1 year from purchase (disqualifying disposition)
3. Sell >1 year from purchase, BUT <2 years from grant (disqualifying disposition)
4. Sell >1 year from purchase AND >2 years from grant (qualifying disposition)
Let's say the stock stays flat and you sell at $25 in every scenario.
The three disqualifying dispositions have no gain because the sale value is equal to the basis.
The qualifying disposition has a higher after-tax value because more of the discount was taxed as a long-term capital gain (at a lower tax rate) instead of being taxed as ordinary income (at a higher tax rate).
What if you hold the shares and the price appreciates to $30 before you sell?
The price appreciation gives you more money across the board, and the qualifying disposition scenario is still the most lucrative.
What if you hold the shares, and the price falls to $20 before you sell?
Now, selling immediately would have been the best option, even with the qualifying disposition tax advantages.
Most people feel like they need to hold shares to meet the qualifying disposition criteria, but that may not always be the best strategy.
As shown, the qualifying disposition tax benefit is less material than the stock’s performance during your holding period.
Employee Stock Purchase Plan Strategy
For the best outcome, filter your ESPP hold/sell decisions with your personal goals and circumstances, including your cash flow flexibility and other employer equity holdings.
Selling shares immediately (if you aren't subject to trading restrictions) is a popular approach when employees have other company equity like stock options and/or RSUs.
Many participants use the built-in gain to give themselves an extra bonus or two throughout the year to replenish cash reserves, spend on lifestyle goals, or allocate to a diversified portfolio.
On the other hand, some employees incorporate the company stock into their long-term investment strategy or view it as the "fun" part of their portfolio.
In either case, you'll need to evaluate the decision in the context of your total financial situation.
Conclusion
Many employees fail to take advantage of the double digit return their Employee Stock Purchase Plan (ESPP) offers.
Don't let the complexity and logistics of ESPPs prevent you from acting on this lucrative opportunity.
If you need help taking advantage of your ESPP, Unrivaled Wealth Management is here to help.
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