Sensible Perspectives

Take full advantage of your Employee Stock Purchase Plan (ESPP)!

Posted by on October 29, 2018

In this installment of my series on employee benefits, I will cover employee stock purchase plans (ESPPs), which offer the ability to purchase employer stock through payroll deductions. Only about 30% of eligible participants take advantage of these plans, and on average, those who don’t participate miss out on over $3,000 per year[1]. You might be asking “Why should I consider this type of plan?” since Sensible Financial doesn’t recommend holding individual stock, especially employer stock. The answer – you can receive a risk-free 17.6% or more rate of return on your contributions so long as you sell the shares immediately upon receipt. Keep reading to find out how these plans work and why we think you should maximize your contributions to the ESPP, cash flow allowing.

What is an Employee Stock Purchase Plan (ESPP)?

ESPPs are generally offered by publicly traded companies and allow employees the option to purchase company stock through after-tax payroll deductions. ESPPs can come in many varieties, but I’m going to focus on the most common type of plan that offers a discount and a “lookback period” (more on these in a minute). ESPPs have an offering period (generally 6 months in length), stretching between the start and end date between which payroll contributions accumulate. Before the offering period begins, you authorize payroll deductions as a percentage of your salary. At the end of the offering period, your accumulated contributions purchase company stock. The two most valuable features of an ESPP are that your company may offer shares at up to a 15% discount and can also offer what’s called a “lookback period”. A plan that offers a lookback compares the stock price at the beginning and end of the offering period and any discount is based on the lower of the two prices. ESPPs generally have a maximum annual purchase limit of $25,000. The ESPP contribution limit is determined by the pre-discount price. If you assume no movement in the stock price between the beginning and ending of the offering period, and you receive a 15% discount, you can contribute only $21,250 (85% of $25,000) to the plan in a calendar year period.

Let’s look at a few examples:

Benefits

With a plan that offers a discount and lookback period, the biggest benefits you receive are a 15% discount on your shares plus the upside of any price increase during the offering period. Many plans also allow you the option to back out of the plan prior to the end of the offering period. If you had this option and an emergency arose, your accumulated contributions would be returned to you.  After your employer retirement plan match, ESPP discounts are the second-best option for no-risk savings. It even makes sense to borrow to fully participate in your ESPP if the interest rate is lower than your expected return.

Risks

You might be wondering, what’s the risk here? We recommend selling immediately at the end of the offering period when your profit is risk-free. That said, many people hold onto their shares beyond the end of the offering period. Some plans impose limits on when you can sell your shares. Holding the shares beyond the end of the offering period poses the risk that the shares lose value. You are not compensated for taking this risk.

Tax treatment

With ESPPs, you pay no tax until you sell your shares. This is an important distinction relative to most other equity compensation plans. Nor will you have to deal with alternative minimum tax (AMT).

The tax treatment on the sale of ESPP shares depends on whether you satisfy a special holding period, defined as the later of:

Your employer will provide you (and the IRS) a form 3922 which will detail all the important dates and prices needed to calculate the tax. This will help you (or your accountant) properly calculate any tax liability you owe.

Disqualifying Disposition

If you sell the shares before meeting the special holding period (outlined above), you are deemed to have made a disqualifying disposition. The tax treatment of your sale under this circumstance is easy to calculate. Any discount you receive on the shares is treated as compensation income. Your basis is the purchase price of the shares plus any compensation income. If you sell the shares after the end of the holding period, the updated basis is subtracted from your sale price to determine your capital gain.

Let’s look at a few examples of a disqualifying disposition:

Qualifying Disposition

If you plan to sell your ESPP shares at the end of the offering period (recommended), you can skip the remainder of this tax section.

With a qualifying disposition, you held your shares for at least two years from the beginning of the offering period and at least one year from when you received the shares. At the time of sale, there is still a portion that is taxed as compensation income and a portion taxed as capital gain. Compensation income is calculated differently with a qualifying disposition than with a disqualifying disposition. In this case, the compensation income is the lower of:

Let’s look at few examples of a qualifying disposition:

Conclusion

It pays to understand and take advantage of every valuable benefit your employer offers. ESPPs offer a very low to no-risk opportunity with significant upside. Selling the shares when you receive them limits your risk while you receive the discount your employer offers and any offering period stock price appreciation. With the plans described in the article, the minimum profit is 17.6% if you sell immediately upon receiving the shares. This benefit translates to at least an additional $3,740[2] each year if you maximize your contributions.

The details of your ESPP may differ from the examples discussed in this article. You may also have questions about where to prioritize your savings dollars. If you have any questions about how your ESPP works or whether and how much to participate, please contact your advisor for guidance.


[1] Babenko, Ilona and Sen, Rik, Money Left on the Table: An Analysis of Participation in Employee Stock Purchase Plans (March 14, 2014). Review of Financial Studies, Vol. 27, pp. 3658-3698, 2014. Available at SSRN: https://ssrn.com/abstract=2166012

[2] $21,250 contribution limit (based on a 15% discount on $25,000) multiplied by a minimum of 17.6% profit.