Employee Stock Purchase Plan (ESPP)

Introduction to Employee Stock Purchase Plans (ESPPs)

Pre-Read: Key Questions This Article Answers

• What is an Employee Stock Purchase Plan (ESPP); how does it work?

• What are the different types of ESPPs, and how do they differ?

• What is a lookback provision in an ESPP?

• Should you participate in your company ESPP; what are the pros/cons?

What Is an Employee Stock Purchase Plan (ESPP)?

An ESPP is a program commonly offered by public companies that allow eligible employees to purchase company stock, often at a discount. ESPPs can provide a way for employees to gain equity in their company, usually with unique benefits (discounts and lookbacks).

There Are Two Types of ESPPs: Qualified and Non-Qualified

ESPP Plans come in two types: Qualified and Non-Qualified. Qualified must meet IRS requirements (IRC Section 423); they have more favorable tax treatment but also more restrictions. Conversely, Non-Qualified ESPP plans have less favorable tax treatment, but more flexibility in how the plan is designed and works. In practice, ~80% of ESPP plans are Qualified, and ~20% are Non-Qualified

Qualified ESPP	Non-Qualified ESPP
More strict criteria (must confirm to IRC Section 423 requirements)	More flexible/no requirement to conform
More favorable taxation	Less favorable taxation
Discount rate (if any) may not exceed 15%	No cap on discount rate
Offering period must be 3-27 months (most are 6, 12, or 24 months)	No offer period limitation (most are still either 6, 12, or 24 months)
May have a lookback provision (or not)	May have a lookback provision (or not)
Max contribution of $25,000 per year	No requirement maximum

How ESPPs Work

Eligible employees enroll in an ESPP during an enrollment period by electing the amount they want to be deducted from their after-tax paycheck. The funds are deducted during an offering period, typically 3-27 months. On the purchase date (at the end of the offering period), the company uses the accumulated funds to purchase shares on behalf of the employee.

A key motivating reason for employees to participate in ESPPs is that the price they purchase shares at may be at a discount to the current value (depending on two criteria):

• Does the ESPP specify a discount purchase price? Many ESPP plans explicitly discount the purchase price by a certain percentage (e.g. 15%)

• Does the ESPP have a "lookback" provision? If yes, shares are purchased at the lower of

  • The stock price at the beginning of the offering period

  • The stock price on the purchase date

• Note: Plans can include both a lookback provision and a discount. If both apply, the lookback is applied first, and the discount is applied second

Key Components

Contribution Limit

For Qualified plans, the IRS limits employee contributions to $25,000 per calendar year based on the stock's fair market value. Companies may place further limits on employee contributions.

Any stock discount essentially reduces the maximum contribution amount allowed to stay within the $25,000 limit

Key ESPP Time Periods

ESPPs have a handful of key dates and time periods:

• The enrollment period is when employees elect to participate and authorize payroll deductions. This is typically 2-4 weeks prior to the enrollment date

• The enrollment/grant date signifies the end of the enrollment period and the start of the offering period

• The offering period is when paycheck deductions (for the eventual purchase of shares) are made. The length of the offering period is pre-specified by the company, with most being 6, 12, or 24 months in length

• The purchase date is the date on which the shares are purchased (and the end of the offering period). If the ESPP plan has a discount and/or lookback provision, they are applied at this time to determine the purchase price.

  • Note: After the purchase date, the employee owns the shares. They can sell them immediately or hold them. If the ESPP is a Qualified plan, selling early triggers a disqualifying disposition, which has less favorable tax treatment than if the individual holds the shares and eventually sells once a qualifying disposition has been achieved

• The qualifying disposition period is after the purchase date and only applies to Qualified plans. If shares are held for at least (i) 2 years after the grant date and (ii) at least 1 year after the purchase date, the sale is considered a qualifying disposition and the gains are taxed more favorably

Stock Discounts & Lookback Provision

The stock discount is one of the main benefits of an ESPP (though it is not required). If it exists, it allows employees to purchase stock below the fair market value as of the purchase date. Discounts typically range from 1-15%.

A lookback provision specifies that the price at which participating employees purchase shares can/will be at the lower of (i) the stock price at the beginning of the offering period or (ii) the stock price at the end of the offering period.

Lookback Provision Diagram (Price Increases)

Lookback Provision Diagram (Price Decreases)

How ESPPs Provide Employees With Value

ESPPs provide employees with a structured program to purchase company stock. Because most employees could just purchase stock on the open market instead of participating in the ESPP -> most ESPP programs have features such as discounted purchase prices, lookback provisions, and/or employee matches to make participating an attractive proposition. These ESPP provisions/perks make it more affordable for employees to accumulate company stock and share in the potential upside.

ESPPs typically have a VERY attractive risk/reward

Most ESPP plans provide employees the opportunity to purchase company shares at a discount, with many also including a lookback provision as well (i.e. an opportunity for additional price discount). This makes many ESPP plans attractive:

• Price discount. If the plan has a price discount, you're buying shares at a price lower than the current market price. One can then immediately sell the shares at full value (a strategy we frequently recommend doing)

• Lookback provision. A lookback provision provides a "free option" where you (1) would financially benefit if shares increased in price during the offering period, but (2) not be exposed to any losses if the stock declined during the period

Given the above dynamics, We frequently (but not always) recommend individuals participate in Qualified ESPPs. Though as with every decisions, it depends on individual circumstances. For more information see: ESPP Planning/Strategy

How to Exercise/Purchase ESPP Shares

During your company’s ESPP enrollment period, employees elect how much they want to contribute from each paycheck toward purchasing company stock. The contributions are deducted from your paycheck on an after-tax basis and accumulate until the purchase date. On the purchase date (sometimes also known as the exercise date) your company uses the contributions to purchase shares of stock on your behalf. The number of shares you receive depends on the current stock price and your contribution amount. Any unused funds are refunded back to you.

Once you receive the shares, you have two options:

1. Sell the shares immediately. This is known as a “quick sale” and allows you to lock in the gain (if applicable) from the discounted purchase price (and if applicable, gain from the lookback provision). The gain will be taxed as ordinary income.

2. Hold the shares to qualify for preferential tax treatment. If your plan is a Qualified plan and you (i) hold the shares for at least 2 years from the grant date and (ii) 1 year from the purchase date, the sale will be a qualifying disposition. In this case, the discount is taxed as ordinary income (but deferred until the year of the sale date) and any gains above the discount are taxed at lower long-term capital gains tax rates.

ESPP Benefits, Drawbacks & Less Common Elements

Key Benefits

Potential discounted purchase price: A common benefit of an ESPP is the ability to purchase company stock at a discount. This discount essentially provides an immediate return on your investment and can be very close to “free money” if you sell the shares immediately after purchasing them.

Lookback provisions provide a “free option”: If your ESPP has a lookback feature, it gives you the chance to buy shares at a lower price at the start of the offering period or the ending purchase date. This lookback acts as a free option and provides additional opportunities for gains if the stock price increases over the offering period, but without any financial penalty if the stock price declines over the offering period.

Tax advantages: If your ESPP plan is a qualified plan and you hold the ESPP shares long enough to achieve a qualifying disposition, you will get favorable tax treatment.

Flags/Drawbacks

Increased exposure to company stock: Participating in an ESPP increases your concentration in company stock. Purchase discounts and lookback provisions can help mitigate this risk, but only if you plan to sell immediately after purchasing.

Complex tax implications: The tax treatment of ESPP shares and dispositions can be complicated to understand. You must keep careful records to properly report discounts, gains, and losses, and qualify for preferential tax rates when applicable. For more information see: ESPP Taxation

Limited liquidity: During the ESPP offering periods and any company-imposed trading blackout dates, your funds are locked up and the shares are illiquid. You do not have access to the contributions or the ability to sell shares during these periods. Make sure you understand your company’s specific ESPP terms regarding offering frequency, duration, and any blackout dates.

Less Common Elements

Read your company’s rules. These can and do differ between companies. The IRS specifies certain maximums for ESPP plans, such as a $25,000 annual contribution limit. However, companies can choose to offer less than the IRS maximums. Make sure you understand the specific details of your company’s ESPP plan.

Automatic enrollment. Some companies automatically enroll employees in the ESPP, while others require employees to actively elect to participate. If automatically enrolled, the company will deduct contributions from your paycheck unless you opt out of the plan. Review your enrollment information to understand if participation is automatic or optional and make changes as needed.

Dividend reinvestment options. Some ESPPs allow dividends paid on company stock to be automatically reinvested to purchase additional shares. The reinvested dividends provide a way to acquire more shares over time without contributing more out of your paycheck. However, also recognize that reinvesting dividends further concentrates your holdings in your employer’s stock.

ESPP Tax Implications

Qualified Plan: Qualifying Disposition

In a qualified plan, if you hold ESPP shares for (i) at least two years after the grant date and (ii) at least one year after the purchase date, the sale qualifies as a “qualifying disposition.” In this case, the taxes you will owe are:

• Ordinary income taxes on the discount percentage (paid in the year you sell)

• Long-term capital gains tax on the gains above that, including the lower price (if any) received due to the lookback provision

Qualified Plan: DQ Disposition

In a qualified plan, a disqualifying disposition occurs if you don't hold ESPP shares for (i) at least two years after the grant date and (ii) at least one year after the purchase date. In this case, the taxes you will owe are:

• Ordinary income taxes on the discount percentage (paid in the year you sell) and the lower price (if any) received due to the lookback provision

• Capital gains tax on the profit above that (if any). Whether these are short-term or long-term capital gains depends on if you sold the shares more than 1 year after the purchase date (long-term) or less than 1 year after the purchase date (short-term)

Non-Qualified Plan

In a non-qualified ESPP, there are no incremental tax benefits (and thus no qualifying or disqualifying dispositions).

The discount upon purchase, including the lower price (if any) received due to the lookback provision is taxed as ordinary income on the purchase date.

Thereafter, you own the stock and if it increases/decreases in value, you will have a capital gain/loss. Whether that is a short-term or long-term capital gain/loss depends on if you hold the stock for more than 1 year after the purchase date.

ESPP taxation can be taxed in multiple different ways depending on the circumstances. For more information see: ESPP Taxation

Related Pages

🔗 ESPP Taxation

🔗 ESPP Planning/Strategy