How Does an Employee Stock Purchase Plan Work?

An Employee Stock Purchase Plan (ESPP) is a company-sponsored benefit that allows employees to acquire company stock. Participants can typically buy shares at a reduced price compared to the market value. ESPPs offer a structured way for employees to invest in their employer, potentially building wealth through regular, automated contributions.

What is an Employee Stock Purchase Plan?

An Employee Stock Purchase Plan (ESPP) is a benefit program where a company offers its employees the opportunity to purchase company stock. This is generally done at a discount from the prevailing market price, often ranging from 5% to 15%.

Employees typically contribute to an ESPP through regular payroll deductions, which accumulate over an “offering period.” This period can last several months, often between three and twenty-four months. At the end of this period, the accumulated funds are used to purchase company stock on behalf of the employee.

ESPPs are categorized for tax purposes as “qualified” or “non-qualified.” Qualified plans adhere to Internal Revenue Code Section 423 and must meet specific IRS guidelines, including shareholder approval and equal rights for all participants. Non-qualified plans offer greater flexibility in design but do not receive the same favorable tax treatment.

How to Participate and Purchase Shares

Participation in an ESPP requires meeting employer-set eligibility criteria. Plans are generally open to most employees, though restrictions may apply, such as not allowing individuals owning over 5% of company stock or requiring a minimum length of service.

Eligible employees enroll during a designated period, often once or twice a year. They elect how much to contribute from each paycheck, usually as a percentage of salary or a flat amount. Contributions are made through after-tax payroll deductions.

The Internal Revenue Service (IRS) limits stock purchases through a qualified ESPP to $25,000 per calendar year, based on the stock’s fair market value without the discount. Companies may set lower limits, often restricting contributions to a percentage of gross salary, commonly 1% to 15%.

Funds accumulate throughout the “offering period,” the duration of payroll deductions. Within this period, “purchase periods” are shorter windows, often six months long, at the end of which shares are purchased. The “purchase date” is when accumulated funds buy company stock.

Many ESPPs include a “look-back provision.” This allows the discount to apply to either the stock price at the beginning of the offering period (offering date) or the stock price on the purchase date, whichever is lower. For example, if the stock price was $50 on the offering date and $60 on the purchase date, a 15% discount with a look-back provision would apply to the $50 price, allowing purchase at $42.50. This feature enhances potential gains if the stock price increases.

Understanding ESPP Taxation

Taxation of Employee Stock Purchase Plans depends on whether the plan is “qualified” or “non-qualified.” This classification determines when and how income from the plan is taxed.

For qualified ESPPs, there is no taxable event when shares are purchased. Taxes are generally deferred until the shares are sold. Tax treatment upon sale depends on a “qualifying disposition” or a “disqualifying disposition.”

A “qualifying disposition” occurs if shares are held for at least two years from the offering date and one year from the purchase date. The discount received at purchase is typically taxed as ordinary income, up to the actual gain or discount percentage, whichever is less. Any additional gain above the discounted purchase price is taxed as a long-term capital gain.

A “disqualifying disposition” happens if shares are sold before meeting either holding period requirement. The difference between the discounted purchase price and the fair market value on the purchase date is taxed as ordinary income. Any gain or loss from the fair market value on the purchase date to the sale price is treated as a capital gain or loss, short-term or long-term depending on the holding period from the purchase date. This ordinary income component is typically reported on an employee’s W-2 form for the year of sale.

For non-qualified ESPPs, the discount received on shares is typically taxed as ordinary income at the time of purchase. This amount is considered compensation and often included in the employee’s W-2 wages for the year acquired. Any subsequent gain or loss when shares are sold is treated as a capital gain or loss, depending on the holding period from the purchase date.

Managing Your ESPP Shares

After shares are purchased through an ESPP, they are typically held in a designated brokerage account managed by the plan administrator. Employees control these shares and decide whether to hold or sell them, considering personal financial goals and tax implications.

Holding shares for at least two years from the offering date and one year from the purchase date allows for potential long-term capital gains tax rates on a portion of the gain. Selling before these periods results in a disqualifying disposition, where a larger portion of the gain may be taxed as ordinary income.

When selling ESPP shares, employees initiate a sale order through the brokerage account. Proceeds from the sale, minus fees, are disbursed to the employee. Companies generally do not withhold taxes on sales in qualified ESPPs.

Some ESPPs allow employees to withdraw accumulated payroll contributions before shares are purchased. Withdrawing funds means forfeiting the opportunity to purchase shares at the discounted price during that offering period. This option provides financial flexibility but means missing out on potential benefits.