What Is a Stock Purchase Plan and How Does It Work?

An Employee Stock Purchase Plan (ESPP) provides a structured way for individuals to acquire company stock. These plans are typically offered by employers, allowing their employees to buy shares of the company.

Understanding Stock Purchase Plans

An Employee Stock Purchase Plan (ESPP) is a company-sponsored program that enables employees to purchase shares of their employer’s stock, often at a discounted price. This type of plan aims to foster a sense of ownership among employees, aligning their financial interests with the company’s performance. Companies offer ESPPs to encourage employee loyalty and engagement.

Employees contribute to the plan through regular payroll deductions, accumulating funds over a specified period. These accumulated funds are then used to buy company stock on predetermined dates. ESPPs differ from other forms of equity compensation, such as stock options or restricted stock units, because they involve the employee actively purchasing the stock rather than receiving grants.

Key Components of a Stock Purchase Plan

Participation in an ESPP typically begins with meeting specific eligibility criteria established by the employer. Many plans require employees to be full-time and may have a minimum service requirement. Some plans also exclude employees who own more than 5% of the company’s stock.

Once enrolled, employees contribute to the plan through payroll deductions over a defined “offering period,” which can range from three to twenty-four months, though qualified plans have a maximum of twenty-seven months. Within this offering period, there are often “purchase periods,” which are shorter intervals where contributions accumulate. At the end of each purchase period, on a designated “purchase date,” the accumulated funds are used to buy company stock on the employee’s behalf.

A common feature of many ESPPs is a discount on the stock’s market price, often between 5% and 15%. The 15% discount is frequently observed in such plans. Many plans also include a “look-back provision,” which compares the stock price at the beginning of the offering period to the price on the purchase date, using the lower of the two for the discount calculation.

There are limits on how much an employee can contribute to an ESPP, typically expressed as a percentage of their salary, often ranging from 1% to 15% or 10% to 20%. Federal tax rules limit the amount of stock an employee can purchase through a qualified ESPP to $25,000 per calendar year, based on the stock’s fair market value at the beginning of the offering period. After the shares are purchased, employees can usually sell them, though holding periods may apply for more favorable tax treatment, which varies based on the plan and disposition.

Tax Treatment of Stock Purchase Plans

The tax implications of an ESPP depend on whether the plan is classified as “qualified” or “non-qualified” under Internal Revenue Code Section 423. Qualified plans adhere to specific IRS guidelines and generally offer more favorable tax treatment. Non-qualified plans provide companies with more flexibility in design but do not receive the same tax advantages.

For qualified ESPPs, the discount received on the stock is generally taxed as ordinary income, but this taxation typically occurs when the shares are sold, not at the time of purchase. If the shares are sold before meeting specific holding periods—generally at least two years from the offering date and one year from the purchase date—it results in a “disqualifying disposition.” In such cases, the difference between the stock’s market price on the purchase date and the discounted purchase price is taxed as ordinary income.

If the shares are held for the required periods, resulting in a “qualifying disposition,” the amount of the discount taxed as ordinary income may be less. Any appreciation in the stock’s value beyond the initial discount is treated as a capital gain or loss when the shares are sold. This capital gain can be short-term if the shares were held for one year or less after purchase, or long-term if held for more than one year, with long-term capital gains often subject to lower tax rates than ordinary income.

Employers typically report the ordinary income portion of ESPP transactions on an employee’s Form W-2. Capital gains or losses from the sale of ESPP shares are generally reported on Form 1099-B by the brokerage firm.