What Is a Stock Purchase Plan and How Does It Work?
Demystify Stock Purchase Plans. Learn how this valuable employee benefit works, its financial and tax aspects, and how to participate.
A Stock Purchase Plan (SPP) is an employer-sponsored program that enables eligible employees to buy company stock. These plans are provided as a benefit, allowing employees to acquire ownership in the company they work for. Employees typically contribute funds through regular payroll deductions, which are then used to purchase shares. This arrangement often facilitates stock acquisition below the prevailing market value.
Types of Stock Purchase Plans
Stock purchase plans generally fall into two main categories: Qualified Employee Stock Purchase Plans (ESPPs) and Non-Qualified Stock Purchase Plans. The distinction primarily lies in their adherence to Internal Revenue Service (IRS) regulations, particularly Section 423 of the Internal Revenue Code, which dictates their tax treatment. Qualified ESPPs comply with these rules, offering potential tax advantages.
Qualified ESPPs, governed by IRS Section 423, must meet several criteria for favorable tax status. These plans are typically non-discriminatory, meaning they must be offered to all eligible employees. The purchase price for shares cannot be less than 85% of the stock’s fair market value at either the beginning of the offering period or the purchase date. An employee’s right to purchase stock cannot accrue at a rate exceeding $25,000 in fair market value per calendar year.
In contrast, Non-Qualified Stock Purchase Plans do not adhere to the strict requirements of IRS Section 423. This offers companies greater flexibility in designing their plans, including who can participate and the terms of the stock purchase. However, this flexibility means they lack the specific tax advantages of qualified plans.
Key Features of Stock Purchase Plans
Stock Purchase Plans operate through distinct features that govern how employees contribute and acquire shares. A fundamental aspect involves payroll deductions, where employees elect a percentage of their earnings to be automatically withheld and accumulated towards stock purchases. This automated savings mechanism simplifies participation and ensures consistent contributions.
The accumulated funds are used to purchase shares during specific intervals known as purchase periods. These periods typically occur quarterly or semi-annually, at the end of a longer offering period, which is the timeframe during which employees can enroll and make contributions.
A significant benefit of many stock purchase plans, especially Qualified ESPPs, is the discount offered on the company’s stock. This discount allows employees to buy shares at a price below the prevailing market value, commonly ranging from 5% to 15%. A 15% discount is particularly prevalent among qualified ESPPs, with many plans offering this maximum allowable discount.
Many qualified plans also include a “look-back provision.” This allows the purchase price to be based on the lower of the stock’s fair market value at the beginning of the offering period or at the end of the purchase period, with the discount then applied to that lower price.
There are limits to how much stock an employee can purchase. For Qualified ESPPs, the IRS limits the value of stock an employee can buy to $25,000 per calendar year, based on the stock’s fair market value at the beginning of the offering period. Even if the purchase price is lower due to a discount or look-back provision, the $25,000 limit is calculated using the undiscounted price at the start of the offering period.
Tax Considerations for Stock Purchase Plans
The tax implications of stock purchase plans differ significantly and depend on when the shares are sold. For Qualified ESPPs, there is no taxable event when shares are initially purchased. Taxes are triggered only when the shares are sold.
When selling shares from a Qualified ESPP, tax treatment depends on whether the sale is 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 at least one year from the purchase date. In a qualifying disposition, the discount received at purchase is taxed as ordinary income, and any additional gain is taxed as a long-term capital gain, which typically benefits from lower tax rates.
Conversely, a disqualifying disposition occurs if shares are sold before meeting both holding period requirements. In this scenario, the discount received at purchase is taxed entirely as ordinary income, based on the difference between the fair market value on the purchase date and the actual purchase price. Any further gain or loss is treated as a capital gain or loss, which will be short-term if held for less than one year from the purchase date.
For Non-Qualified Stock Purchase Plans, the tax treatment is typically simpler but less favorable. The discount received on the stock is generally taxed as ordinary income (compensation) at the time the shares are purchased. Any subsequent gain or loss when the shares are sold is treated as a capital gain or loss, depending on the holding period from the purchase date.
Employers report the ordinary income portion of ESPP gains on an employee’s Form W-2. Brokerage firms issue Form 1099-B for stock sales. Employees also receive Form 3922 from their employer for qualified ESPP purchases.
Participating in a Stock Purchase Plan
Participating in a stock purchase plan typically begins with an enrollment process managed by the employer, often through a human resources department or an online portal provided by a plan administrator. Employees receive plan documents outlining the specific terms, eligibility criteria, and deadlines for enrollment.
Upon enrollment, employees elect a contribution amount, usually as a percentage of their pay, deducted from their paycheck over the offering period. The accumulated funds are then used to purchase shares on the designated purchase dates.
After shares are purchased, they are typically held in a brokerage account established by the plan administrator on the employee’s behalf. Employees can access information about their purchased shares through this account.
When considering selling shares, it is essential to be aware of any potential holding periods for tax purposes. While shares can often be sold immediately, understanding the tax implications of holding them longer can influence the decision. Employees should also be mindful of re-enrollment periods if they wish to continue participating in future offerings.