What Is an Employee Stock Purchase Plan?

An Employee Stock Purchase Plan (ESPP) is a company-sponsored benefit that allows eligible employees to purchase their company’s stock, often at a reduced price. These plans provide a structured way for employees to acquire an ownership stake in the company they work for. Participation in an ESPP is voluntary. Contributions are made through payroll deductions, accumulating funds over a set period to buy shares.

Understanding Key Plan Features

Employee Stock Purchase Plans operate through distinct periods and provisions that determine how and when shares are acquired. Understanding these features clarifies the mechanics of an ESPP.

An “offering period” is the defined timeframe during which employees can enroll in the plan and begin accumulating funds through payroll deductions. Within an offering period, there are often shorter “purchase periods,” at the end of which the accumulated funds are used to buy company stock. The specific date when shares are purchased is known as the “purchase date.”

Many ESPPs include a “look-back provision.” This feature allows the purchase price of the stock to be based on the lower of two values: the stock’s fair market value (FMV) at the beginning of the offering period or its FMV on the purchase date. For example, if a stock is $50 at the start of the offering period and $60 on the purchase date, a look-back provision would use the $50 price as the base for the purchase. This ensures employees benefit from any stock price appreciation during the offering period.

In addition to a look-back provision, shares are commonly purchased at a “discount” from the prevailing market price. This discount ranges from 5% to 15%. The discount is applied to the lower of the two prices determined by the look-back provision, if applicable, or simply the stock price on the purchase date if no look-back is offered. For instance, if the base price is $50 and the plan offers a 15% discount, employees would purchase the stock for $42.50 per share ($50 x (1 – 0.15)). Employee contributions for these purchases are automatically deducted from paychecks.

Eligibility and Contribution Rules

Participation in an Employee Stock Purchase Plan is open to a broad base of employees, but specific criteria and limitations apply. Companies set eligibility requirements, which may include factors such as full-time employment status or a minimum length of service with the company. Additionally, Internal Revenue Code Section 423 prohibits employees who own 5% or more of the company’s stock from participating in a qualified ESPP.

There are also specific limits on the amount an employee can contribute to an ESPP. The IRS imposes a statutory limit on the value of stock that can be purchased through a qualified plan. An employee cannot purchase more than $25,000 worth of stock in any calendar year. This $25,000 limit is based on the fair market value of the stock at the beginning of the offering period, not the discounted purchase price.

Beyond the federal limit, companies establish their own plan-specific contribution limits, which can be more restrictive. These limits are expressed as a percentage of an employee’s eligible compensation, such as their base salary. Common plan-specific limits on contributions range from 1% to 15% of an employee’s gross pay, though some plans may allow up to 20%. Employees formally enroll in the ESPP by electing their desired contribution percentage through payroll deductions.

Tax Implications of Your Shares

The tax treatment of shares acquired through an Employee Stock Purchase Plan is important to understand. When shares are purchased through an ESPP, income is not taxed at the time of purchase. Tax obligations arise when the shares are ultimately sold. Income from an ESPP sale is comprised of two main components: an ordinary income component and a capital gains or losses component.

The ordinary income component arises from the discount received when purchasing the shares, and any additional benefit from a look-back provision. This discount is considered compensation and is taxed at an employee’s ordinary income tax rate. This income is reported by the employer on the employee’s Form W-2 for the year the shares are sold. The capital gains or losses component applies to any appreciation or depreciation in the stock price above the fair market value on the purchase date. This gain or loss is subject to capital gains tax rules, which depend on how long the shares were held.

The timing of a sale determines whether it is classified as a “qualifying disposition” or a “disqualifying disposition,” each with different tax consequences. A qualifying disposition occurs if the 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 amount taxed as ordinary income is the lesser of the actual discount received based on the offering date’s fair market value, or the actual gain from the sale (sale price minus purchase price). Any additional gain above this amount is treated as a long-term capital gain, which is taxed at a lower rate than ordinary income.

A disqualifying disposition, conversely, occurs if the shares are sold before meeting either of the holding period requirements for a qualifying disposition. In this scenario, the difference between the fair market value of the stock on the purchase date and the actual purchase price is taxed as ordinary income. Any further gain or loss on the sale is treated as a capital gain or loss, which can be either short-term or long-term depending on the holding period from the purchase date. Short-term capital gains are taxed at ordinary income rates, while long-term capital gains are taxed at preferential rates.

Employers are required to issue Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan,” to employees. This informational form details the stock purchase and assists employees in accurately calculating their cost basis and reporting capital gains or losses on their tax returns.

Managing and Selling Shares

Once shares are purchased through an Employee Stock Purchase Plan, they are deposited into a brokerage account designated by the company. At this point, employees have control over their shares and can decide whether to hold them or sell them.

One option is to hold the shares, which allows for long-term growth. However, holding shares also means being subject to market volatility. The other primary option is to sell the shares. Employees can sell their shares through the brokerage account where they are held.

The decision to hold or sell shares involves considering personal financial goals and the importance of diversification within an investment portfolio. While the ESPP provides a convenient way to acquire company stock, employees should assess how these shares fit into their overall financial strategy.