When choosing a company to work for, people not only consider the salary, type of work, and culture but also the benefits the company provides. Beyond salary and bonuses, another form of compensation an employer might provide is a stock plan.

While many may associate stock plans with high-profile tech companies from the news, stock plans are certainly not exclusive to this industry. Stock plans can be found in any industry and can be a significant determining factor in someone’s total compensation.

One of the more common plan types is called an employee stock purchase plan (ESPP). In this plan, employees defer money from their paychecks to buy company stock shares, often at a discount. However, not all ESPPs are created equal, and the tax considerations can be equally complex. If you have an ESPP, evaluating it is crucial for determining whether it’s a valuable employee benefit or more of a marketing tactic for the company.

In today’s post, we’ll review what ESPP is, the tax considerations, and some general best practices for evaluating and managing an ESPP.

What Is an ESPP

An ESPP is a stock plan provided by a company that allows employees to purchase stock of the company they work for over a period of time. Similar to contributing to a 401(k), money is withheld from each of your paychecks and set aside to buy the stock at a specified time. Also, just like a 401(k), the exact details of each ESPP will vary. But each plan will generally consist of a discount percentage off the purchase price, a purchase period, and a holding period.

The discount part of an ESPP determines what deal, if any, you get for participating in the plan. The discount is a percentage that reduces how much you pay for the stock compared with what the stock is actually valued at. There is a 15% maximum discount on qualified ESPP (more on qualified plans later), but an ESPP does not need to provide any discount at all. Nonqualified ESPP plans can have a discount percentage greater than 15%, but a discount larger than that is rare.

Example: Mary participates in an ESPP that offers a 15% discount on her purchase price. On the purchase date, XYZ company is trading at $10 a share, and Mary has set aside $850 of payroll deductions over the course of the purchase period. Since she gets a 15% discount, she can buy 100 shares at $8.50 a share.

The purchase period is the length of time that money is set aside for the purchase. Most plans have a purchase period of six months, but there can be other periods (e.g., 12 months or even 24 months). Money is set aside from each paycheck during that period and shares are bought at the end. Now, just because shares are bought eventually does not necessarily mean that the ending price is what the discount is based on. Some plans offer an incredible feature called a lookback period, which will take the lower price between the first day and last day of the period to determine the price at which the stock is bought.

Example: Mike participates in an ESPP with a purchase period that starts on January 1 through June 30. He receives a 10% discount on the stock, and the company uses a lookback period. On January 1, ABC company is trading at $10 a share, and on June 30 the stock has increased significantly to $25 a share. Since the company uses a lookback period, Mike will buy at $9 a share, using the January 1 price for calculating the discount.

Another key consideration of an ESPP is whether they require any holding period after you purchase the shares. Publicly traded companies report earnings and other important company details on a regular basis. Depending on the time of these reports and plan preference in general, there may be a holding period before you can sell your shares. This adds additional risk to the plan because even if you receive a discount on the purchase, you have to hope the stock doesn’t drop in value between when you buy the shares and when you’re allowed to sell them.

Qualified and Nonqualified ESPP

Taxes are a key factor in any financial decision. When it comes to ESPPs, not only can the discount be an attractive aspect, but if the plan is a qualified ESPP, there may be additional tax benefits as well.

A qualified ESPP is one that complies with section 423 of the IRS code. A nonqualified plan is simply any other plan that does not meet the criteria of that code. Some key aspects of a qualified plan are: 1) the discount portion of the plan cannot be more than 15%; 2) a qualified plan can have a lookback feature, but the lookback cannot be longer than 27 months; 3) plans without a lookback feature can extend all the way to five years if you are using the last day as the purchase price; and 4) someone participating in a qualified ESPP cannot purchase more than $25,000 of stock through the plan during the calendar year, and the $25,000 value is based on the actual value of the stock, not the discounted purchase price. There are, of course, other aspects that make up a qualified plan, but these are the major points. Your HR department should be able to tell you whether your ESPP is a qualified plan if you ask them.

In addition to an ESPP meeting certain criteria in order to be considered qualified, you, as the buyer, also need to meet some conditions. As the buyer, you need to hold the stock for two years from the start date of the offering and one year after the purchase date. If the stock is sold before those periods, it is considered a “disqualifying disposition” and does not receive preferential tax treatment (more on that later).

Example: Mary participates in a qualified ESPP, and her period starts on January 1, 2022, with stock being purchased on June 30, 2022. In order for the sale to be considered qualified, she needs to sell two years after the starting period (after January 1, 2024) and one year after the purchase date (after June 30, 2023). If she sells before either of those dates (even if she meets one of the criteria), the entire sale is considered disqualified.

Tax Considerations of an ESPP

A sale of stock bought from an ESPP with a discount will have some mixture of ordinary income and capital gain or loss. The benefit of a qualified sale is that there is more potential to have a larger amount of the sale considered capital gains, which are taxed at a lower rate than income tax rates.

Regardless of whether the stock is sold as qualified or disqualified, the discount portion of the purchase price is taxed as ordinary income. Where a qualifying disposition shines is if there was a lookback period and the stock appreciated considerably. In a qualified situation, the ordinary income portion is only the percentage discount, not the entire difference of the lookback period. When a sale is qualified, the lookback period is all taxed as long-term capital gains. When a sale is disqualified, both the discount and the amount of the lookback are taxed as ordinary income.

Example: Mike starts this current round of ESPP on January 1, 2020, when his ABC company is valued at $10 a share. On June 30, 2020, the stock is valued at $25 a share, but his plan has a lookback period. Mike buys 100 shares at the January 1 price of $9 a share after the 10% discount ($900 total). Mike holds on to the shares until July 15, 2022, which is more than two years since the beginning of the period and more than one year since he bought the shares, making the sale a qualified disposition. At the time of the sale, ABC company was trading at $50 a share. Mike has $100 of the transaction taxed as ordinary income from the original discount ($1 * 100 shares). The portion included as income is added to the basis of the sale. The remainder of the sale, $40 a share, is taxed as long-term capital gains ($50–$10).

If the plan was not qualified, or if Mike did not meet the holding period, then the lookback amount would also be considered income. In that case, $16 would be taxed as ordinary income ($25–$9), with the remaining $25 taxed as long-term capital gains.

Of course, in the case of a disqualifying disposition, the appreciation is only taxed as long-term capital gains if you hold the stock for more than one year after the purchase. If you sell in less than a year, then any gain or loss is considered short-term.

It’s also important to keep in mind that the discount is taxed as income, regardless of the price at which the stock is sold. In an unfortunate situation, if the stock drops between when it was bought and sold, the discount amount is taxed as income, even if the stock is now less than the discounted purchase price.

Evaluating Your ESPP

There is much to consider when deciding whether it’s worth participating in your company’s ESPP. The biggest determining factor is whether there is a discount and what the percentage is. If your plan does not offer any discount, you should almost certainly pass on participating. There is really no benefit in participating in the plan versus buying the stock yourself in the open market.

Plans that offer a generous discount and a lookback period should be strongly considered. The lookback option is what can make an ESPP incredibly valuable. An ESPP can provide significantly more monetary value if you get a discount and a more favorable price when you buy. A plan without a lookback provision should still be considered, but adding this to the discount can provide immense value if the stock does well.

Lastly, even if the discount is generous and there is a lookback provision, you may still want to avoid a plan if there are significant restrictions on when you can sell the stock. If your ESPP does not let you sell right away and may make you hold the stock for a few months, there is a risk that the stock may drop between when you buy and when you’re able to sell. This does not necessarily mean you shouldn’t participate, but you must be comfortable knowing that risk.

Your ESPP in Conjunction With Other Saving Opportunities

Of course, at the end of the day, whether it makes sense to contribute to an ESPP comes down to whether it helps you reach your financial goals. Depending on the plan, an ESPP can provide both financial and tax benefits, but if it doesn’t help you reach your goal, compared with other options, it may make sense to forego this option.

Participating in an ESPP competes with other savings alternatives. While it would be nice if everyone could max their 401(k) and contribute to an ESPP, not everyone has the cash flow available to do this. Generally speaking, you should be contributing up to the employer match in a 401(k) before even considering setting aside additional money in an ESPP. The match is “free” money provided by your employer. If it’s a dollar-for-dollar match, that’s a 100% return, which is significantly higher than a 15% max discount on a qualified ESPP.

While the tax benefits of a qualified ESPP can be great, an ESPP does come with risks. First, you need to hold the stock for at least a year after purchase. Buying an ESPP in a single company is inherently riskier than investing in a diversified fund. In addition to that, you’re investing in the company you work for. So, your investment, salary, and benefits are tied to a single company. While no one wants to think their employer may have trouble, it does happen. Just ask the employees of Enron. That’s why it’s generally ill-advised to have too much of your net worth tied up in your company’s stock. Depending on where you are in your savings journey and how long you plan to hold the stock is a significant factor.

You also need to weigh the tax benefits of a qualified ESPP with the tax benefits of other options, such as contributing more to a 401(k) or Roth 401(k). Depending on your tax situation and whether you’re already maxing out your 401(k), it may make more sense to reduce your income further in a regular 401(k) or add to your tax-free savings in a Roth in a given year. At Milestone, we advocate for tax diversity, having funds in tax-deferred, tax-free, and taxable buckets, but depending on your situation, where it is best to allocate your resources may vary.

Lastly, depending on your personality, having money in an ESPP may not actually help you reach your savings goals. Once you have the stock and can sell it, the money is yours. If you are using the ESPP as a savings vehicle and are not actually saving the money afterward, that is not helpful. Sometimes, putting money in a harder-to-reach place, like a 401(k), can be beneficial for people who lean more toward spending and have trouble saving. On the flip side, if you need the money quicker, funds in an ESPP will usually be accessible sooner, which is a benefit compared with a retirement savings plan.

Clearly, there are many factors to consider when evaluating whether to contribute to an ESPP in terms of your personal tax situation, personality, and overall goals.

ESPP Best Practices

We believe there are two main ways to manage ESPPs effectively, depending on your risk tolerance, personal situation, and goals.

The first is the conveyor belt method. In this method, you’re using the ESPP just for its immediate profit from the discount and are not aiming for a qualified disposition. Think of a conveyor belt, in which products are assembled at the beginning and taken off at the end. When you’re contributing to an ESPP during the purchase period, that’s the assembly line. Deductions are taken out, and you’re building a pool of funds to buy discounted stock. When the product is assembled and finally purchased, you immediately sell the stock and take whatever profits from the discount and possible lookback period. Everything is taxed as ordinary income, but you’re essentially locking in a guaranteed gain because you’re not holding the stock and giving it a chance to decline in value. And just like a conveyor belt, you begin the assembly process again with the next purchase period.

The obvious benefits of this strategy are that the risk is low, and you’re almost always pocketing a profit unless your plan has an unusually long holding period. This is generally our preferred method because, as mentioned before, holding on to stock for a company you work for can be incredibly risky. While the additional tax benefits of a qualified disposition are nice, they often do not outweigh the risks of holding on to stock from your employer.

The second method is trying for a qualified disposition. You should only consider this if you are comfortable with the risk of holding on to your company stock and if the amount of company stock you own is not a significant portion of your net worth. If neither of these is your situation, then you should likely avoid a qualified disposition.

Obviously, trying for a qualified disposition can have significant tax benefits. The tax savings increase the amount of money you keep, which can be a significant sum depending on your tax bracket and the amount of stock appreciation. In addition to this, depending on your tax situation in a given year, it may make sense to delay generating additional income. Deciding not to sell the stock defers that taxable income to a future year, hopefully when you’re in a more favorable tax situation.

Wrap Up

ESPPs can be a fantastic employee benefit, but they are not all created equal. Depending on the discount amount, whether it has a lookback period, and if it has any restrictions on selling are all significant factors in determining whether it makes sense to participate. In addition to evaluating the benefits of the plan, the potential tax implications are another significant consideration, especially when weighing your other savings options.

Like many things in finance, the exact details of these plans can be quite complex, especially when weighing the benefits with your personal situation and goals. If you need help with your financial plan, please reach out to our team.

Disclaimer/Author(s) Bio: This is not to be considered investment, tax, or financial advice. Please review your personal situation with your tax and/or financial advisor. Milestone Financial Planning, LLC, (Milestone), a fee-only financial planning firm and registered investment advisor in Bedford, NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our client’s interests first.  If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.  Advisory services are only offered to clients or prospective clients where Milestone and its representatives are properly licensed or exempt from licensure.

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