Employee Stock Purchase Plans (ESPP)

Q:  What’s your take on Employee Stock Purchase Plans?  I have an opportunity to participate in my company’s ESPP, but don’t quite know the details of how they work.  Should I participate?

A:   An Employee Stock Purchase Plan (ESPP) is a company-sponsored employee benefit which allows participants to purchase company stock through payroll deferral.  Most ESPPs allow participants to buy shares at a discount from the market price.  The discount is generally applied to the lower of the beginning price or ending price during a designated offering period (a time-frame usually ranging from three to six months, depending on the plan).  This means at the time of purchase, ESPP shares’ built-in profit may be even greater than the stated discount, as participants benefit if the stock price appreciates during the offering period.

The discount varies from plan to plan, but can be as much as 15%.  Opportunities to earn an immediate return on investment don’t come along very often.  Consequently, we generally recommend anyone who is eligible to participate should consider doing so.

Here are some details to consider:

Tax Considerations

Although contributions to an ESPP are made through payroll deferral, they are not tax-advantaged like 401(k) plan deferrals.  There is no tax-deduction for contributions to an ESPP.  Furthermore, the discount on stock purchases is considered compensation for tax purposes.  Taxable income is not recognized, however, until the shares are disposed of through a sale or gift to another party.  When shares are sold, this “disposition” of shares is characterized as either “qualified” or “disqualified” depending on how long the shares were held.  Whether a disposition is qualified or disqualified dictates how much of the sale proceeds are considered ordinary income versus capital gain/loss.

Qualified Dispositions

The sale or gift of ESPP shares is considered “qualifying,” if both of the following criteria are met:

  1. The shares must be held for at least twelve months from the date of purchase.
  2. The shares must also be held for at least twenty-four months from the grant date (generally defined as the first day of the offering period).

If the disposition is deemed “qualifying,” compensation income is the lesser of two numbers:

  1. The difference between the market price and the discount price calculated on the grant date (not necessarily the actual purchase price).
  2. The difference between the sales price (or market price when gifted) and the purchase price.

Disqualifying Dispositions

The sale or gift of ESPP shares is considered “disqualifying,” if both the criteria above are not met.  If the disposition is deemed “disqualifying,” compensation income is the difference between the market price on the date of purchase and the actual purchase price.

Capital Gain or Loss

In both qualifying and disqualifying dispositions of ESPP stock, cost basis is calculated by adding the compensation income to the actual purchase.  The difference between the sales price and the cost basis is either a gain or loss.  The gain or loss is considered short-term if the shares were held less than twelve months from the time of purchase and long-term if held longer than twelve months.

Quirky Transactions

A disqualifying disposition of ESPP shares that have declined sharply since purchase can result in paying taxes on “phantom income.”  Remember, the compensation income in a disqualifying disposition is the difference between what was paid and how much the shares were worth at the time of purchase.  That is true even when a subsequent decline erases that initial profit.  Under this scenario, with only up to $3,000 of capital loss allowed to offset income—an ESPP participant might end up paying taxes on income that no longer exists.  A qualifying disposition in this same scenario results in no compensation income.

Finally, in an instance in which the share price declines during the offering period, but then appreciates prior to when the ESPP shares are finally sold, a disqualifying disposition can actually result in less tax than a qualifying one.

Obviously, it pays to be aware of the implications of ESPP dispositions across different holding period and stock price scenarios.

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