For many businesses today, finding and retaining top talent remains a big challenge.
One way some companies are meeting this challenge is by implementing an employee stock purchase plan, or ESPP.
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An ESPP allows employees to purchase company stock at a discounted price with no taxes due on the discount at the time of purchase. These plans can be especially useful for companies with fierce competition to hire and hold onto the best and brightest employees.
Get the Full Picture: Your Guide to Employee Equity Compensation
What is an ESPP?
An employee stock purchase plan is a program whereby employees are given the option of buying stock in the business at a price that’s lower than the current market price — typically up to 15% lower. Stock purchases are made via payroll deductions, similar to the way employee contributions are made to retirement accounts like a 401k.
These payroll deductions accumulate between the offering date to purchase stock and the date employees purchase company stock. On the purchase date, the funds are used to buy the stock on the employee’s behalf. If the plan has a look-back provision, it can use a historical closing price that may be the lower of the price on the stock offering date or the purchase date.
Who is Eligible to Participate?
Unlike phantom stock, which companies can choose to make available only to key executives and other highly compensated employees, ESPPs are usually made available to all full-time, permanent employees.
Businesses are generally allowed to establish their own eligibility requirements, including a minimum tenure with the company. Also, any employee who owns 5% or more of the voting power or value of all stock classes is generally ineligible to participate.
Employee contributions to an ESPP are limited by the IRS to $25,000 per year as of 2021, and most plans allow annual contributions of up to 15% of compensation.
What Types of ESPPs Are There?
There are two main types of ESPPs: qualified and non-qualified.
As the name implies, a qualified ESPP qualifies for tax benefits under IRC Section 423. More specifically, employees can postpone recognition of the capital gain on the discount and defer the payment of tax until they sell their shares. Other tax benefits may also be available, depending on how long the shares are held and other factors.
Non-qualified ESPPs do not offer these tax benefits. Instead, taxes on capital gains are due when shares are purchased. However, non-qualified ESPPs aren’t subject to as many restrictions as qualified plans.
How are ESPPs Taxed?
Taxation of ESPPs differs based on the type of plan.
With a qualified plan, employees are not taxed when they purchase shares — only when shares are sold. If shares are held at least one year after purchased and two years after granted, the gains will be taxed at favorable long-term capital gains rates. A holding period may be required for employees to receive this favorable long-term capital gains tax treatment. Meanwhile, the discount on the price of the stock is taxed as ordinary income.
With a non-qualified plan, the difference between the fair market value of the stock and the amount paid for it is considered ordinary income and taxed as such when the shares are purchased. Employers are required to withhold taxes on stock purchases in non-qualified plans, but not in qualified Section 423 plans.
Should You Participate in an ESPP?
An employee stock purchase plan could be a good opportunity for you to earn extra income. In addition, by having a game plan for your ESPP, you can avoid being too heavily concentrated in your company’s stock. Your ESPP provides a great benefit by increasing your overall compensation, but it is critical that you have a plan of action as it grows.
If your company offers a plan, it’s important to carefully investigate the pros and cons of ESPPs. Consider talking to a fiduciary financial advisor to see how it may fit into your long-term investing plan.
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