An employee stock purchase plan, or ESPP, is an employee benefit that allows employees to purchase company stock via salary deductions. If you have an ESPP, you can often purchase shares at a discounted price to the fair market value. Some companies offer a discount as high as 15%.
Generally, employee stock purchase plans are offered in an effort to incentivise employees. Over time, with regular and consistent participation, an employee may be able to increase their total compensation by participating in the plan.
That increase is usually due to the combination of receiving a discounted purchase price, a look-back provision, and an appreciating stock price. An increasing stock price is a shared benefit for the employee and the employer. Simply stated, if the company does well and if the stock price goes up, everyone wins.
Let’s look further into how an employee stock purchase plan works, what the benefits may be, and what you should think about from a tax perspective.
The Workings of an Employee Stock Purchase Plan
Not all companies offer ESPPs, and employers are under no obligation to do so. If your company happens to provide an employee stock purchase plan as a benefit, you may want to reach out to HR to learn the details of your plan.
The details can often be obtained via a plan document. Once you read the plan document and enroll in the plan, you can begin making contributions to your ESPP through payroll deductions using after-tax dollars.
The employer typically holds the contributions made from all employees in an escrow account. Then, on a pre-set schedule (often every six months), the company uses the money in the escrow account to purchase company shares for everyone who participates.
When your shares are purchased, they’re usually deposited into a brokerage account that your company chooses. Once in the brokerage account, you can likely treat them like any other investment you own — meaning you can sell them at your leisure (although you should check your plan document to be sure of your plans specific rules regarding what you can do with your shares).
What Price Do I Pay for My Shares?
Employee stock purchase plans can give plan participants an advantage on price compared to buying those same shares on the open market. Specifically, they can offer one or both of the following:
A discount from fair market value, up to 15%
A look-back provision
To determine how your ESPP works, check your plan document.
If yours offers a discount, then it might allow you to buy shares at a lower price than what you can on the open market. For example, if you can buy shares at a 15% discount you can buy company stock worth $100 at $85 a share.
If you have a look-back provision, things get a little more complicated. A look-back provision allows the employer to set the purchase price of the plan shares at the lesser of:
The fair market value on the offer date OR
The fair market value on the purchase date.
To understand how this works, say the fair market value (FMV) of the stock price on the purchase date is $100. We then need to know the FMV on the offer date, a date that often occurs several months prior to the purchase date.
The price on the offer date was either higher or lower than the current $100 per share value. For illustrative purposes, let’s just assume the higher value was $120 and the lower value was $80.
On the purchase date of the stock, you can buy shares through your ESPP at the best price — which is the lower of the purchase date price or the offer date price — plus the 15% discount!
The Right Moves to Make Based on the Movement of the Fair Market Value
When you buy company stock through an employee stock purchase plan, you pay nothing in taxes.
Upon selling the stock, however, you will owe taxes if the stock has increased in price.
It’s also possible that the discount received on the purchase price will be taxed as ordinary income — but the gain above the discount to the final sale price will receive the long-term capital gains tax treatment.
Should I Participate in My Employee Stock Purchase Plan?
Employee stock purchase plans often allow for additional flexibility compared to their Restricted Stock (RSU) and employee stock options. In short, the ability to cash out is often easier.
However, it’s important to note that all investing carries with it the risk of losing money. Employee stock purchase plans are no different.
It’s easy to run hypothetical examples that illustrate the benefits of owning employee stock, and it’s equally easy to become enamoured with purchasing stock at a 15% discount.
Before you decide to participate in your employee stock purchase plan, you should consider a number of things:
Can I afford to purchase stock?
Am I saving elsewhere?
Do I already own company stock through other plans (i.e., options or restricted stock)?
Am I okay with market volatility?
Do I already own too much company stock?
Do I have a strategy in place to hold and/or liquidate my stock?
As always, the decision to participate or not is not one that should be made in a vacuum. The decision to participate should be weighed with and against the other pieces of your financial plan.
