As your career advances, you’ll likely encounter equity compensation. Having equity in your company is a great way to feel connection and purpose to the work you do.
But equity compensation is hardly one size fits all. There are several different types, all of which could have a significant impact on your financial plan.
One of the most common ways to purchase your company shares is through an Employee Stock Purchase Plan (ESPP).
What is an ESPP, and can it enhance your total compensation?
Let’s find out.
What Is An ESPP?
An Employee Stock Purchase Plan (ESPP) is a common type of equity compensation that allows employees to purchase company stock at a discount, usually 5% – 15%. You contribute to the plan through payroll deductions, and once you check all the boxes, the company uses the account balance to purchase company stock on your behalf.
There are two types of ESPPs: qualified and non-qualified.
Each comes with its set of differences that can influence their effectiveness and inform the best ways for you to participate in them.
The most important difference to be aware of? Taxes. Qualified ESPP’s come with more favorable tax treatment, and as a bonus, qualified plans are more common than unqualified ones.
Key Dates for Your ESPP
Equity compensation is riddled with specific financial terminology. Below is a quick refresh of all the critical dates and periods for your ESPP.
- Enrollment Period: The window where an employee is eligible to enroll in their ESPP. This period usually comes along twice per year. Like your 401(k) payroll deferral, you decide how much of your compensation to contribute to your ESPP.
- Offering/Grant Date: The date the company “starts the clock” of taking your payroll deductions, earmarked to buy company shares during the purchase period.
- Purchase Period: A specific period, typically six months, where your employer buys company shares.
- Purchase Date: The exact date(s) when the company uses your ESPP account balance to buy company shares.
How and When Employees Get an ESPP
Employees participate in their ESPP via after-tax payroll deductions. The employee’s payroll deductions accumulate in a “separate account” between the offering and purchase dates.
On the purchase date, the company uses the employee’s accumulated funds to buy company stock. An ESPP can have a “look-back provision,” which allows the plan to use a historical closing price of the stock. This would enable the employee’s purchase price to be the lower of either the offering date or the purchase date.
The IRS limits ESPP purchases to $25,000 worth of stock value (based on the grant date fair market value) for each calendar year in which the offering period is effective.
How ESPPs Are Taxed
As noted, the most significant difference between a qualified and a non-qualified ESPP is in its tax treatment. Let’s take a look.
Qualified ESPPs are the more common of the two and spin a web of tax rules. With this type of plan, employees are only taxed when shares are sold.
In general, qualified plans receive preferential tax treatment, but that favorable tax rate comes with a few more strings, namely qualifying and disqualifying dispositions.
Whether you make a qualifying or disqualifying disposition in a qualified ESPP (try saying that five times fast) determines the resulting tax treatment.
To be considered a qualifying disposition and receive preferential tax treatment, the following must be upheld:
- Shares must be held at least one year after the purchase date
- Shares must be held at least two years after the grant date
When you meet these two requirements before the sale, the gains are taxed at the more favorable, long-term capital gains rates. However, it is essential to note that the discount on the stock price will be taxed at ordinary income rates.
If you don’t complete the holding requirements for a qualifying disposition, you make a disqualifying disposition. Doing so could stick you with both ordinary income and capital gains tax. There are two taxable events to be aware of in a disqualifying disposition:
- Ordinary income tax on the difference between the fair market value on the purchase date and the purchase price.
- Capital gain (short or long term depending on how long you held the stock) on the difference between the stock’s price on the purchase date and the final sale price.
When you purchase shares with a non-qualified ESPP, you pay ordinary income tax on the difference between the stock’s fair market value and your purchase price. When your shares are sold, any additional gain is taxed at a capital gains rate.
Here’s a quick example of qualified vs. non-qualified ESPP plans in action.
- Your company offers a 10% discount on the stock with a look-back feature.
- The offer price is $25
- The purchase date price is $30
- The sale price is $35
In this situation, a qualified plan uses the lower offer date amount of $25 – 10% (2.50) = $22.50 basis. You’ll only pay ordinary income tax on the discount, which in this example is $2.50. The remaining profit is taxed at capital gains rates.
On the other hand, with a non-qualified ESPP, you start with the less favorable purchase date price of $30, leaving $7.50 subject to ordinary tax, with any remaining profit taxed at capital gains rates.
Three Common ESPP Mistakes (And How To Avoid Them)
ESPPs can be complex vehicles, and it’s important to use them efficiently and effectively. Here are three mistakes employees can make with their ESPPs and potential ways to avoid them. Keep in mind that every person’s situation is different, and you should consult with your financial and tax professionals before making any decisions.
Overconcentration In Company Stock
No matter what type of equity compensation you have, you run the risk of being too heavily concentrated in your company. This warning certainly rings true for ESPPs.
Not only do you work for a publicly-traded company, but by participating in your company’s ESPP, you take added risk should your company not succeed, perform poorly, or in the worst case, shut down.
While it can be beneficial to receive additional compensation and participate in your company’s success, you want to be mindful of how much of your net worth is tied to your company.
The ever-present adage, don’t put all your eggs in one basket, couldn’t be more accurate. If you find yourself accumulating a lot of your company stock, talk with your advisor about strategic diversification efforts that fit your plan.
Buying Too Much (Or Too Little) Stock
Another common mistake is not contributing the appropriate amount to your plan.
If the company’s future and stock performance decrease, deferring too much of your income could harm your portfolio. Even though you got the stock at a discount, what happens if the fair market value falls below that lower rate?
It’s also easy to buy too much if you receive additional forms of equity compensation like restricted stock units (RSUs) or incentive stock options (ISOs). RSUs are a type of compensation in the form of company stock. They are a promise of stock once the employee reaches the vesting requirements. ISOs give employees the opportunity to purchase company shares at a discounted price.
Instead of participating in the ESPP, you may find more opportunities by reallocating that cash flow to more diversified avenues.
On the other hand, if your company’s performance (and thus their stock) does well, you want to take advantage of that growth and contribute enough to reap those benefits.
Deferring the right amount of your income depends on several factors:
- Company specifics
- How long you plan to remain at the company; (creating an ESPP exit plan is critical).
- Additional equity compensation
- Investment goals
- Diversification efforts
- Risk tolerance and capacity
Knowing When To Sell
Given the favorable tax treatment of qualified dispositions related to qualified ESPPs, you must understand the holding period requirements to take full advantage of long-term capital gains rates. The last thing you want to do is not follow those rules and pay 100% ordinary income tax rates on your ESPP proceeds.
Create a Comprehensive Plan With Your ESPPs
Every employee offered an Employee Stock Purchase Plan (ESPP) needs to have a strategy to set themselves up for success and avoid tax-related heartache.
By understanding your overall financial picture, the standing of your company stock, and the details of ESPPs, you will be able to make an informed decision on participating (and to what degree) in your plan.
ESPPs have several moving pieces. You should be mindful of:
- Proactively planning for tax impacts.
- Building a smart plan to maximize benefits and avoid overconcentration risk in your portfolio.
When it comes to ESPP’s and other forms of equity compensation, we at Wingate Wealth Advisors are experts at guiding our clients with these financial decisions. Contact us today.