Stock Options Made Simple: What Do You Need To Know About ESPPs?

You’ve made it to the final installment of our equity compensation series! So far, we’ve delved into ISOs and RSUs. Today, we’ll round out our conversation with ESPPs, a more prevalent and highly beneficial form of equity compensation. How can you make the most of your ESPPs?

The Basics of Employee Stock Purchase Plans (ESPPs) + Key Terms

Employee Stock Purchase Plans (ESPPs) are company-run programs where employees can purchase company stock at a discounted price, usually between 5% and 15%. Employees contribute to the plan through payroll deductions (similar to a 401(k)), and at the time of purchase, the employer adds up the deductions to buy the stock. ESPPs come with several key terms and dates that can provide insight into your next best step:

• Enrollment Period: The time when you can elect to enroll in the ESPP.

• Offering (or Grant) Date: When payroll deductions are taken out of your paycheck. Your company will use these funds to purchase the discounted shares of company stock.

• Purchase Period: The window of time (with a start date and end date) when payroll deductions are to be “accumulated.”

• Purchase Date: The last day of the purchase period, specifically when the shares are purchased (via the funds earmarked from payroll contributions).

• Lookback Provision: These stipulations apply to some ESPPs; in most cases, Qualified ESPPs. With a lookback provision, your purchase price is not based on the stock’s fair market value at the time of purchase. Instead, it’s the lower of either (1) the price at the beginning of the offering period or (2) at the end of the purchase period.

The IRS limits the dollar amount of company stock that you can purchase in one calendar year to $25,000. Most plans have certain checks and balances on this provision, but it’s essential to ensure that you remain within the IRS boundary.

Qualified vs. Non-Qualified ESPPs (Plus How They’re Taxed)

What is the primary difference between the two types of ESPPs? Taxes. Let’s take a closer look.

Qualified ESPPs

Qualified plans are the most common, and they can come with favorable tax treatment (if you follow the rules). Your tax liability depends on IRS holding requirements, which results in either a Qualifying Disposition or a Disqualifying Disposition. With a Qualifying Disposition, you must hold the stock for,

• One year from purchase and, 

• Two years from grant. 

The gains on the sale are taxed at long-term capital gains rates, and only the stock’s discount (5-15%) is taxed at ordinary income tax rates. By not meeting the holding requirements, you make a Disqualifying Disposition, which comes with a separate set of tax consequences. 

• Ordinary income is the difference between the fair market value (FMV) on the purchase date and the purchase price. 

• Capital gains (long-term or short-term) on the sale. 

Understanding the tax consequences can help you create a proactive plan.

Non-Qualified ESPPs

With this type of ESPP, you pay ordinary income tax on the difference between the stock’s fair market value and your purchase price. When shares are sold, any additional gain is taxed at capital gains tax rates.

Tips To Optimize Your ESPPs

ESPPs can be complex, especially when you factor taxes into the equation and come with important decisions. Below are a few tips as you look to optimize your ESPP:

1. We’ve said it before, and we’ll say it again: understand how your equity, in this case, an ESPP, can help you achieve your financial goals. Get clear on your long-term goals and then allocate a specific amount of money (and effort) towards your company’s ESPP. You may not have to max out contributions every year or participate in every enrollment season to make the most of this opportunity. We can work together to build a plan that accounts for your other investments, savings, goals, and more.

2. Don’t hold too much of your company’s stock as part of your portfolio. Continue to diversify and rebalance as you receive shares through your ESPP. Since shares are bought in bulk at the purchase date, it’s easy to amass a concentration in your company stock. While you may want to retain some shares, it’s best to make investment decisions based on long-term data, not predispositions about your company’s future.

3.  Create a comprehensive plan for holding and selling your shares. Remember, to receive favorable long-term capital gains tax treatment in your qualified ESPP, you must reach specific holding parameters and make a Qualifying Disposition. But taxes also aren’t everything. It’s critical to look at this decision in the context of your other financial needs. For example, you may be targeting a specific goal and would benefit from the cash flow now.

4. Equity compensation doesn’t exist in a bubble. This statement is especially true if you receive other forms of equity compensation (ISOs, RSUs, etc.). Integrate your ESPP when considering your annual tax situation to keep all of your benefits working together.

Should You Partake in Your ESPP?

In most cases, yes. However, with any financial decision, each person has their own set of circumstances, tax situation, cash flows, financial balance sheet, goals, values, etc. If your company offers you an ESPP, you need to thoroughly understand the plan and identify how it can help you achieve your goals. Additionally, it’s vital to grasp the tax implications and portfolio impact of your participation in the ESPP. Equity compensation is another financial tool and opportunity we can use to help you reach your goals. The good news? We’re here to help. We would love to help you optimize a plan and strategy for your ESPPs. Reach out today.