Do you know what’s in your employer’s benefits package? It’s often worth more than you think.

Getting a competitive salary is important, but prospective employees should look at their employer’s benefits package as part of their compensation.  If you work for a publicly-traded company that offers employee stock purchase plans (ESPPs), you are fortunate. This benefit is a desirable part of your overall compensation package while improving employee retention and motivation.

An ESPP is a win-win for both the company and its employees. Owning stock purchased at a discount may be meaningfully additive to employee’s compensation and net worth.

That said, employee participation in  ESPPs is relatively low. According to the 2018 Global Equity Insights report, 70% of North American companies surveyed have implemented share discount plans, with 42% of employee participation. This percentage is below the 48% rate targeted by employers.

Companies can boost this low rate with increased employee awareness through human resource professionals.

Employee stock purchase plans may seem technical or intimidating to employees. Once there is a better understanding of how ESPPs work and provide incentives, more employees may participate in the plan. We have examined the four most common equity compensations, including ESOP, ESPP, ESO, and RSU, in this post here.

What Is An ESPP?

An ESPP plan allows employees to buy their company’s stock at a discount price up to 15% of their salary but no more than $25,000 annually. You can contribute via paychecks. Contributions typically are 1-10% of wages. It is a right way for employees to participate in the success of their company.

Similar to employer-sponsored 401K retirement plans, ESPPs are usually:

  • broad-based programs offered to all employees,
  • participation is voluntary; and
  • handled by payroll deductions.

 

Qualified and Unqualified Plans

According to the National Association of Stock Plan Professionals (NASPP), 82% of companies with ESPP plans are tax-qualified plans under Sec 423 of the Internal Revenue Code. A qualified plan has more restrictions but favorable tax treatment. Non-qualified plans have fewer restrictions but less favorable tax benefits.

To implement a qualified ESPP plan, a majority of shareholders must vote to approve it.  All employees must have equal access to the plan.

A qualified plan allows employees to purchase company stock up to a 15% discount, meaning your share purchase is 85% of its price in the stock market. The plan’s purchase date must be within three years of the offering date, that is, when the company announces its ESPP.

The maximum offering term allowed for employees to participate is 27 months unless purchases are at market value ( is offered by the company, i.e., no discount). The employer can offer the plan for as long as five years.

Favorable Tax Treatment For Qualified Plans

As mentioned above, if you are participating in a qualified employee stock purchase plan (ESPP), you may reap the benefits of tax-advantaged treatment. If you sell shares at a higher price than your purchase price, you will have income (rather than a loss).

The income is taxed treated differently depending on two varying sources. The gain between the market price and discount is considered ordinary income tax. On the other hand, you may pay capital gains tax on the income differential between your sale of shares and purchase price, depending on how long you held the shares.

Capital gains treatment requires  you to have held the shares:

  • a year and a day from the purchase date AND
  • at least two years from the offering date.

Qualified plan holders pay taxes during the year of the sale of shares. If you don’t satisfy the timing, you pay ordinary income tax. Capital gain rates are lower than ordinary income tax rates.

How The Tax Treatment Works

Significantly, the qualifying disposition occurs in the year when the stock was sold and is taxed accordingly. The taxation of income discount from market value is at a higher rate. If you hold the shares short term, your income from its sale will be treated as ordinary income and treated at a higher tax rate. However, if you own shares long time according to the qualifying disposition rules, your income will be taxed at the capital gain rate.

An Example

Carol bought one share with a 15% discount offered by her company. The stock has a $20 market value, and she pays $17 per share based on her 15% discount. She held the stock for more than a year and a day from her purchase date and more than two years from her company’s offering date.

She sells the stock at $30 per share. Carol earned $13 per share ($30 less $17) with two different tax treatments. The difference between $20 less $17 or $3 will be recognized as ordinary income and taxed at her 33% tax bracket. The remaining $10 will be taxed at the capital gain rate of 15% because she held the shares long enough according to the rules above.

Carol enjoyed a pretty favorable return on her investment or 13/17 or 76% before calculating the tax impact. Her after-tax return is effectively 62%. This is based on using the $3 x (1-.33)= $2  plus $10 x (1-.15) =$8.50. As such, it equates to $10.50/17 or 62% after-tax.

Long Term Holding Period For Tax Advantages

Most plans allow the employee to immediately sell their shares upon their purchase without requiring vesting or holding period. However, if you sell your shares before the required holding period, then your entire income is taxed as ordinary income at a higher rate. You might want to annualize your return if you held less than one year. To calculate your return on an annual basis, use a formula like here.

However, a 2017 NASPP Deloitte Consulting Survey reported that two-thirds of companies that offer an ESPP say participants hold their purchased shares under Section 423 for at least one year and a day and get the favorable capital gains treatment.

The unqualified plan has fewer restrictions, except the plan still requires majority shareholder approval. These plans do not have tax advantages like the qualified plan. Instead, employees pay the ordinary taxation rate.  

Most Plans Have 15% Discount From Market Price

According to surveys, the employees’ discount price for shares is 5%-15% lower than the market price, with 15% being the most prevalent discount. Employers usually impose a limit of 10% of after-tax pay. In any case, the IRS allows purchases up to $25,000 of stock annually.

Look-back provisions are standard. The employer will calculate the stock price as the lower between the offering date or the purchase date.

Eligibility

Offering periods are generally six months, twice per year though some companies have shorter periods of 1-3 months or as long as 18 months.

An employee cannot participate in a plan if they own 5% or more of company shares.

Companies may require that an employee work at the company for a specific duration, such as one year, before participating in the plan.

The ESPP may exclude contractors, highly compensated employees, and part-time employees from participation.

Benefits For Employees

 

Easy To Purchase Stock

Companies make it relatively straightforward for all employees to participate in the plan, purchasing the stock through their paychecks on favorable terms assuming employees get a discount.

Potential for Higher Returns On Stock

ESPPs can provide employees increased compensation, especially if there is a 15% discount offered by the company, even if there is a look-back. Most plans have purchase periods of 6 months.

So your purchase price is discounted either at the beginning of the end of the period. Assume the stock price is $15 at the beginning of the purchase period. Let’s say it goes up to $20 at the end. The lower of the two-time frames is $15, but you will pay $12.75 per share at a 15% discount. If you sell your shares at $20, that is a 57% return. Not too shabby!

On the other hand, if the stock price stays at $15, you pay $12.75, and the market price for your stock remains $15, and you decide to sell. Your gain is not 15% but a  built-in profit of 17.6%. The calculation is ($15 less $12.75 purchase price)/$12.75=17.6%.

Dollar-Averaging

If the stock goes down, you can hold on to the shares or do dollar-averaging. Investors use the dollar-averaging strategy when they believe it is an opportunity to make purchases at lower prices, potentially reducing your cost basis. You should only do this if you remain comfortable with your company’s future and can afford more shares.

Favorable Tax Treatment

Contributions to the ESPP are deducted from your paycheck and taxed at ordinary rates like your salary. If your plan is qualified, you will be eligible for tax advantages if you hold the shares long enough according to IRS rules discussed above.

Stock Appreciation + Dividends + Long Term Holding = Rewarding

If you can afford to buy shares at a  successful company’s discount, holding for the long term may be beneficial. In addition to stock appreciation, your company may also pay dividends generating more income. If qualified, this income may receive a more favorable capital gain tax rate.

All stocks are risky but generally are in an asset class with higher returns than other securities such as money markets or bonds.  To reduce risk, make sure you have a diversified group of stocks besides the company shares to avoid being too concentrated.

Buying a stock at a discount through your employer’s stock purchase plan is an excellent way to begin investing and benefit from compounding growth.

Better Confidence And Control Over Financial Well-being

Employees positively benefited by buying company shares through an ESPP. Among the findings in the two year Fidelity study released in 2016, employees:

  • feel more in control over their financial well-being,
  • were less likely to borrow from their 401K retirement account,
  • showed improved productivity and morale at work; and
  •  held the shares they bought with a great sense of ownership.

The ESPP provides employees with a boost to earnings and a psychological benefit of feeling more valued. Workers tend to stay in companies longer when they are better compensated, and morale is strong. For companies, ESPPs are often an excellent recruitment and retention tool.

 Drawbacks

While employee participation in an ESPP has many benefits, notably increased compensation to their salary and feeling more valued as an employee, there are some drawbacks.

No Guarantees Of A Higher Stock Price

It is not predictable when or if the company stock price will rise above your purchase price. You are not required to sell your share at a predetermined price or time. However, you may want to cash out your shares for greater liquidity to buy a home or pay for your child’s college education.

Consider making only the purchases you can afford.

Concentration In One Stock Is Risky

Employees like buying their employer’s stock, especially when the company is doing well. However, be careful about having too much concentration in one stock when the company is paying your salary. Concentration in few stocks can be very risky. Companies go through downturns due to the economy, increased competition, increased regulation, management changes, and potential fraud.

Those that worked at companies like Worldcom and Enron received generous compensation, including discounted stock purchase plans. Employees were loyal to these companies, benefiting the companies with lower turnover. Many employees stayed on for many years, grateful in the knowledge that they owned many shares in those companies and would retire with significant net worth.

Enron and Worldcom filed for bankruptcy in late 2001-mid-2002, rendering their respective stocks virtually worthless. Many employees lost the vast majority of their savings and investments.

Diversification of your portfolio is important for all investors. You should own stocks in multiple industries and different asset classes, such as various bonds and real estate.

Final Thoughts

If offered by your employer, your employee stock purchase plan is a desirable benefit of your compensation plan. Participation in a qualified plan with a discount to the stock market price is a great way to earn incremental income, have tax advantages, and get a psychological boost at work. Consider buying shares you can afford, hold your shares for the long term, and diversify your investment portfolio.

The benefits outweigh the risks as long as your ownership of your company shares is not too concentrated. Thank you for reading!

Have you reviewed your company’s benefit plan? Do they offer an ESPP, and are you participating? Let us know about your plan. We would love to hear from you.

 

 

 

 

 

 

 

 

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