Saving and investing in your company’s Employee Stock Purchase Plan (ESPP) is on our list of permanent recommendations. An ESPP allows you to buy your employer’s stock at a discount of up to 15% or more of its current market value. You can then sell your ESPP shares when you receive them to capture the built-in investment gain.
Publicly-traded companies offer ESPPs to give their employees an opportunity to earn more. ESPPs help companies by creating incentives for employees to contribute to the company’s success, through and aligning their interests with other shareholders.
Regular Payroll Deductions
When enrolled in an ESPP, you buy shares of your company’s stock over time via regular deductions from your paycheck. These paycheck deductions do not reduce your taxable income—they are “after-tax” deductions. Your payroll deductions are collected during the offering period, which usually varies in length from six months to 24 months depending on the features of your company’s ESPP on the purchase date. At the end of the offering period, your company’s plan administrator buys shares of the company’s stock for you with your collected funds and deposits the shares to your account. The number of shares purchased is determined by the total monies collected from your paycheck deductions during the offering period divided by the purchase price on that date.
Discounted Purchase Price
The price you pay to buy shares depends on your company’s ESPP. It can range from market price on the purchase date to as low as 85% of market price for plans designed to meet certain tax rules.[i] Some plans also have a special feature called “lookback” pricing, which allows you to buy shares at a discount from the price at the beginning or end of the offering period, whichever is lower.[ii] Lookback pricing enables you to buy shares at a greater discount if the company’s stock price appreciates during the offering period.
For example, assume that the company stock price was $100 per share at the beginning of the offering period. Also assume that the stock price increased to $120 by the purchase date at the end of a 24-month offering period. With lookback pricing, the purchase price for your ESPP shares is equal to 85% of the lower number. Because the market price of the stock was lower on the first day of the offering period, your buy price would be 85% of $100, or $85 per share. This represents a discount of 29% from a market value of $120 on the purchase date.
Instead, if the company’s stock price dropped to $80 per share by the purchase date, your buy price would be 85% of $80, or $68. The buy price would then represent a discount of 15% from the market value. This demonstrates an important point: Even if the company’s stock price declines, the smallest possible discount on your share purchases would be 15% (for ESPPs that allow the maximum 15% discount).
The investment gain on your shares in this case is greater than the 15% discount at which you can buy shares. Your investment gain is equal to $80 minus $68, divided by $68, or 17.6%. If you sell your shares when you receive them, you will earn a 17.6% return on your investment, with little or no risk. This is the smallest investment return you can earn (again, for ESPPs that allow the maximum 15% discount).
Your investment gain will be even greater if your company’s stock price increases during the offering period. In the appreciated stock price case, you earned $120 minus $85, divided by $85, or 41.2%. The combined effects of buying at a 15% discount, lookback pricing, and rising stock price can lead to big gains in your ESPP account.
To contribute to your ESPP, you must wait until the start of the next offering period.
The structuring of offering periods varies from plan to plan and company to company. Some companies run ESPP offering periods one after another, in which case a new offering period begins at the end of the last offering period. Other companies run ESPPs with overlapping offering periods. Several offering periods, each with a different start date, are open at the same time.
Some ESPPs buy shares at intervals within the offering period called purchase periods. For example, if the offering period is 24 months, the ESPP may have four purchase periods. The purchase periods may end at six months, 12 months, 18 months, and 24 months. Other ESPPs may purchase shares only at the end of the offering period. Purchase periods within the offering period allow you to sell your investment sooner.
If your company’s ESPP is a tax-qualified plan, your tax treatment may be better if you hold your shares. With a tax-qualified plan, you report no income when shares are purchased in your account. You report income only when you sell the shares. The amount and type of income you earn depends on how long you hold your shares. The income you earn will either be compensation income or capital gains.
To receive favorable tax treatment, you must hold your shares for two years from the first day of the offering period and one year after shares are moved to your account. If you meet the holding period rule, then the compensation income you report is equal to the lesser of 1) the difference between the stock price on the date you sold your shares and the amount you paid to buy them, or 2) the difference between the market value of the shares on the first day of the offering period and the price you would have paid under the terms of the ESPP if you had bought shares that day.
The second part of the above calculation is what can allow you to pay lower tax by meeting the holding period rule. If you do not meet the holding period rule, your compensation income is equal to difference between the stock price on the purchase date and the amount you paid for the shares. When the stock price is appreciating, the purchase discount, (which is taxed as compensation income), will be lower when measured on the first day of the offering period rather than on the purchase date, resulting in lower taxable compensation income.
If your company’s ESPP is not a tax qualified plan, you report compensation income on the date shares are purchased. This income is equal to the difference between the market value of the shares on that day and the amount you paid for them.
1. We recommend selling your ESPP shares when you receive them.
By selling your shares immediately, you secure your built-in investment gain. At the same time, you remove any possibility that your investment can lose value if the stock price falls. In the ESPP, you bought stock at a discount, allowing your investment to step up in value without market risk. (In the office, we call this free money). If you hold your shares beyond the purchase date, you expose your investment to much more risk, with no way to earn a built-in investment gain.
You may consider holding your shares to receive better tax treatment. However, tax benefits for holding are difficult to calculate and they are also risky. The best option depends on the company’s stock price on the first day of the offering period, the purchase date, and the date you sell your shares. If you are holding shares, your sell date will be in the future. You cannot know ahead of time what your sell price will be. You will not know until then whether or not it would have been better to sell before the end of the holding period. By holding, you risk your shares losing value in exchange for uncertain tax benefits.
Some companies impose “black-out” periods surrounding earnings announcements and corporate transactions. During a black-out period, employees may not sell or buy the company’s stock. Companies enforce black-out periods to prevent insider trading either deliberate or inadvertent—by employees with inside information. You cannot sell your ESPP shares during black-out periods, which usually last a few days or weeks. Holding shares exposes your investment to market risk until you can sell them. Your company’s black-out practices should be a factor in your decision to enroll in the ESPP.
When you sell your shares, you get your cash back, which is then available to invest again in your company’s ESPP. By recirculating funds and reinvesting, you earn the built-in rate of return non-stop.
2. We recommend that you contribute the maximum amount possible to your ESPP.
Tax law limits your annual contributions to your company’s ESPP. The maximum annual contribution is $25,000, but, the contribution limit is calculated in a tricky way. The amount of stock purchased must have less than a $25,000 market value on the first day of the offering period. If you buy your shares at a discount, you will not be able to contribute the full $25,000. Your contribution amount will be less.
ESPPs also often have limits on the amount you can contribute as a percentage of your pay. A common limit is 10% of your annual compensation.
Saving and investing in an ESPP can strain your cash flow once you begin contributing, as you divert money you’re using for other purposes to the ESPP. But once your first offering (or purchase period) ends, you can sell your shares and get your money back. Your sale proceeds include built-in gain and will be more than your contributions. You now have cash to reinvest your original contribution back into the ESPP, and you can also add the funds from built-in gain to your long-term investment portfolio. Affirmatively, you can use these funds as extra income to meet living expenses.
Most ESPPs will automatically enroll you in the next offering period unless you opt out, so you can continue taking advantage of this great benefit with little effort. Your total cash commitment is one offering period (or purchase period) of contributions.
The Silicon Valley chapter of the National Association of Stock Plan Professionals found that ESPP participation in northern California is the highest in the nation. Almost 60% of companies in northern California report employee ESPP participation rates of 61% to 90%. Only 20% of companies in the rest of the country report participation rates this high. They attribute this difference to generous features including lookback pricing and 24-month offering periods.[iii] If your company’s ESPP has great features like these as well as the maximum 15% purchase discount, consider enrolling and contributing as much as you can.
[i] Tax qualified ESPPs meet the requirements and receive the special treatment of Internal Revenue Code section 423. These plans are sometimes referred to as Section 423 plans.
[ii] Lookback pricing is allowed for tax qualified, Section 423 plans.
[iii] NASPP Blog, Silicon Valley vs. the Nation, March 3, 2015.