If I offered to sell you a $100 bill for $85, would you buy it? A no-brainer, right?
The popular employee compensation program, known as an Employee Stock Purchase Plan (ESPP) allows you to do just this.
In this article, we will outline how these plans work, where you have an advantage (and where you don’t), so you can tip the odds in your favor and hopefully always get that $100 bill at a discount.
How ESPP Plans Work
Offered by most publicly traded companies, ESPP plans are an excellent way for employees to purchase stock in their employer at a discount. And it’s this discount that is the most significant advantage of ESPP plans.
Under the program, employees can elect to defer salary and bonus after-tax up to $25,000 per year. At the end of a subscription period, typically every six months, this money is used to purchase shares at a discount of up to 15%. This discount is often applied to a lookback period where shares are purchased based on the lower price at the beginning of the enrollment period (the Offering or Grant date) or the end of the period (the Exercise date or Purchase date).
An ESPP is a fairly straightforward program that only gets complicated when introducing taxation into the equation. Under an ESPP, taxes are not due until selling the shares but the tax treatment works in two different ways depending on if the sale results in a Qualifying or Disqualifying disposition.
- The two types of Dispositions are:
- Qualifying: Shares held for two years from the grant date and one year from the purchase date.
- Disqualifying: Not held for two years from the grant date or one year from the purchase date.
If shares are sold under a Qualifying disposition, a portion of the discounted purchase price is treated as income while the remaining gain (if any) is tax at lower long-term capital gains tax rates. However, in order to lock in the free money, which could be lost if the stock price falls while waiting for the disposition to become qualified, we typically recommend selling the share as soon as possible.
The portion taxed as compensation income is:
- If Qualifying: Lesser of; Discount on shares purchased as of the grant date or purchase/exercise date.
- If Disqualifying: Market Value, on the purchase date, less the discounted purchase price.
If your shares rise sharply between the beginning of the offer period and the exercise date, this results in much of the gain taxed at capital gains rates; however, again, this leaves you subject to market movements on the stock for an additional year.
For more on the tax treatment, including examples, see here.
As mentioned above, the primary advantage to exploit in an ESPP plan is the 15% discount. Shares can be sold immediately (known as a QuickSale) and locking in a minimum 18% pre-tax gain on our money. With a lookback period, we are always getting a minimum of 15% off the market price at the date of purchase and sometimes more if the stock price has increased from the beginning of the purchase period. The payoff profile assuming a $10 price at the beginning of the offering period can be seen in the chart below.
Source: Cordant’s calculations
- ESPP plans allow employees to purchase stock in their employer at a discount of up to 15%
- Because of this discount, employees should consider contributing as much as they can afford to defer from their paychecks into the ESPP plan
- However, because the tax benefits of holding the shares for two years from the grant date can easily be reversed from a falling stock price, a QuickSale disposition of stock on the exercise date (and locking in a minimum 18% pre-tax gain) is often the best way to go.
As always, if we can be of any help or if you would like to discuss your ESPP strategy, you can get in touch here.
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