Last time we covered Restricted Stock Units (RSUs). This week I will talk about another common type of stock compensations offered by many companies nowadays - Employee Stock Purchase Plans (ESPPs).
Basically, ESPP is a stock compensation plan offered by a company that permits employees to purchase the company's stock using after-tax payroll deductions, often at a discount. Unlike RSUs, ESPPs are more like 401(k) plans which you can decide whether you want to participate and how much you would like to contribute to the program. Here are five things I think you need to know about your company's ESPP.
1. Section 423/ Qualified ESPP or not
First of all, you need to figure out whether your ESPP is a Section 423/ Qualified plan or not. An ESPP meeting certain requirements under Section 423 of the Internal Revenue Code receives some favorable tax treatments which will be covered in details later. Since most of ESPPs are Section 423 plans, I will mainly focus on this type of ESPP here.
2. Look-back provision
A regular ESPP usually allows you to purchase your company's stock at a discounted price based on the market price at the time of purchase. Some Section 423 ESPPs offer the discount based on either the market price of your company's stock at the beginning of the offering period or at the end of the purchase period, whichever is lower. This great feature is often called the look-back provision. For example, assuming your company's ESPP offers a 15% discount, your company's stock price was $10 per share on the offering date and $20 per share on the purchase date. Your actual purchase price would be $17 per share under a regular ESPP without the look-back provision and $8.5 per share under a Section 423 ESPP with the look-back provision.
3. Discount VS. Return
The maximum discount allowed in a Section 423 ESPP is 15%. However, your actual return is actually higher. For the same example above, if your ESPP doesn't have a lookback feature, your before-tax return would be 17.65% = ($20-$17)/$17 if you sell the stock right away. If the plan has a lookback feature, your before-tax return would be 135.29% = ($20-$8.5)/$8.5. In other words, the minimum before-tax return you can get from an ESPP with 15% discount is 17.65%. Keep this in mind when considering whether to participate in your specific ESPP.
4. Contribution limits
The Internal Revenue Code imposes a limit on how much worth of stocks a participant can buy in a Section 423 ESPP which is $25,000 a year in general. The stock price is based on the market price of the stock on the first day of the offering period rather than the purchased date. For the same example above, the maximum number of shares you can purchase is 2,500 = $25,000/$10. In other words, you can actually purchase up to $42,500 = 2,500*$17 worth of stocks without lookback provision or $21,250 = 2,500*$8.5 worth of stocks with lookback provision.
Your company has right to set a lower limit on its ESPP in the form of a specific dollar amount, a percentage of your payroll deduction, or a number of shares. Any overfunded money will be either returned to you or carried forward to the next purchase period if you choose.
Participants in Section 423 ESPPs receive two special tax treatments. First of which is that unlike Nonqualified ESPPs, you are taxed only at the sale, not at the purchase. In other words, you can control the timing of taxation. Second of which is that you can get favorable long-term capital gains treatment in certain cases if you hold the stocks for more than one year from the purchase date and more than two years from the offering date. Let's take a look at two different scenarios for the same example we used above. Tax treatments on ESPPs with or without a lookback provision are the same.
In the first scenario, let's assume you sold the stock at $30 per share.
For an ESPP with a look-back provision, if you meet the holding period requirement, $1.5 (the lesser of discount based on the market price on the first day of offering and the actual gain) = $10-$8.5 will be taxed as ordinary income and $20 = $30-($8.5+$1.5) will be taxed as long-term capital gains. If you don't meet the holding period requirement, $11.5 = $20 (market price on the purchase date) -$8.5(purchase price) will be taxed as ordinary income and $10 = $30-($8.5+$11.5) will be taxed as short-term or long-term capital gains, depending on the holding period.
In the second scenario, let's assume you sold the stock at $5 per share.
For an ESPP with a look-back provision, if you meet the holding period requirement, $0 (the actual gain is $-3.5 = $5-$8.5) will be taxed as ordinary income and $-3.5 = $5-$8.5 will be treated as long-term capital losses. If you don't meet the holding period requirement, $11.5 = $20-$8.5 will be taxed as ordinary income and $-15 = $5-($8.5+$11.5) will be treated as short-term or long-term capital losses, depending on the holding period.
Tax is a very important factor in determining the timing of the disposition of your shares.
In summary, like a 401(k) plan with employer match, a Section 423 ESPP with a discount is a no-brainer for people who don't need the money for daily living. And like other types of stock compensations, ESPPs are very company specific. Each plan can have some special features or provisions which are unique to others and not covered in this post. I recommend you read your plan document thoroughly, bring any questions to your HR department, or even consult outside professionals if necessary to help you make informed financial decisions and avoid any unintended consequences.