How to Manage Your ESPP Plan

How disqualifying and qualifying positions can have a big impact on your wealth.

ESPP at a glance

An Employee Stock Purchase Plan (ESPP) provides employees an option to purchase stock in the company they work for at a discount below market price. This can present a unique opportunity to employees, as they are able to purchase shares at prices not available to the public. Understanding how these plans work, including the tax implications, will allow an individual to make an educated decision on whether to participate in the plan and how much to invest.

How it works

Employees can contribute to an ESPP through after-tax payroll deductions during a period referred to as the offering period. This period occurs between the offering date of the ESPP and the purchase date.  Some offering periods will contain several purchase dates in which shares of stock can be purchased. Prior to commencement of the offering period, an employee will decide on the amounts to contribute to the ESPP. This decision typically occurs during an organization’s enrollment period. The discount rate for the stock purchase depends on the details of the specific plan, but on average is  about 10-15%. If the plan contains what is known as a lookback provision, then the discount for the shares is calculated on the lesser of the market price of the stock at the beginning, end, or any point during the offering period. Again, check you plan for how your plan applies the discount.

Let’s see how this works using an example.

Jeff decides to sign up for his employer’s ESPP during the enrollment period which occurs in October. The ESPP offering period is defined as January 1st through June 30th, and Jeff elects to have $50 deducted from each of the twelve paychecks he will receive during this six-month period. On July 1st after the offering period has concluded, the company uses the $600 total that Jeff has contributed to purchase stock in the company on his behalf at a 15% discount. The market price on the purchase date is $53 and the market price at the start of the offering period was $47. Applying the lookback provision, the discount is calculated using the initial offering period market price of $47 which results in shares being purchased for Jeff at a discounted price of $40 each. Jeff now owns 15 shares of stock in his company which has a current market value of $795 ($53 X 15).

In addition to understanding how the purchase takes place in an ESPP, it is essential to understand how this transaction is treated from a tax perspective.

Qualifying versus Disqualifying Positions and Tax Implications

At the time the shares are purchased, there are no taxes due under an ESPP. Instead, a tax liability is generated when the shares are sold. Under both qualifying and disqualifying positions, the difference between the lookback price and the discounted price the participant receives the shares for is taxed as compensation income using ordinary income tax rates.

A qualifying position in an ESPP is one where the shares are held for at least two years following the offering date, and at least one year following the purchase date. This position results in favorable tax treatment when the shares are sold. A disqualifying position, however, occurs when shares are sold prior to this defined timeline. With a qualifying position, additional gains realized above the lookback price at the conclusion of the offering period are taxed at the long-term capital gains rate. Under a disqualifying position, these additional gains are taxed under ordinary income tax rates. Let’s use an example to illustrate the impact of this.

Upon receiving the shares purchased as part of his employer’s ESPP, the total difference between the market price at the end of the offering period and the price Jeff receives the shares for is $13 ($53 - $40). Jeff is not responsible for paying taxes on this gain at this time, and he will only incur a tax liability when these shares are sold. Let’s assume the shares grow from a market price of $53 to $63 over a six month period, and Jeff decides to sell the shares at this time after holding them for six months. The $13 per share gain he received as a result of the discount is taxed as ordinary income, and his additional gain of $10 is also taxed as ordinary income since the shares were not held for the required period to be classified as a qualifying position. Assuming Jeff’s ordinary income tax rate is 35% (Federal and State), he pays a total of $8 in taxes per share (total gain of $23 X 35%).

Alternatively, if Jeff decides to hold the shares for a period of time which exceeds two years since the offer date and one year since the purchase date, his initial discount benefit will still be taxed under ordinary income tax rates however the additional market growth of the shares will be taxed at the long-term capital gains tax rate of either 15% or 20%. Assuming a market price of $63 at the time the shares are sold and Jeff’s capital gains rate is 15%, he pays a total of $4.9 in taxes at the time the shares are sold ($7 X 35% combined with $16 X 15%).

As discussed in this example, the tax implications of a qualifying position versus an unqualifying position can be substantial. Jeff’s tax bill just over $3 less per share which equates to over 20% more profit as a result of meeting the requirements for a qualifying position. These are savings he can use to continue to grow his wealth.

Other Considerations

In addition to understanding qualifying versus disqualifying positions along with the tax implications, there are several other considerations to keep in mind in deciding whether to participate in an ESPP. Understanding the state of the company and future plans is a key aspect in determining whether an ESPP is a good fit. The same way an investor would analyze a company to determine whether to purchase shares, ESPP participants should complete a similar analysis of the future growth prospects of the organization. Diversification is also a key aspect to consider, as investing a substantial portion of a portfolio into one security drives increased risk. With these factors considered, participating in an ESPP can be a great opportunity to participate in the profitable growth of a company at a discounted purchase price.

Additionally, due to the fact that these funds are invested in a non-retirement account, they can be used to fund purchases such as a home, car, or other expenses. Understanding an ESPP, along with the differences between qualifying and disqualifying positions, and utilizing these plans effectively can make a meaningful impact on an individual’s long-term wealth.