Employee Stock Purchase Plans are one of the most underutilized forms of equity compensation offered to employees from startup tech companies to established legacy companies. Our ESPP Guide will help you understand what ESPPs are, how they are taxed, how you can include your ESPP in your financial plan, and what happens to your ESPP when you leave your job.

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What are ESPPs?

Employer Stock Purchase Plans (sometimes referred to as Employee Share Purchase Plans) or ESPPs are a unique form of equity compensation that function somewhat differently from other forms of equity compensation. These plans are designed to allow employees to regularly buy company stock at a discounted rate. The goal of these plans is to encourage employee investment in the organization and incentivize them toward company growth.

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How do ESPPs work?

Even though planning steps may be complex, ESPPs operate on a fairly simple premise. Employees contribute a portion of their salary to the plan, usually through payroll deductions, and during specific purchase periods, the accumulated funds are used to buy company shares at a discounted price. The discount, often up to 15% of the market price, provides employees with an affordable opportunity to invest in their company's stock. 

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There are two types of Employee Stock Purchase Plans. Qualified ESPPs and Non-Qualified ESPPs. Qualified ESPPs follow guidelines set by the IRS and offer tax advantages to those that follow appropriate rules. Non-Qualified ESPPs don’t offer the same tax advantages but the plans can be far more flexible since they are not required to follow the same IRS guidelines. Qualified ESPPs are the far more common type.

How are ESPPs Taxed?

The main focus of questions and financial planning for ESPPs tends to be around taxes. Since the tax treatment varies between qualified and non-qualified ESPPs we will review them separately. You can also take a look at our free resource, “WILL I HAVE TO PAY TAX ON MY QUALIFIED ESPP?” below to help make the process more clear.

Taxation of Non-Qualified ESPPs

While the terms of your plan (ie who qualifies, the discount amount and how much you’re allowed to buy) will vary between employers, the mechanics of a Non-Qualified Employee Stock Purchase Plan are fairly straightforward. You will owe taxes on the discount you receive on the stock as ordinary income at the time you purchase it. This discount is also called the “spread”. Taxes are generally withheld at the time you make the purchase. 

For shares you purchase, you will also owe taxes at the time you sell them in the form of Short-Term or Long-Term Capital Gains depending on how long you’ve owned the shares. Shares sold at a loss will similarly be treated as Short-Term or Long-Term Capital Losses.

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Taxation of Qualified ESPPs

The tax advantages of Qualified ESPPs make them more complicated but very valuable. Under a Qualified Employer Stock Purchase Plan, no taxes are owed at the time the shares are purchased. From there, employees have a few options outlined below:

• If you hold the shares for 2 years from the grant date (the start of the offering period) and more than 1 year from the exercise date (end of the offering period) you will owe income taxes on the discount you received (called the “spread” or the “bargain element”) at the time you sell*. Other remaining gains will be taxed as long-term gains.**

*Note that if your discount was more than the profit you made on the sale of your shares, that amount will be tax as ordinary income instead
**Note that your cost basis in the shares will be adjusted to include the amount taxed as ordinary income.

• If you do not hold the shares for the required time period above you will owe ordinary income taxes on the discount you received at the time you sell. Additionally, gains and losses on the shares will be taxed as Short-Term or Long-Term Capital Gains depending on how long you’ve held the shares.you’d 

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Making the Most of Your ESPP

We call planning for your Employee Stock Purchase Plan Strategic Planning. That’s because a good plan means looking at your goals for this year as well as into the future and it means considering multiple areas of your financial life like income, expenses, taxes and personal goals. Here are a few key planning strategies to consider for your ESPP:

• Understand Your ESPP -  While it may seem trivial, taking the time to review the terms, dates, and features of your plan will allow you to plan your steps well
• Consider the Lookback Period - If your plan has a “lookback provision” you will have the ability to get the lowest possible price for your employee share purchase
• Take a Global View - As with any equity compensation, take your whole portfolio into account with what stock you plan to buy and hold. Having too much of your net worth tied to a single stock (of a company that also happens to control your paycheck) can be extremely risky
• Take the Money? - Many employees ask, “how much should I contribute to my Employee Stock Purchase Plan?”. This question is valid but is different from, “how much of my Employer Stock should I own?”. Employees may be (rightly) concerned about owning too much of their employer stock but that fear may mean you miss a simple planning opportunity for your ESPP, just taking the money. If you contribute to your ESPP, purchase shares up to your company limit, and immediately sell you will not receive any tax benefits but you will effectively receive a bonus in the form of the discount on the shares you’ve sold. You will be taxed on that discount but, if sold immediately, will not face additional taxes on the sale since there would be no gain or loss.

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What Happens to my ESPP if I leave or get laid off?

As always, your plan document will give you the most specific information on what happens to your Employee Stock Purchase Plan (ESPP) if you leave but generally there are two possibilities if you are laid off:

• Any money you’ve contributed to the plan but hasn’t been used to buy shares will be refunded to you. This money was already taxed and is always yours.
• Any shares you’ve purchased are also yours to keep but if you sell them you will need to review your situation to determine what taxes you’ll owe. It’s possible you’ll need to transfer these shares from the plan your employer structured into an account you hold directly.

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Good planning around your Employee Stock Purchase Plan (ESPP)  means not only understanding what it is, how it works, and how it’s taxed but also how it fits into your personal goals and plans in the event of life changes like moving jobs.

As financial planners who specialize in working with equity compensation, we have seen how important it is to have a professional on your team to coordinate how you build and preserve wealth so you can lower your stress, pay less in taxes, and focus on reaching your goals. Schedule an Intro Call to get a better understanding of how your ESPP fits into your plan to build wealth.

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