Employees at both startups and well-established public companies alike may receive opportunities to contribute towards, or engage in, company stock plans. These plans are generally referred to as equity compensation plans. An equity compensation plan allows for employees to participate in the performance of their company stock, typically via some benefit or advantage not available to the general investing public. The most common forms of equity compensation are Restricted Stock or Restricted Stock Units (RSUs), Nonqualified Stock Options (NSOs or NQSOs), Incentive Stock Options (ISOs), Performance Shares, and Employee Stock Purchase Plans (ESPP) - among others. Each plan has it’s own pros and cons, but perhaps none are as underutilized yet offer such certain benefits as the ESPP. Below we go through the basics of an ESPP, some of the tax considerations, some thoughts for how to get the most out of this type of equity compensation plan, and other things to keep in mind with this unique plan.

What is an ESPP?

An Employee Stock Purchase Plan (ESPP) is a company stock benefit plan in which employees are granted the option to contribute a portion of their compensation towards purchasing company stock at a discount. The most common form of ESPP is what may be referred to as a §423 Plan. In a §423 Plan, an employee is permitted to contribute between 1% and 15% of their earnings (most commonly after-tax) each paycheck towards an account that will be used to purchase company stock at pre-defined intervals - sometimes referred to as “purchase dates”. Contributions are made during an “offering period”, yet stock is only actually purchased on the pre-established “purchase dates” within, or at the end of, the offering period. An offering period can span varying amounts of time, but most offering periods have several purchase dates - commonly at equal six-month intervals. Limitations typically exist to permit a maximum of $25,000 of employer stock to be purchased in a single tax-year by a single employee, though unique plan designs may be able to accommodate separate limitations and rules.

What is the benefit of an ESPP? Should you participate?

ESPPs are attractive because they allow employees to purchase shares of company stock for less than what they (or the investing public) would otherwise pay to acquire the same shares. Most commonly, and for purposes of our discussion, an ESPP often offers a discount of up to 15% on the fair market value of the stock. The discount is most often applied in one of a few ways; by applying a discount on the lesser of fair market value at the beginning of the offering period or purchase date, by applying the discount directly to the purchase date price, or in some cases applying the discount to the lowest closing price of the stock during the purchase period. Some combination of these situations is typically built into a workplace ESPP when determining at what price company stock is acquired.

Depending on the ESPP in place, there can significant opportunities in two senses. First, and most obviously, a plan participant can acquire shares at a 15% discount from a price that others would have been able to buy it at. Second, a participant is not just acquiring shares at a 15% discount, in many cases they are acquiring shares at a discount with the benefit also of doing so at a favorable price. For example, if a plan permits acquiring shares at the lowest closing stock price during an offering period, an employee has locked in buying at a low-point, while ALSO receiving an additional price discount of possibly up to 15%. When combined with one another, these benefits can lead to an attractive opportunity for participating employees.

Should you participate in an ESPP if it is made available to you through work? The short answer is yes - the vast majority of the time. To the extent someone can afford to contribute, it is generally a good idea to participate. You are acquiring shares at a discounted price otherwise not available. If done correctly, you may be able assure yourself some level of return.

The primary reasons you may NOT want to participate are the following; your cash-flow situation does not allow you to participate (e.g. you need the money from your paycheck now rather than contributing to this plan to buy stock), your plan restricts when you may sell your ESPP acquired shares once you’ve purchased them, you have high pre-existing company stock exposure and face trading restrictions and blackout periods, or you have not considered all other savings vehicles (are you maximing your 401(k) or other workplace benefits?).

Tax considerations of ESPP acquired shares

The most favorable tax outcome when dealing with ESPP acquired shares is typically the eventual sale of the shares through a qualifying disposition. This is an important distinction because while the tax rules of ESPP can be complex and must be navigated carefully, the most favorable tax outcome may not be the most favorable overall outcome when weighing what to do with ESPP shares.

A qualifying disposition is one in which the employee holds the stock from an ESPP longer than one-year from when it was acquired (purchase date) and more than two-years from when the option was granted (typically the beginning of the offering period). The benefit to a qualifying disposition is the appreciation above the purchase price can qualifying for long-term capital gain tax treatment, when that appreciated gain is realized through sale. The higher the tax bracket, the more significant the impact and desirable the tax savings.

If the one-year from purchase and two-years from grant rule is not met, a disqualifying disposition is considered to have occurred (since it fails to meet the criteria of a qualifying disposition above). Selling ESPP acquired shares always leads to the existing discount portion at the time of sale resulting in ordinary income treatment for tax purposes. A disqualifying disposition however also produces ordinary income on the appreciated position - a less desirable tax outcome to most. For those in higher income tax-brackets this will have a larger impact and becomes less and less desirable from a pure tax perspective.

Still the tax treatment can vary significantly depending on the classification of the disposition as well as the price movement of the stock between grant date, acquisition date and sale or transfer date. Rarely is the tax analysis static with regards to ESPP and with varying rules among plans with regards to how the discount is applied, it is important that ESPP participants work with a qualified tax and financial professional who understands these rules.

How to get the most out of your ESPP

As we touched on earlier, most of the time an ESPP is a good idea if it’s available to you. Before jumping into the detailed investment, risk and tax planning considerations of what to do with ESPP-acquired stock, the first step is to determine what you can afford to contribute towards this plan. While you may be allowed to contribute approximately $25,000 a year to this plan, not everyone can afford this. Working through a cash-flow projection can tell you what may be feasible given your means and standard of living. Perhaps contributing makes sense, but not at the maximum amount permitted by your plan or the IRS. Consider your entire picture, from a budgetary standpoint as well as any other company stock exposure you maybe already have. Knowing the investment, liquidity and concentration risk you are assuming is a key consideration.

To enjoy the most certain gain from your ESPP - the best choice (depending on your plan rules) is to consider selling your shares as soon as you acquire them. It can be tempting to want to hold the stock for a year to attain the long-term capital gains treatment, however this approach does not provide any certainty as the share price can move considerably over a year after purchase. Instead, consider that an ESPP uniquely allows plan participants to already have captured a 15% automatic pre-tax return by selling on the purchase date. While the entire discount will be taxed as ordinary income, even at a top combined effective tax rate of 50%, a participant is able to lock-in an approximate 7.5% automatic return with this approach. This entire amount is considered compensation income rather than investment income which can be an important factor in some instances, depending on each investor’s unique tax situation. Any rise in the price over the purchase price would have been short-term capital gain (investment income) taxed at ordinary income rates.

Consider the following example. You make $150,000/year in salary and participate in an ESPP. Your ESPP contributions are at 15% pre-tax earnings per paycheck. In total this comes to $22,500 of contributions per year. If 30% all-in withholding is assumed (federal, state and applicable payroll taxes) your amount going towards purchasing shares in the ESPP would be $15,750. If during the offering period the stock price/share opens at $100 to start, reaches $110 for the first purchase date and then continues up to $120 for a second purchase date, under the most basic type of ESPP where the lower of the beginning or ending price for a purchase period is used to determine a 15% discount, you would have purchased 92.65 shares ($7,875/$85) on the first purchase date and 84.22 shares ($7,875/$93.5) on the second purchase date. If the plan allows it, and there are no other employer trading restrictions, if both sets of shares were sold immediately after purchase you would walk away with $10,191.50 and $10,106.40 respectively before tax. Assuming the same 30% tax rate is applied to the discount a total of $1,364.37 would be due from the sales. In the end, you would have $18,933.53. This represents a simple total after-tax return of about 20.2% by taking advantage of the discount. If the $22,500 had not been contributed to the plan and instead taken as normal salary, it would have resulted in $15,750. A difference of nearly $3,200. If this approach is adopted over many periods and with varying prices, the benefits can become substantial.

But what if the price drops?  Let’s continue our example but assume the price drops to $90 and $80 over the same two purchase periods.  Shares would be purchased at $76.50 and $68 for 102.94 and 115.8 shares, respectively.  If sold immediately again, this creates $1,945 of combined additional after-tax wealth more than if just $15,750 had been received as after-tax salary instead. This is a simple total return of 12.35%, despite the stock falling 10% the first six months, another 11% the next six months and 20% for the year as a whole.

Final Thoughts

ESPPs offer distinct benefits and advantages that other employee stock plans lack, yet it is still often misunderstood, underutilized or mismanaged by employees. It can offer a unique advantage to buy company stock at a discount and potentially assure some level of certain return. Despite all of the benefits of an ESPP, how appropriate it is for an individual investor should be examined on a case-by-case basis within the context of a financial plan. Below are some of our final thoughts.

• In some instances it may be worthwhile to consider holding a portion of your ESPP acquired stock to participate directly in the longer-term upside of the company’s stock price, after having acquired it for so cheap relative to market price. If the price is very depressed, it may be worth hanging on to some ESPP shares a little longer once you’ve acquired them. You have been acquiring more shares at this lower price than you would have had prices risen during the offering period. Whether this is the appropriate approach depends on many individual and company-related financial factors.

• While increased returns through an ESPP seem great, there is an opportunity cost to consider. Participating a large amount in an ESPP may come at the cost of the ability to meet another financial need if an opportunity presents itself where available cash would have been more desirable. Participating in an ESPP is an active choice to defer your ability to use the cash that otherwise would have been received as salary.

• Understand when and how often contribution elections can be changed. Many ESPPs may only allow a participant to change their election once or twice per period. Does this work for your needs?

• Depending on a complete and customized financial plan, ESPP participants should considering mixing their ESPP contributions with 401(k) elections.  It is always smart to put as much as one reasonably can into your 401(k) but it could be beneficial to try and at least contribute the same or a similar amount into an ESPP. Effectively, don’t sacrifice one for the other, if you must choose between one or strike a mix between them, it is best to do so in accordance a well-designed financial plan. 

• In the end, no matter how good the deal of an ESPP seems, an employee should ensure they are properly diversified and that stock acquired via ESPP does not become an overly material portion of an employee’s wealth and invested funds.   An ESPP participant is already risking some of their wealth simply by investing in the stock of a company where they already work and earn a salary. If they are not diligent and actually follow through with a sales plan (if that was the initial intent) then a concentrated position may occur somewhat rapidly.

• Ensure that the stock being acquired through an ESPP is liquid enough to sell when desired. Liquidity may be determine by the market the stock trades in or what the average daily trade volume is, among other considerations. Further, if the employee faces restrictions on when and how much they can sell, it can increase the risk being assumed by contributing to an ESPP.

• ESPPs differ from more common plans such as RSUs or Nonqualified Stock Options. If an employee is involved in several of these plans, be sure to understand how they each work and when they may or may not be appropriate.

Overall, with the uncertainty surrounding future single stock volatility and potential concentration risk, having a well-developed and methodical plan to oversee an ESPP can produce significant long-term value. Rarely, however, is analysis with ESPP’s simply black and white. There are many simultaneously competing investment, tax and risk management considerations that need to be analyzed. As independent wealth advisors with no conflicting incentives we believe that if consistent with an existing comprehensive financial plan’s parameters, that engaging in an ESPP is a wise approach. To learn more or speak with us about your ESPP, other company stock plans or comprehensive wealth management and financial planning considerations, we encourage you to contact us.

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