Does your company offer an employee stock purchase plan or ESPP?
An ESPP can be a great way to get a discounted deal on your company’s stock. And if your company does well, the stock may increase in value. On the other hand, you'll want to be careful about overloading on your company’s stock, lest it loses value or your company suffers financially - you could find yourself with worthless stock and in extreme circumstances, even jobless. In addition, ESPPs can have some tax surprises if you don’t take the time to understand how they work. It’s important to be planful, particularly around when to sell your ESPP shares.
What is an Employee Stock Purchase Plan?
An Employee Stock Purchase Plan is an employer-sponsored program that allows employees to buy company shares at a discount. ESPPs are more common among publicly listed companies although private companies may also offer them.
Typically, an employer will designate an upfront enrollment period during which you have to decide whether to enroll. During this period, you’ll need to decide how much of your paycheck you will devote to your ESPP contribution. Most plans will allow you to contribute up to 10% of your salary. These contributions will be first subject to income tax and then can be used to buy shares. The withholdings from your paycheck to buy the shares will accrue until your employer uses the funds to purchase company shares on the designated purchase date.
Your employer will purchase the stocks on your behalf at a discount of up to 15% based on the market price on the purchase date. If there is a “lookback provision” in your company’s ESPP, the discount will be applied to the fair market value of the stock on the first day of the offering period or the purchase date, whichever is lower.
For example, say your company’s ESPP gives you the option to purchase stocks at a 15% discount. The stock value was $10 at the end of the day on the offer date and at $13 at the purchase date.
If there is no lookback provision, you can purchase the stock through ESPP at $11.05 (85% of $13).
If there is a lookback provision, the discount will apply to the $10 price from the offer date (the lower stock value). Hence, you can purchase the stock at $8.50 ($10 multiplied by 85%). This is a better deal because now you purchased $13 stock for $8.50 as opposed to $10! Either way it is great because you got discounted stock.
Qualified vs Non-Qualified ESPP
ESPP plans can come in two flavors: Qualified and Non-Qualified. Qualified plans are ESPP plans that meet the requirements in Section 423 of the Internal Revenue Code. A qualified ESPP plan requires:
Offering period not exceeding 27 months
Limitation of ESPP enrollment to company employees
Maximum discount of 15%
Annual investment cap of $25,000 per employee
Some companies limit participation to ESPP to full-time employees with a tenure of at least one or two years; other companies allow you to participate starting on your first day.
Qualified plans are eligible for preferential tax treatment which is why most companies maintain a Qualified ESPP. A qualified plan allows you to defer the tax on the discount you received for your ESPP contributions. You pay this tax when you sell your shares.
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How to Sell ESPP Shares
Most plans allow you to sell ESPP shares anytime once you own them. It is possible that your company may restrict or require approval on the sale of certain securities. Check with your human resources or compliance department to be sure. If there are no restrictions, you may sell the shares at any time once you own them.
The Best Time to Sell Your ESPP Shares Depends on Your Goals
If you are risk-averse, you might consider selling your ESPP shares right away so you don’t have overexposure in one stock, particularly that of your own employer. ESPP shares can put you in an overexposed position. If the stock value goes down, you may suffer losses and in extreme cases, even lose your job.
However, selling too early may have unfavorable tax consequences compared to holding the stock for a longer period of time.
To Maximize Tax Benefits, Wait Until You Meet the Requirements for a Qualifying ESPP Disposition
Taxes on your ESPP transaction will depend on whether the sale is a qualifying disposition or not. The sale will be considered a qualifying disposition if it meets both of these criteria:
You held the stocks for at least one year from the PURCHASE date.
You held the stocks for at least two years from the OFFERING date.
What is an offering date (or grant date)?
The offering date refers to the start of the offer period during which your company starts to deduct ESPP contributions from your paycheck. The offering date is also called the grant date. The purchase date, which is when the company buys its own shares at a discounted rate on behalf of employees, marks the end of the offer period.
Here’s An Example:
Stock Price on Offering Date
$15 Per Share
Stock Price on Purchase Date
$20 Per Share
Discount Your Employer Offers You On Stock Through ESPP
If Your Employer Has Lookback Provision, the Price You Pay Will Be
$12.75 Per Share
Ordinary Income Tax Owed On
Long Term Capital Gains Tax Owed On
Short Term Capital Gains Tax Owed On
If You Sell At $28
>2 Years After the Offering / Grant Date and >1 Year After Purchase Date
$15 - $12.75 =
$2.25 Per Share
$28 - $15 =
$13 Per Share
If You Sell at $28
<2 Years After the Offering / Grant Date and >1 Year After Purchase Date
$20 - $12.75 =
$7.25 Per Share
$28 - $20 =
$8 Per Share
If You Sell At $28
<1 Year After Purchase Date and <2 Years After Offering / Grant Date
$20 - $12.75 =
$7.25 Per Share
$28 - $20 =
$8 Per Share
Short term capital gains are taxed as ordinary income.
Long term capital gains tax rates are 0%, 15%, or 20% depending on your ordinary income.
If there are any commission or transaction costs, you can deduct this from the selling price of your ESPP share.
Strange Tax Consequences Can Result From ESPPs With Sudden Sharp Declines in Value
When stock prices decline after the purchase date and the sale is a disqualifying disposition, you may end up paying taxes on a phantom income.
For a disqualifying disposition, you have to pay ordinary income tax on the difference between the purchase price and the market value of the stock at the closing date, even if the stock is now worth less than you bought it for.
Not that there are instances where you may have to pay tax from your ESPP shares even if you sold the shares at a loss because you are taxed separately on the discount provided by your employer and the later stock sale. This is known as phantom income.
Using the example above, say that you later sell the shares for $12 per share during a really bad week that is 1.5 years after the offering date and 1 year after the purchase date. You will still have to pay ordinary income taxes on $7.25 per share. You will also have a capital loss of $8 ($20 minus $12) per share. You can use these losses to offset any capital gains or even to offset $3,000 per year of your ordinary income.
If your capital loss is greater than $3K, the extra losses will be carried forward. In the next tax year, you can offset the carry forward loss with capital gains. After exhausting the capital gains, you can deduct up to $3K from your ordinary income. The carry forward can go indefinitely until you exhaust the capital loss.
Had this been a qualifying disposition (at least 2 years after the offering date) you would not owe income taxes on your ESPP contribution or this transaction and you would only have a loss.
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Tax Forms You Will Receive From Your ESPP
Ordinary income from the ESPP is usually reported on Box 1 (Wages, Tips, and Other Compensation) of your W-2 form. Provide these forms to your tax preparer so that they can include your ESPP transactions in your taxes. You should also receive Form 3922 containing the purchase price of the ESPP. If you sold your shares through a broker, you should also receive Form 1099-B Proceeds from Broker and Barter Exchange Transactions.
Other Things to Know About Participating In An ESPP
Every company may have a slightly different policy for its ESPP. It is best to consult your HR or benefits departments for more details specific to your company.
All contributions to an ESPP are also exempt from Social Security and Medicare taxes.
Employers are not required to withhold taxes if you sell your stocks, but you would still owe taxes on any gain on sale.
A Note About Private Company ESPPS
Most private companies, usually startups, offer ESPPs with something called “double trigger vesting.” As the name suggests, the vesting of the ESPP plan will be accelerated when two distinct events occur. These events are the “triggers.”
The vesting criteria usually include a service or time-based component and a liquidity event.
For these companies, the time-based vesting is usually over four years with a one-year cliff followed by quarterly vesting.
This means that 25% of the ESPP will vest on the anniversary of the first year. Every quarter thereafter, 6.25% (1/48 multiplied by three months) will vest. Thus, if you leave after your second year, you will get 50% of the total ESPP shares granted.
The second trigger is usually a liquidity event such as an Initial Public Offering (IPO) or a Merger or Acquisition. The condition for vesting when a liquidity event happens is usually included to allow employees who are terminated to receive their full stock compensation as remuneration for their contributions to the company. Some companies may also regard voluntary resignation as a trigger.
If the employee decides to stay with the company after the liquidity event, they would enjoy the same incentives for their position.
In double trigger vesting, you do not have to pay taxes on the vested shares until both conditions are met. You can still hold the shares if you resign as long as they have vested. However, these shares will have no value until an event activates the second trigger.
In double trigger vesting, your employer will not report anything related to the vested shares on your W-2 unless the two triggers happen. As a result, there will be no tax event or settlement of shares until both conditions are met.
It’s Almost Always A Good Idea to Maximize ESPP Contributions But Exercise Caution And Plan Out Your Selling Strategy
An ESPP is a great way to make additional money and get a discounted deal on your company’s stock. There is no right or wrong time to sell your ESPP shares - it will depend on your risk appetite and your financial goals. However, it’s not wise to keep all of your investments (or even a large portion of your investments) in your company’s stock. It’s important to keep your investment portfolios diversified. Whether you sell right away or hold to see substantial growth on those shares, consider your overall financial plan.
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