An employee stock purchase plan (ESPP) is a plan that allows a company to compensate a broad group of employees with options to buy the company’s stock at a specified price, usually at a discount. Many large companies use these plans as an employment incentive, giving employees an opportunity to share in the growth potential of the company’s stock. Generally, the employee is not taxed at the time the stock is purchased. As long as the appropriate holding period is met, the employee only pays taxes when the stock is sold.
- As a form of equity compensation, it provides an appropriate incentive to employees.
- An ESPP is an easy form of savings.
- An ESPP has little or no out-of-pocket cost to the company. The only cost associated with it is that the company gives up the opportunity to sell the same stock on the market, and realize the proceeds for company purposes.
- An ESPP is a form of compensation on which tax to the employee is deferred; generally the tax is not payable until the employee sells the stock.
- The employee bears the market risk for this type of compensation. In the event that the market price of the stock declines after purchase, the employee is not compensated to cover this loss.
- An employee may consider borrowing money to buy the stock and deduct part or all of the interest on the borrowed funds as investment interest. However, if the investment interest is more than the investment income, the employee may not deduct it.
- Fluctuations in the market value of the stock may weaken the value of an ESPP as a performance incentive.
- The employer normally receives no tax deduction under an ESPP.
Usually, employees make contributions for certain period of time through payroll deductions. At designated points in the year, the employer uses the accumulated money in the fund to purchase stock for the employee. Employees may also use external funds to purchase the stock.
The plan must cover all employees, with a few exceptions. The following may be excluded:
- employees with less than two years of service;
- employees with customary service of less than 20 hours per week or not more than five months in any calendar year, and/or
- highly compensated employees.
- All covered employees must have equal rights and benefits, but the amount of stock purchased can be limited to a uniform percentage of compensation for all employees.
- The plan can provide for a maximum amount of stock that can be purchased. In any event, no employee can purchase more than $25,000 of stock under an ESPP in any one calendar year.
- The price of the stock must not be less than the lesser of:
- 85% of the fair market value at the time the option is granted, or
- 85% of the fair market value of the stock at the time it is purchased.
- Generally, options must be exercised within five years.
The two main tax benefits are:
- The employee has no taxable income at the time the ESPP option is granted.
- The employee has no taxable income when the ESPP option is exercised (when the employee buys the stock).
In order to receive these tax benefits, the stock must be held for at least two years after the date the option is granted, and one year after the employee buys the stock. Also, the employee must remain an employee of the company until at least three months before exercising the option. If the holding period is not met, the employee will have additional compensation income in the amount of the difference between the option price and the fair market value of the stock when it was purchased.
In the event that the employee sells the stock and the holding period is met, there are two elements of taxable income:
- There is ordinary compensation income equal to the lesser of:
- the difference between the option price and the fair market value of the stock when granted; or
- the difference between the amount paid by the employee for the shares and the fair market value of the shares at the time of the sale.
- The remainder of the gain on the sale (if any) is capital gain.
If the employee sells the stock after the holding period, the employer does not receive a tax deduction. However, if the employee must include a portion in income because the holding period was not met, the employer may deduct this.
At Henssler Financial we advise never having more than 10% of your portfolio invested in any one company. Many people receive stock options from their employer, matching contributions in their 401(k) plans or participate in their employer’s stock purchase plans as well as receive paychecks from the company. Unfortunately, many people do not properly diversify their portfolios when they receive the stock benefits from their employer. If your employer’s stock comprises more than 10% of your total portfolio, you risk losing a large portion of your retirement portfolio. If the company goes out of business, you would not only have lost wages, you would lose your savings in your retirement plan, employee stock purchase plan, and stock options.
If you own stock options with your company and receive matching contributions in your 401(k), we suggest that you do not participate in the company stock purchase plan. If you feel you need to participate in the company stock purchase plan to be politically correct, invest the smallest amount possible. Another option is to find out if you can direct the company’s matching contributions to other investments in your 401(k) plan.