What is an Employee Stock Purchasing Plan (ESPP)? Should you participate if you have access to one? And if you do participate, what is the best way to take advantage of the opportunity?
A stock purchasing plan is the chance for employees to take part in the growth of a company by purchasing shares in the company periodically over a period of time (as dictated by the employer and the rules of the plan). Plans can vary widely, so do not assume the details in this article directly mirror your company’s plan.
Most plans have a three or six month or month offering period. An offering period is the dedicate time when you are allowed to take a portion of your pay and put it into your ESPP account. The IRS allows you to contribute up to $25,000 per year into an account, while some plans have a lower limit. The amount you contribute annually is split equally over the number of pay periods a year and that amount would be deposited each pay period.
At the end of the offering period there is a purchase period. The purchase period is the time when you use the money deposited in your account to purchase company shares. What makes an ESPP attractive is that companies will usually allow their employees to purchase the stock at a discount. The most common discount percentage is 15%. So, you've put all the money into the plan, the purchase date arrives, you purchase the stock at that discount, ending up with a certain amount of company shares in the account with a minimum of a 15% rate of return (or whatever your discount rate may be).
In addition, some plans allow a lookback provision. A lookback provision allows you to purchase your shares, at the discount, at either the purchase period price or at the beginning of the offering period, whichever was lower. There are also plans that allow participants to purchase shares at the lowest price during the entire offering period, whether that price occurs at the beginning of the period, the end or somewhere in the middle.
There are some ways to make your Employee Stock Purchasing Plan a tax efficient savings vehicle (more about that later), but no matter what decisions you make regarding you shares, once purchased, the delta between the stock price you are allowed to use for purchase and your actual price, via the discount, will always be considered ordinary income, taxed at your ordinary income rate. When making any decision, it is important to remember that the discount will be taxable upon receipt.
When should you consider selling your shares?
There are two strategies to implement when it comes to a stock purchasing plan. The first, and simpler strategy, is to simply accept the received shares as a source of income. Gaining 15% more of your contribution as additional income. You sell the shares upon purchase and walk away with the extra funds. Most advisors will concur that at a minimum, you should participate in your plan (as much as you can part with during the offering period) so that you can benefit from the discount and the small gain upon the return of your funds. If your goal is to increase cash flow, this is the best way to use the plan. A vanilla, not very exciting strategy, but for the extra income this strategy achieves your goal through maximizing income earned via the discount.
The second strategy for using an employee stock purchasing plan requires you to accept taking on some investment risk. This strategy requires a participant to hold on to shares for a period of time, so that any gains in the purchase stock (above the discount) receives favorable tax treatment via a qualified disposition. A qualified disposition occurs when you sell your shares two years after the grant date (or offering date) and one year after the purchase date.
What are some of the reasons that we might want to forgo the instant income of an employee stock purchasing plan and instead hold on to the shares and experience the long-term gains? For some, it is attractive to have some exposure to the company stock. They feel confident in the company's future and want to have some opportunity to take part in the growth. For those people who might have a variety of different equity compensation packages, such as ISOs, NQSOs, RSUs, etc., because of the greater tax efficiency of a stock purchasing plans, they may choose to use their ESPPs to participate in company growth while using other forms of equity compensation to increase income.
The main reason you would want to consider holding your shares, is when there is a large difference between your stocks purchase price and the fair market value on the purchase date. For those who have the lookback option, your shares may have instantly accumulated some value above your purchase price. In addition to the discount, your shares may have also increased in value by 10%, 25%, 50 % or more the moment you own them. In those instances, we might want to consider holding on to the shares for a long period of time.
Again, we need to accept that there is going to be some investment risk. There's going to be volatility and we might lose the initial gains. But if we are confident that the company is either going to stay flat or continue to grow, and we have a large amount of initial gains, it might be worth taking on the risk to wait the period of time it takes to get to a qualified disposition and a lower tax consequence.
Even with the substantial growth during the offering period, if you are a cash flow case or you just don't want the risk, it may still be worth paying the ordinary income to get the money immediately. But for people who are willing to take the risk, or if there was significant growth during the offering period, then it might be a reason to transition our strategy from income to investment. It really depends on your situation, your risk tolerance and how you feel about your company going forward.