Employee Stock Purchase Plan (ESPP): What It Is and How It Works

What Is an Employee Stock Purchase Plan (ESPP)?

An employee stock purchase plan (ESPP) is a company-run program in which participating employees can purchase company stock directly, at a discounted price.

Employees contribute to the plan through payroll deductions which build up between the offering date and the purchase date. At the purchase date, the company uses the employee's accumulated funds to purchase stock in the company on behalf of the participating employees.

Understanding Employee Stock Purchase Plans (ESPPs)

With an employee stock purchase plan, employees have the option to buy stock in their employer at a discounted price. This is offered as a benefit of employment when they are hired, in the same way that access to a 401(k) plan for retirement savings is a benefit. The goal is that employees can purchase valuable stock for lower than the market price, allowing them to make a profit. The company growing and becoming more successful then causes the stock to become even more valuable, which then increases the benefit to the employee.

With employee stock purchase plans, the discount rate on company shares depends on the specific plan but can be as much as 15% lower than the market price. ESPPs may have a “look back” provision allowing the plan to use a historical closing price of the stock. This price may be either the price of the stock offering date or the purchase date—often whichever figure is lower.

Qualified vs. Non-qualified Plans

ESPPs are categorized in two ways: qualified and non-qualified. Qualified plans require the approval of shareholders before implementation, and all plan participants have equal rights in the plan. The offering period of a qualified ESPP cannot be greater than three years and there are restrictions on the maximum price discount allowable. Non-qualified plans are not subject to as many restrictions as a qualified plan. However, non-qualified plans do not have the tax advantages of after-tax deductions that qualified plans do.

Important Dates

Participation in the company ESPP may only commence after the offering period has begun. This period begins on the offering date, and this date corresponds with the grant date for the stock option plans. The purchase date will mark the end of the payroll deduction period. Some offering periods have multiple purchase dates in which stock may be purchased.

Eligibility

ESPPs typically do not allow individuals who own more than 5% of company stock to participate. Restrictions are often in place to disallow employees who have not been employed with the company for a specified duration—often one year. All other employees typically have the option to participate in the plan, though they are not required to.

Key Figures

During the application period, employees state the amount to be deducted from their pay and contributed to the plan. This may be subject to a percentage limitation. In addition, the Internal Revenue Service (IRS) restricts the total dollar amount to be contributed to $25,000 per calendar year. Most ESPPs grant employees a price discount of up to 15%.

Taxes and Employee Stock Purchase Plans

The taxation rules regarding ESPPs are complex. In general, you will be taxed on any stock you purchase through an ESPP during the year you sell it. It can be counted either as taxable income or as a deductible loss.

The difference between what you paid for the stock and what you received when you sell it is considered a capital gain or loss. Any discount offered to the original stock price is taxed as ordinary income, while the remaining gain is taxed as a long-term capital gain. The entire gain will be taxed as ordinary income if you have not held it for:

• One year after the stock was transferred to you; or
• Two years after the option was granted

The Bottom Line

An employee stock purchase plan is an employment benefit that allows employees to purchase stock in the company that employs them at a discounted price, sometimes up to 15%. Employees can build contributions through payroll deductions until the purchase date specified in their contract is a program in which employees can purchase company stock at a discounted price.

In general, shares purchased through an ESPP are treated like other stock at tax time: you would report a capital gain or loss on your income taxes the year that you sell the stock, though you may have to pay your ordinary tax rate on the difference between what you paid at the market price of the stock.