Navigating Employee Stock Purchase Plans

Courtney Jones, CFP®
Posted on 
December 1, 2021

Navigating Employee Stock Purchase Plans

A classic investment strategy is “Buy What You Know” – in other words, invest in companies and brands that you are familiar with and believe in. Investing in the company you work for can be part of a solid equity allocation, particularly when your company has an Employee Stock Purchase Plan (ESPP) that allows you to buy shares of company stock at a 5%-15% discount with after-tax dollars. There are also advantages included in some plans, such as a lookback, that can let employees get an even better deal.

A Breakdown of the ESPP Cycle

Enrollment/Offering Date

An ESPP is a benefit extended at some publicly traded companies that grants employees the ability to buy their employer’s stock at a discount. Employees usually can enroll twice a year in the plan and choose the percentage of salary to contribute, typically up to 15% of annual salary or $25,000.

Once enrolled, the company will set up your personal ESPP account, often with a brokerage company, and transfer funds from your paycheck into the account to buy shares. The program enables employees to sign up for a 12-month offering period, the official start of ESPP participation with most plans. This is the beginning date for tax purposes, along with helping to set the price for the lookback benefit.

Enrollment Period/Purchase Period

During this time, payroll deductions begin to be set aside, and you are accumulating funds within the plan. This typically lasts for a year, and shares are then purchased twice a year with the funds in your account. The company buys stock for you at a below-market price (usually a 15% discount). Plans that adhere to the rules under Section 423 of the tax code specify that the employee’s discount on stock purchases is capped at 15% below the market price.

Some ESPPs include an extra benefit called the “lookback period.” With this feature, the employee still obtains a 15% discount, but it is applied to the lower of two prices — the stock price on the first day you began to set aside money or the stock price on the day of the purchase.

Here’s how the lookback works, using as an example a company that has a 15% discount and a six-month lookback:

On the employee's offering date of June 1, the stock was trading at $15 a share. By the purchase date of December 1, it had climbed to $20 per share. The lookback means you can purchase a stock trading at $20 for $12.75 (a 15% discount on the June 1 price of $15).

The purchase date is the end of the payroll deduction period and when shares are bought. Some offering periods include several purchase dates when stock may be bought.

The Transfer Phase

The employer is responsible for safeguarding employee funds that are accumulating in the plan. The company then buys shares of the company's stock twice a year. The mechanics of this process is that the brokerage administering the ESPP plan makes the actual equity purchases. The brokerage then transfers ownership of the stocks to the employees enrolled in the plans. Any cash that is leftover from the purchases is refunded to the employee.

The brokerage that is administering the ESPP will also mail a trade confirmation to the employee. Employees do not receive a tax bill when the shares are purchased on their behalf and transferred to them. But there are tax obligations when you sell the shares.

Different Plans; Different Tax

The most common ESPPs are qualified (different from a qualified retirement plan). Other types of ESPPs are nonqualified or direct purchase plans. With tax-qualified or qualified ESPPs (adhering to IRS Section 423), the employee obtains favorable tax treatment for the purchase discount if they own the shares for enough time. The optimum waiting period is more than two years from enrollment in the plan and at least one year from purchasing the shares.

After waiting the requisite time before selling, the discount on the purchase price and the remainder of the profit will be taxed at the long-term capital gains tax rate. If you sell the shares immediately after the units are purchased on your behalf, you will pay ordinary income tax on the discount you receive on each share (the IRS considers the discount to be salary).

Non-qualified plans may offer discounts higher than 15% on each share and provide matching shares. However, they lack the tax advantages. With non-qualified plans, employees receive a tax bill when the shares are purchased on their behalf (you pay ordinary income taxes on the discount you received at the time of purchase).

Thinking it Through: What to Consider

Just as with any individual equity, the value of the stock in your ESPP can fall for a variety of reasons, including company bankruptcy, a recession or other economic slowdown. A 15% drop in the value of your shares can eliminate the value earned by participating in the plan. The risk of losing money is even more critical when your income and a substantial portion of your investment portfolio depend on one company's performance.

In addition, some employees at firms with an ESPP may also receive stock options and restricted stock as part of their total compensation. If the company is enjoying robust performance, these employees may end up owning a substantial percentage of company stock relative to their total holdings.

The Bottom Line

ESPPs is one of the most valuable ways to participate in the success of your company. ESPP enables employees to invest in company stock at a significant discount, but it’s important to monitor your account to prevent your holdings from becoming too a large percentage of your investment portfolio. Your financial advisor can help you take advantage of this valuable employee benefit within the frame of your personal circumstances.

Navigating Employee Stock Purchase Plans

Courtney Jones, CFP®
Posted on 
December 1, 2021
Navigating Employee Stock Purchase Plans

Navigating Employee Stock Purchase Plans

A classic investment strategy is “Buy What You Know” – in other words, invest in companies and brands that you are familiar with and believe in. Investing in the company you work for can be part of a solid equity allocation, particularly when your company has an Employee Stock Purchase Plan (ESPP) that allows you to buy shares of company stock at a 5%-15% discount with after-tax dollars. There are also advantages included in some plans, such as a lookback, that can let employees get an even better deal.

A Breakdown of the ESPP Cycle

Enrollment/Offering Date

An ESPP is a benefit extended at some publicly traded companies that grants employees the ability to buy their employer’s stock at a discount. Employees usually can enroll twice a year in the plan and choose the percentage of salary to contribute, typically up to 15% of annual salary or $25,000.

Once enrolled, the company will set up your personal ESPP account, often with a brokerage company, and transfer funds from your paycheck into the account to buy shares. The program enables employees to sign up for a 12-month offering period, the official start of ESPP participation with most plans. This is the beginning date for tax purposes, along with helping to set the price for the lookback benefit.

Enrollment Period/Purchase Period

During this time, payroll deductions begin to be set aside, and you are accumulating funds within the plan. This typically lasts for a year, and shares are then purchased twice a year with the funds in your account. The company buys stock for you at a below-market price (usually a 15% discount). Plans that adhere to the rules under Section 423 of the tax code specify that the employee’s discount on stock purchases is capped at 15% below the market price.

Some ESPPs include an extra benefit called the “lookback period.” With this feature, the employee still obtains a 15% discount, but it is applied to the lower of two prices — the stock price on the first day you began to set aside money or the stock price on the day of the purchase.

Here’s how the lookback works, using as an example a company that has a 15% discount and a six-month lookback:

On the employee's offering date of June 1, the stock was trading at $15 a share. By the purchase date of December 1, it had climbed to $20 per share. The lookback means you can purchase a stock trading at $20 for $12.75 (a 15% discount on the June 1 price of $15).

The purchase date is the end of the payroll deduction period and when shares are bought. Some offering periods include several purchase dates when stock may be bought.

The Transfer Phase

The employer is responsible for safeguarding employee funds that are accumulating in the plan. The company then buys shares of the company's stock twice a year. The mechanics of this process is that the brokerage administering the ESPP plan makes the actual equity purchases. The brokerage then transfers ownership of the stocks to the employees enrolled in the plans. Any cash that is leftover from the purchases is refunded to the employee.

The brokerage that is administering the ESPP will also mail a trade confirmation to the employee. Employees do not receive a tax bill when the shares are purchased on their behalf and transferred to them. But there are tax obligations when you sell the shares.

Different Plans; Different Tax

The most common ESPPs are qualified (different from a qualified retirement plan). Other types of ESPPs are nonqualified or direct purchase plans. With tax-qualified or qualified ESPPs (adhering to IRS Section 423), the employee obtains favorable tax treatment for the purchase discount if they own the shares for enough time. The optimum waiting period is more than two years from enrollment in the plan and at least one year from purchasing the shares.

After waiting the requisite time before selling, the discount on the purchase price and the remainder of the profit will be taxed at the long-term capital gains tax rate. If you sell the shares immediately after the units are purchased on your behalf, you will pay ordinary income tax on the discount you receive on each share (the IRS considers the discount to be salary).

Non-qualified plans may offer discounts higher than 15% on each share and provide matching shares. However, they lack the tax advantages. With non-qualified plans, employees receive a tax bill when the shares are purchased on their behalf (you pay ordinary income taxes on the discount you received at the time of purchase).

Thinking it Through: What to Consider

Just as with any individual equity, the value of the stock in your ESPP can fall for a variety of reasons, including company bankruptcy, a recession or other economic slowdown. A 15% drop in the value of your shares can eliminate the value earned by participating in the plan. The risk of losing money is even more critical when your income and a substantial portion of your investment portfolio depend on one company's performance.

In addition, some employees at firms with an ESPP may also receive stock options and restricted stock as part of their total compensation. If the company is enjoying robust performance, these employees may end up owning a substantial percentage of company stock relative to their total holdings.

The Bottom Line

ESPPs is one of the most valuable ways to participate in the success of your company. ESPP enables employees to invest in company stock at a significant discount, but it’s important to monitor your account to prevent your holdings from becoming too a large percentage of your investment portfolio. Your financial advisor can help you take advantage of this valuable employee benefit within the frame of your personal circumstances.

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC.  Advisory services offered through Sanctuary Advisors, LLC., an SEC Registered Investment Advisor. Credo Wealth Management is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC. This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here. This communication has not been reviewed for completeness or accuracy, does not necessarily reflect the views of Sanctuary Securities, Inc. or Sanctuary Advisors, LLC., and is not a recommendation or endorsement of any product, service, or issuer. For additional information, please refer to one of the following consumer websites: www.FINRA.org, www.SIPC.org.

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