Should you participate in your company’s ESPP program?
Congratulations! You have just landed a top tech job offering an Employee Stock Purchase Plan (ESPP). You may have the opportunity to purchase equity in your employer's company at a discount. Still, some people hesitate to participate in an ESPP. Sometimes employees are reluctant to participate because the taxes associated with this plan open them up to a new tax landscape with unfamiliar terrain, sometimes employees don’t see how they can build wealth with an ESPP, but not participating could mean missing out on a premium benefit. Let’s explore more about what an ESPP is, how it works, and how you can use it to reach your goals.
What is Equity an Employee Stock Purchase Plan?
An ESPP is a company-run program that provides employees the right to purchase their company stock at a discount through accumulated payroll deductions. Employees contribute a portion of their paycheck towards the plan and at the end of a certain period, the accumulated funds are used to purchase company stock. ESPPs are allowed only in publicly traded companies and the employee purchase discount can range anywhere between 5-15 percent.
How do ESPPs work?
Typically, companies offer an Enrollment or Offering Period during which payroll deductions are accumulated for purchasing company stock. A single enrollment period may contain one or more purchase periods. The last day of the purchase period is the purchase date on which company shares are purchased by the company on behalf of the employee.
Most companies offer Qualified ESPPs which are established and operated as per regulations listed in IRC Section 423. Qualified ESPPs can be implemented only after prior approval by the shareholders and may contain restrictions on plan eligibility, offering period, maximum purchase discount permissible, and so on.
Non-qualified ESPPs on the other hand, are not bound by as many constraints, but may not offer the tax advantages provided by qualified plans.
Your employer determines the maximum percentage of your gross paycheck that can be contributed to your ESPP (typically 15%) but is subject to a maximum of $25,000 in a calendar year per IRS tax laws. While the percentage of the deduction is calculated on your pre-tax pay, the actual deduction happens on your take-home pay.
For instance, say you receive $5,000 per paycheck before withholdings and your take-home pay after deductions and withholdings comes to $3,000 per paycheck. If you elect to contribute 15% to your company’s ESPP, then you will essentially contribute $750 ($5,000 x 15%) per paycheck and this amount will come out of your take-home pay of $3,000, reducing your net take-home pay to $2,250 per paycheck.
Additionally, if the ESPP incorporates a “Lookback Provision”, employers purchase shares based on the stock price at the beginning or at the end of the offering period, whichever is lower. If the stock price is $50 on Jan 1st and its market price on Jun 30th (purchase date) is $70, you will be able to lock in the price at $50 and post the 15% ESPP discount, your purchase price will be $42.50.
How is ESPP taxed?
The main advantage of Qualified ESPPs is that you will not owe taxes at the time of purchase. Additionally, if a qualifying disposition occurs (sale happens two years after the offering period and one year after the purchase date), your ordinary income would be the lesser of the sale price less the actual purchase price paid, or the actual discount per share. The rest of the profit or loss would be taxed as long-term capital gains or losses.
In contrast, if a disqualifying disposition occurs (sale happens within two years of the offering period), the difference between the purchase price and the purchase date market value would be taxed as ordinary income. Capital gains or loss on the sale would be the difference between the sale price and the purchase date market price and will be taxed as a long-term or short-term capital gain or loss depending upon the holding period.
How to avoid getting double-taxed on ESPP?
Note that your broker is required to show only the unadjusted cost basis (what you paid for the stock) on your Form 1099-B. Since a part of your profit is considered compensation and included in your W-2 income, you have to ensure that the cost basis is adjusted on Form 8949 while filing your taxes. Otherwise, your compensation component will end up getting double-taxed, both as an ordinary income and as a capital gain.
ESPP tax rules can be overwhelming for the most part and can impact your investment and selling decisions. Questions such as ‘Should I participate in the company ESPP program?’, ‘When should I sell my ESPP shares?’, ‘Will I get double-taxed on my ESPP gains?’ are all commonly asked across the spectrum. The ‘When to sell?’ question is especially a complicated decision and should be based on your long-term financial goals and individual risk appetite.
Our team has extensive experience helping tech professionals answer complex questions regarding company-sponsored ESPPs and has formulated customized investment and selling strategies for multiple clients. Contact us to learn more about the advantages of ESPPs, the related sell decisions, and tax implications, to optimize your financial goals.
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