Employee Stock Purchase Plans are one of the most underutilized forms of equity compensation offered to employees from startup tech companies to established legacy companies. Our ESPP Guide will help you understand what ESPPs are, how they are taxed, how you can include your ESPP in your financial plan, and what happens to your ESPP when you leave your job.
Employer Stock Purchase Plans (sometimes referred to as Employee Share Purchase Plans) or ESPPs are a unique form of equity compensation that function somewhat differently from other forms of equity compensation. These plans are designed to allow employees to regularly buy company stock at a discounted rate. The goal of these plans is to encourage employee investment in the organization and incentivize them toward company growth.
Even though planning steps may be complex, ESPPs operate on a fairly simple premise. Employees contribute a portion of their salary to the plan, usually through payroll deductions, and during specific purchase periods, the accumulated funds are used to buy company shares at a discounted price. The discount, often up to 15% of the market price, provides employees with an affordable opportunity to invest in their company's stock.
There are two types of Employee Stock Purchase Plans. Qualified ESPPs and Non-Qualified ESPPs. Qualified ESPPs follow guidelines set by the IRS and offer tax advantages to those that follow appropriate rules. Non-Qualified ESPPs don’t offer the same tax advantages but the plans can be far more flexible since they are not required to follow the same IRS guidelines. Qualified ESPPs are the far more common type.
The main focus of questions and financial planning for ESPPs tends to be around taxes. Since the tax treatment varies between qualified and non-qualified ESPPs we will review them separately. You can also take a look at our free resource, “WILL I HAVE TO PAY TAX ON MY QUALIFIED ESPP?” below to help make the process more clear.
While the terms of your plan (ie who qualifies, the discount amount and how much you’re allowed to buy) will vary between employers, the mechanics of a Non-Qualified Employee Stock Purchase Plan are fairly straightforward. You will owe taxes on the discount you receive on the stock as ordinary income at the time you purchase it. This discount is also called the “spread”. Taxes are generally withheld at the time you make the purchase.
For shares you purchase, you will also owe taxes at the time you sell them in the form of Short-Term or Long-Term Capital Gains depending on how long you’ve owned the shares. Shares sold at a loss will similarly be treated as Short-Term or Long-Term Capital Losses.
The tax advantages of Qualified ESPPs make them more complicated but very valuable. Under a Qualified Employer Stock Purchase Plan, no taxes are owed at the time the shares are purchased. From there, employees have a few options outlined below:
*Note that if your discount was more than the profit you made on the sale of your shares, that amount will be tax as ordinary income instead
**Note that your cost basis in the shares will be adjusted to include the amount taxed as ordinary income.
We call planning for your Employee Stock Purchase Plan Strategic Planning. That’s because a good plan means looking at your goals for this year as well as into the future and it means considering multiple areas of your financial life like income, expenses, taxes and personal goals. Here are a few key planning strategies to consider for your ESPP:
As always, your plan document will give you the most specific information on what happens to your Employee Stock Purchase Plan (ESPP) if you leave but generally there are two possibilities if you are laid off:
Good planning around your Employee Stock Purchase Plan (ESPP) means not only understanding what it is, how it works, and how it’s taxed but also how it fits into your personal goals and plans in the event of life changes like moving jobs.
As financial planners who specialize in working with equity compensation, we have seen how important it is to have a professional on your team to coordinate how you build and preserve wealth so you can lower your stress, pay less in taxes, and focus on reaching your goals. Schedule an Intro Call to get a better understanding of how your ESPP fits into your plan to build wealth.
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