Updated: Dec 6, 2021
A timeless investment strategy is to “Buy What You Know” – to 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 strategy, especially 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 can be advantages in some plans, such as a look back, that can let you get an even better deal. I'll break down what you need to know if you're looking to add your company stock to your investment plan.
An ESPP is a benefit offered at some publicly traded companies that grants an employee the ability to buy their company stock at a discount. Usually you can enroll twice a year in the plan and choose the percentage of salary you want to contribute, usually up to 15% of your salary or $25,000.
Once enrolled, your employer will set up your personal ESPP account, typically with a brokerage company, and transfer funds from your paycheck into the account to buy shares. The program allows an employee to sign up for a 12-month offering period - which is usually the official start of participation with most plans. This is the beginning date for tax purposes, along with helping to set the price for the look back benefit.
Enrollment Period/Purchase Period
During this time, payroll deductions are set aside, and you accumulate funds in the plan. This usually lasts for a year, and shares are then bought twice a year with the funds in your account. The company buys stock for you below the market price (usually a 15% discount). Plans that follow Section 423 tax rules specify that the employee’s discount is capped at 15% below the market price.
Some ESPPs include another benefit called the “look back period.” Under this feature, the employee still gets a 15% discount, but it can be 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 look back works using an example of a company with a 15% discount and a six-month look back:
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 climbed to $20 per share. The look back 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 at the end of the payroll deduction period and when shares are bought. Some offering periods may include several purchase dates when stock may be bought.
The Transfer Phase The employer is responsible for watching over your money that's accumulating in the plan. The company then buys shares of the company's stock twice a year. The mechanics of the process is that the brokerage firm administering the ESPP plan makes the actual stock purchase. The brokerage then transfers ownership of the stock to the employee enrolled in the plan. Any cash that's leftover from the purchases is refunded to the employee.
The brokerage firm administering the ESPP will mail a trade confirmation to the employee. Employees do not get a tax bill when the shares are bought and transferred to them. But there will be tax obligations when you sell the shares.
Different Plans; Different Tax
The most common ESPPs are qualified (this is different from a qualified retirement plan). Other types of ESPPs are non qualified or direct purchase plans.
With tax-qualified or qualified ESPPs (following IRS Section 423), you get favorable tax treatment if you own the shares long enough. 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 optimum amount of time before selling, the discount received when the stock was bought is generally considered additional compensation, and you will pay ordinary income tax on it. The profit above the discounted amount is taxed at the long-term capital gains tax rate.
If you hold the stock for less than a year before you sell it, any gains will be considered compensation and taxed as ordinary income.
Non-qualified plans may also offer discounts, but they lack the tax advantages. With non-qualified plans, employees receive a tax bill at the time of purchase (you pay ordinary income taxes on the discount you received at the time of purchase).
Considerations To Think About
Like any stock, the value of the stock in your ESPP can fall for different reasons, including company bankruptcy, recession or a market crash. A 15% drop in the value of your shares can cancel the benefits of participating in the plan. The risk of losing money is even greater if your income and a large portion of your investment portfolio is tied to one company's performance.
Also, some employees with an ESPP may additionally 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 are a much different animal than other plans that companies use to offer employee stock ownership. An ESPP allows you to invest in company stock at a significant discount. Nevertheless, you should try prevent your holdings from becoming too large of a weighting of your investment portfolio in case something goes wrong with that stock. It has happened.
John Piershale, CFP®, AEP®
John Piershale Wealth Management, LLC is an Investment Adviser registered with the State of IL and in other jurisdictions where exempt from registration. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned.
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