An Overview of Qualified ESPPs (Employee Stock Purchase Plans)
What is an ESPP
An ESPP, or an employee stock purchase plan, allows you to buy company stock, typically at a discount. They can either be non-qualified or qualified under Section 423. Qualified plans are limited to a 15% discount but have favorable tax treatment due to only being taxable when you sell the stock. In addition, if you meet specific holding requirements, the gain will be taxed at favorable long-term tax rates. Non-qualified plans are taxed when you purchase the stock at ordinary income tax rates and include payroll taxes, unlike qualified plans. This article will focus on qualified ESPP plans.
Generally, you will defer a percentage of your salary (post-tax) every paycheck for the offering period, typically six months. At the end of the offering period, your company will buy stock for you at a discount. If your ESPP plan has a lookback provision, the price used to determine the discounted price will be the smaller of the grant price and the price at the end of the offering period. For example, let us assume the company stock was initially $10 and rose to $15 at the end of the offering period. If the ESPP had a lookback provision with a 15% discount, your company would buy the stock at $8.50, netting you a $6.50 profit (76.46%). A lookback provision can be very lucrative, providing a less risky* technique to speculate on your company’s stock price than is usually available. Even without a lookback provision, if the stock price is flat or falls during the offering period, you can at least be guaranteed your discounted purchase price on the purchase date. At a 15% discount, this equates to a 17.65% profit.
*ESPPs are not entirely risk-free. If your company goes bankrupt before they purchase the stock for you, you will become a secured creditor of your company. Furthermore, if you decide to hold your stock after the purchase date, you are subject to market risk as usual.
How Much Can I Contribute
You can purchase $25,000 of company stock in a qualified ESPP for any calendar year. This limit is based on the grant price of the offering period when you enroll in an ESPP.
For example, if you enroll in an ESPP on January 1, 2024, when the stock price is $10, and the purchase date is December 31, 2024, when the stock price rises to $15. The grant price was $10; thus, you can purchase 2,500 shares ($25,000 / $10). If you contributed $25,000 to your ESPP plan and were given a 15% discount, you would purchase 2500 shares for $21,250 and be refunded $3,750 in cash.
More commonly, ESPPs have two six-month offering periods in a calendar year. Thus, you have to re-calculate your limit each offering period. If you enroll in an ESPP on January 1, 2024, stock is purchased on May 31, 2024. The stock price went from $10 at offering to $15. You contributed $12,500 during this period. You can buy a maximum of 2,500 shares for the year and buy 1470.59 shares at the $8.50 discounted purchase price. This leaves you with 1029.41 shares @ $10 grant price of purchase limit, or $10,294.10. When you enroll in the second offering period for the year (June 1 to December 31) and assume the stock price stayed at $15, you will utilize this reduced limit. However, if you contributed another $12,500 during this period. Because your remaining limit is $10,294.10, the maximum number of shares you can buy is 683.27, calculated from the grant price of $15. Thus, you will buy 683.27 shares at a discounted purchase price of $12.75 and be refunded $3,788.31 in cash.
If a specific offering period extends beyond a calendar year, any unused portion of the $25,000 limit may be rolled over to the year the option is finally exercised.
How are Qualified ESPPs Taxed?
Qualified ESPPs are only taxed once you sell the stock obtained from the purchase. You can receive favorable tax treatment depending on how long you hold the stock. If you have held the stock for more than two years since the offering date and one year since the purchase date, you will receive qualifying disposition (QD) treatment. Otherwise, you will receive disqualifying disposition (DD) treatment. For QDs, you will be taxed at ordinary income rates on the discount only (based on grant price), with the rest of the gain being taxed at the long-term capital gain rate. For DDs, you will be taxed at ordinary income rates based on the FMV at the purchase date, with the rest being subject to capital gain treatment (short-term if held after purchase for one year or less).
For example, if the stock is $10 at the grant date on January 1, 2024, and you purchase it when it rises to $15 on May 31, 2024, with a 15% discount. Your discounted purchase price is $8.50 (assuming there is a lookback provision). You will receive QD treatment if you hold the stock until January 2, 2026. Suppose you sell it on January 2, 2026, for $20. You will owe ordinary income tax equal to 15% of the grant price or $1.50 per share, and then $10 per share for long-term capital gains.
If you sell it before January 2, 2026, you will instead pay ordinary income taxes of $6.50 ($15 – $8.50). You will then pay $5 in capital gains (short-term if sold on January 1, 2025, or earlier, long-term otherwise).
Also, for QDs, the ordinary income is capped by the actual gain when you sell it. If, in the first example, you sold it for $8.50 (the same price as your discounted purchase price), you will owe no ordinary income taxes.
Furthermore, there are times when a DD might be more tax-advantaged than a QD. For example, if the stock price is $10 on January 1, 2024, at the beginning of the offering period. Then, the stock drops to $8 on May 31, 2024, and you purchase it at a 15% discount, $6.80 per share. However, the stock rises to $15 on June 1, 2025. For DD, you would pay $1.20 of ordinary income per share and $7 of long-term capital gain per share. For QD, if you waited until January 2, 2026, and the share price remained at $15, you would pay $1.50 of ordinary income per share (15% of the grant price) and $6.70 of long-term capital gain per share.
As we see in this example, when the offering end price is lower than the grant price, but then the sale price rises higher than the initial grant price, disqualifying disposition treatment may be more favorable than qualifying dispositions.
Sources
Article Post Disclaimer
Astra Wealth Partners LLC is a registered investment adviser registered with the United States Securities and Exchange Commission.
Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment.
The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.