Welcome back to my series on equity compensation. All month we’ve been talking about some of the ways your company may pay you outside of your normal paycheck.  So far we’ve explored Restricted Stock Units, Incentive Stock Options and Nonqualified Stock Options. If you work for a public company, you may already be familiar with the next topic on our agenda — Employee Stock Purchase Plans (ESPP). Employers use ESPPs to attract and retain top talent — that’s you!  But these plans don’t make sense for everyone, so let’s go through the pros and cons of participating in ESPP programs.

 

What is an ESPP?

ESPPs allow employees of publicly traded companies to buy shares of company stock at a discounted price. Your company deducts your contribution from your paycheck every two weeks (or whenever you are paid), and this money accumulates until the next time you can buy shares.

There are a couple of terms you’ll need to understand to participate.  First, the “offering period” (also sometimes called the enrollment period) means the time in which your payroll deductions accumulate. It usually lasts a year.  You decide how much of your paycheck should go towards the purchase plan during this period, and this money is set aside for you.  Your plan may limit the amount you can designate as a percentage of salary (say, less than 10%) or a flat dollar amount (for example, under $25,000). Some plans also have set a minimum contribution in order to participate (at least 2% of your salary). You make these purchases with after-tax dollars.  Unlike 401k contributions, they do not reduce your taxable income.

The second term to know is the “purchase period.” That’s the period when your company purchases shares on your behalf.  Often a one-year offering period will be split into two six-month purchase periods, so that you can buy shares twice in a year. The company uses the funds you’ve accumulated to buy shares on the last day of each purchase period. There are a couple of cool things about this purchase. First, most companies offer a discount on the market price (usually 15% but can be lower). If that weren’t enough of an incentive, most ESSPs have a “look back” provision allowing you to use the lower of either the closing price of the stock on the offering date or the purchase. This double bonus makes ESPPs very attractive plans to take advantage of.

Let’s look at an example. Say your employer offers an ESPP at a 15% discount, with a six-month purchase period and a “look-back provision.” You designate a contribution of  $1000/month from your paycheck to go towards this plan. At the start of your offering period, the share price is $10/share. At the end of the first purchase period it has risen to $15/share.  Even though the price is currently $15/share, your look back provision allows you to purchase $6000 worth of stock at $10/share. Already you’ve locked in a gain of $5 per share.

But remember, you also get a 15% discount, so that $10 share costs you only $8.5/share. That means you can buy 706 shares for $6000 — even though those shares are currently worth $10,590. Once purchased, the stock is held in the brokerage account of your employer’s choosing, waiting for you to make your next move. If there’s no holding requirement (sometimes they make you wait a couple of days), you can guarantee your profit by selling the stock right away after purchase.

What if the stock price falls during the purchase period?  You still win, but not by as much.  For instance say the stock price starts the purchase period at $10/share and ends at $5/share. You get to buy at the lower price of $5/share — and you also get the 15% discount.  So you’re buying 1,412 shares for $6,000, but they’re worth $7,060.  You get immediate profit of $1,060.

 

Tax implications

As you see, you can make some money with ESPPs, but that inevitably creates some tax issues.  Unfortunately, the tax rules for ESPPs can get complicated. I’ve already mentioned that ESPP contributions are made from after-tax income. That’s tax consideration #1: you can’t reduce your taxable income by participating in these plans.

But going further, your tax treatment will vary depending on whether your company offers a qualified or non-qualified plan. Most plans I’ve seen are qualified and regulated by the IRS. That means they must comply with IRS rules on the length of the offering period and the maximum discount the company can offer. Non-qualified plans are not subject to as many restrictions but because of that they lose many of the tax benefits I’m about to discuss. To keep things simple, I’m going only touch on the tax benefits of qualified plans.

In qualified plans, you have tax consequences in the year you sell the stock. If you sell as soon as your company purchases the stock, you have to pay ordinary income tax on any gain above what you paid for the stock. In our example, you bought the stock for $6,000 and sold it for $10,590. So you would have to pay ordinary income tax on the $4,590 of profit.  Federal marginal tax rates for 2018 can go as high as 37%.  This is known as an unqualified disposition.

However, with ESPPs, you can qualify for lower capital gains tax rates if you hold on your stock for most than two years from the first day of the offering period and at least one year from the purchase date. In practice this is holding the stock for 18 months after purchase. Remember the holding period for long-term capital gains is extended if the offering period resets. Any discount you received is still taxed at ordinary income rates (the 15% discount in our example), but any gain beyond that would taxed at long-term capital gains rates (0%, 15% or 20%).

Let’s say in our example above you fall into the 33% marginal income tax bracket and the 15% long-term capital gains bracket. Using approximate figures, you would pay 33% on your discount of $1,059, or $350.  You’d also pay 15% on the remaining $3,530 of capital gains – that’s $529.50. Add them together and you have a total tax liability of $879.  You’d be out $1,514 if you paid income tax on the whole thing.  So, in this example, you save around $635 in taxes if you hold onto your shares for a year.  That’s quite a chunk of change.

If you participate in an ESPP, your employer will provide you with Form 3922 Transfer of Stock Acquired Through an Employee Stock Purchase Plan. This form has all of the details as far as grant date, exercise date, etc. Hold on to that and a Form 1099-B from your broker when you sell your stock.

 

Should you participate?

Ahhh, yes…the question that everyone wants to know. It may surprise you that my default answer is yes, rather than “it depends” (still with some qualifying factors though). The guaranteed discounts plus the benefit of a look back will likely give you returns above any other investment that you make. That being said here are my qualifiers:

• Do you have the money? You have to remember that you won’t have use of this money for at least six months. Can you afford that? If so, how much can you afford? This fundamental concept is why I spend so much time on clients’ cash flow. It pervades every other aspect of their life. Plus, you should also take into account how you’ll pay the taxes when you do sell. That’s why it’s important to have proper tax planning and an emergency fund.
• What are my goals? Another fundamental part of your planning that you should consider is how does this money help you meet your other goals. Will you need this money right away to pay off debt or buy a home? Or will this help you meet your retirement goals?
• Am I diversified? One of the most common problems I see with equity compensation is having too much of your portfolio in your company stock. Not only is this dangerous from a diversification standpoint, but it also doesn’t make sense to be so heavily dependent on your employer for your investment returns and your income. You increase your risk without much more upside. A good rule of thumb is no more than 5-10% of your company stock in your portfolio. (Although I favor 0%)

In short, it often makes sense to participate in ESPPs in 1) an amount you can afford and then 2) sell the shares to lock in any guaranteed profit and limit your risk. You are already getting generous returns. No need to risk anymore.

One final caveat, and this applies to all equity compensation programs, is that it’s critical to know the details of your plan. You will need to dig into the numbers and go through a proper analysis to make your specific ESPP benefits you. For example, it could make a big difference if you’re getting a 5% discount vs. a 15% discount.

As always, I would to love to hear your thoughts and challenges with ESPPs or other equity compensation. You can get in contact with me at the links below.