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Qualified and Non-Qualified ESPPs. Know The Score.

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Employee Stock Purchase Plans (ESPPs) are widely regarded as being one of the most simple and straightforward equity compensation strategies available to businesses today.

However, “simple” and “straightforward” are very much relative terms in this context. Even the most understandable approach will be somewhat complex, at least in certain respects. So, perhaps a more nuanced claim for ESPPs as equity compensation might be that they are among the least complicated, as opposed to being objectively straightforward.

Before we highlight the distinctions between qualified and non-qualified, we need to first be clear on the core characteristics of ESPPs. 

What is an ESPP?

An ESPP is an employee ownership plan that enables employees to purchase shares in their company at a discount.

So far so similar to many other equity compensation approaches, you may think; and you would be right, in terms of outcome, but, with an ESPP, the process of reaching that end plays out in a particular way. What distinguishes an ESPP from most other approaches – and why it is billed by various sources as being so straightforward – is that employees agree to make monthly contributions directly from their salary for an agreed period of time, building up a savings pot, which is then used to buy company stock on the nominated purchase date.

The discount – usually 15% – is designed to make employees confident of achieving a profit when selling the shares on, effectively allowing them to buy low and sell high. An additional layer of reassurance will sometimes be offered, in the form of a lookback clause. With such a clause, employees get to “pick” the most favourable share price during the lookback period – usually six months – and base their purchase off that. 

So, if the share price on the purchase date is $15, but at some point during the previous six months was as low as $10, with a lookback clause the employee will be able to purchase shares at $10 minus the 15% discount, meaning that they would pay $8.50 per share on a date when the stock price is $15.

The net effect of this process is that it gives employees an easy and cost-effective reward for pursuing a disciplined savings plan to build financial wealth, and, in parallel, sees them invest in their company.

Workers who hold company stock – or are in the process of acquiring stock – will tend to think and act in the long-term interests of the company, because they clearly see their own interests aligning with those of the business. This is attractive for employers, as an engaged and motivated workforce constitutes an ideal building block on which to underpin the future and continued success of your organisation.

 

How does an ESPP operate?

While there are many different types of ESPPs, they generally operate in similar ways

Before we look at the distinction between qualified and non-qualified, this is the basic sequence of events associated with an ESPP:

  • The company makes an offer under the plan to its employees.
  • There will usually be a maximum percentage of salary that can be used for the purpose of building the savings pot.
  • With that maximum ceiling made clear, individual employees will decide how much of their net salary they want to be allocated to the pot.
  • That amount is then retained each month by the employer during the offer period – no more than 27 months – and usually placed in a non-interest-bearing account.
  • At the end of the offer period, the accumulated contributions from salary are used to purchase shares for the employees, with the agreed discount applied.

The stock is fully owned by each employee once purchased. Some will look to sell immediately,
with a view towards making a quick profit, whereas others will resist that temptation and instead treat the stock as a long-term investment. 

Qualified vs Non-qualified ESPPs

The key difference between the two types is that a qualified ESPP is designed and operates according to Internal Revenue Section (IRS) 423 regulations, whereas a non-qualified ESPP does not meet those criteria. In practical terms, this means that there is more flexibility in how non-qualified plans can be designed, but qualified plans are treated more favourably on taxation. Indeed, the term ‘qualified’ is used to refer to its tax-advantageous status.

More specifically:

Qualified: Under a qualified ESPP, employees purchase stock at a discount from the fair market value, yet do not owe taxes on that discount at the time of purchase.

Furthermore, if employees hold their stock for a period of two years post-grant date and one year from purchase date, they can further reduce their tax obligations.  When the stocks are held for a time period as above, the profit of the sale price over the purchase price is treated as a long-term capital gain when and if the employee decides to dispose of their investment.

Also, qualified plans must be approved by a shareholder’s vote before they can be implemented.

Non-qualified: A non-qualified ESPP may look exactly like a qualified ESPP, but will not generate the same tax benefits to employees as a qualified plan. With a non-qualified ESPP, when the stock is purchased, the excess of the fair market value of the stock at the time of purchase over the purchase price is taxed as ordinary income.

Any additional gain or loss when the employee sells the stock is taxed as capital gain or loss. 

 

On the upside, as mentioned above, non-qualified plans offer more flexibility in terms of plan design. That can mean, for example, allowing matching shares and offering a larger discount. Even so, because the tax on the discount is due upon purchase, this can discourage employee participation.

Which one is best?

The best ESPP for a company will always be decided by the company's own goals

It isn’t possible to objectively rank one form of ESPP above the other. Qualified and non-qualified can be very similar, but they also diverge, and those points of difference don’t necessarily make one better than the other, they simply make them different.

From the employer perspective, the positive outcomes associated with ESPPs are broadly the same, whether qualified or unqualified.

Namely, an ESPP encourages a long-term view among employees and will also help your retention rate.

From the employee perspective, an ESPP can generate substantial returns, which, it goes without saying, will always be attractive. However, qualified plans almost always generate more interest among employees because the tax isn’t due when they purchase their stock.

As mentioned above, a non-qualified plan offer more flexibility, but the relatively less friendly tax regime can make it a harder sell among employees on day one. 

If you’ve been curious about all the benefits of ESPPs or employee ownership – or you want to understand how they can help your company specifically, contact Global Shares today. Our experts will walk you through the entire process, and see which plan is best for you.

Please Note: This publication contains general information only and Global Shares is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. The Global Shares Academy is not a substitute for professional advice and should not be used as such. Global Shares does not assume any liability for reliance on the information provided herein.

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