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Understanding ESPP for employers & employees in 15 minutes

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what-is-espp

Today, offering employees benefits like a medical and dental insurance plan is almost expected and can’t really make you stand out against the competition.

What about letting them own the shares of your business through an employee stock purchase plan? More than 80% of tech companies such as Adobe and Salesforce offer an employee stock purchase plan (ESPP) to attract top talent.

This ”Understanding ESPP” guide explains what an ESPP is and how it helps both employers and employees achieve their goals. Skip to the relevant section below:

What is an ESPP?

Meaning of ESPP

An ESPP, employee stock purchase plan, is an employee ownership plan that allows participants to purchase stock in their companies at a discount – often between 5-15% off the fair market value (FMV). The way they do this is by making contributions directly from employees’ paychecks. Their accumulated contributions are used to buy company shares at the purchase date.

There are two types of ESPP – Qualified and Non-qualified. The term ‘qualified’ refers to a tax-advantageous status. The tax events will be explained in the ‘’How are ESPP stocks taxed?’’ section.

2 types: qualified ESPP & non-qualified ESPP​

Under a qualified plan, you do not owe any taxes when you purchase shares. Under a non-qualified ESPP, when the shares are purchased, the excess of FMV of the shares at the time of purchase over the purchase price is taxed as ordinary income.

The following table helps you quickly understand their meaning. If you’re interested in understanding more about these two types, head over to our ’Qualified & Non-Qualified ESPPs’’ blog.

Qualified ESPP
Non-Qualified ESPP
Contribution made with after-tax dollars
Contribution made with after-tax dollars
Designed and operates acc. to Internal Revenue Section (IRS) 423 regulations
Does not meet IRS criteria
Discount ranges from 0% to 15%, with 15% most used
May offer a discount of more than 15% from the current FMV of the stock
Approved by shareholders
Not required
More favorably on taxation
Less favorably on taxation
Less Flexible
Flexible 

No matter if you decide to roll out a Qualified ESPP or a Non-qualified ESPP, you can easily set up, manage and administer it in our software. Want to see how our ESPP software program works? Contact us today for a free demo.

How does an ESPP work?

An ESPP works by purchasing shares for participants using their post-tax salary through a sequence of events:

  1. Enroll in the plan: Once you enroll in the plan, you’ll be eligible to participate in the upcoming offering period and will be able to purchase company shares at an agreed discount for the length of that offering period.
  2. Set aside money each month: Within an offering period, your accumulated contributions from your monthly paychecks (post-tax) are set aside to purchase shares at the purchase date.
  3. Purchase shares: Typically at the end of the purchase period (i.e. purchase date), you officially purchase the shares.
  4. Sell shares: Typically the best time for selling ESPP shares is right after you purchase them. Will discuss it later.

Terms associated with ESPPs:

  1. Offering period: You’ll be able to purchase company shares at an agreed discount (5-15% off) for the length of the offering period that you participate. A common ESPP offering period is either 12 months or 24 months. It’s a 12-month offering period in the example below.
  2. Enrollment date: The date that you enroll in the plan, e.g. 1 Jan in this example.
  3. Purchase period: Within an offering period, there are a series of purchase periods in which you set aside money to purchase the shares. The length of a purchase period is usually 6 months. So, there’re 2 purchase periods each year in this case.
  4. Purchase date: The date you purchase the shares, i.e. 30 Jun and 31 Dec in this case.
  5. Purchase price: The price you purchase the shares on the purchase date.
espp-offering-period
An example illustrating a 12-month ESPP offering period with two 6-month purchase windows

ESPP lookback: make your plan more attractive

The ESPP lookback feature allows you to purchase the share price of either A: the enrollment date  (1 Jan) or B: the purchase date (30 Jun), whichever is lower.

An employee stock purchase plan example with/without Lookback

Price on Enrollment Date: $10
Price on Purchase Date: $12
ESPP Discount: 15%

With Lookback
Without Lookback
Purchase Price: $10
Purchase Price: $12
Actual Purchase Price: $10 – $1.5 (discount) = $8.5 / share ✓✓
Actual Purchase Price: $12 – $1.8 (discount) = $10.2 / share

Explanation:

If you are allowed to ‘’look back’’,  you will be able to purchase the shares at a discount off a lower price, i.e. $10 instead of $12. If the price on the purchase date is lower, for example, €8, then you will purchase the shares at a 15% discount off the price of €8 [instead of $10 at the beginning].

So, to make an ESPP more attractive, offering a ”lookback” feature in addition to an ESPP discount can likely boost your enrolment rates.

Bonus tips for employers:
Plans offering a 15% discount with a lookback feature have a participation rate of 44%, well above the rates for plans offering lower discounts or no lookback

How are ESPP stocks taxed?

Non-qualified ESPP

Non-qualified ESPP has simpler tax implications. Income tax (i.e. FMV on the purchase date minus the purchase price) is chargeable at the time of purchase. Tax on capital gain/loss (i.e. Sale price minus FMV on the purchase date) is chargeable at the time of sale.

So far so good. Let’s look at qualified ESPPs.

Qualified ESPP

There’re two classifications of sales for qualified ESPPs: qualifying and disqualifying dispositions. They cause different tax events. Unlike the non-qualified one, no tax is chargeable at purchase in both cases.

When selling ESPP shares, the discount that you received when the shares are bought is considered additional compensation to you, so you have to pay taxes on them as your regular/ordinary income.

You also have to pay taxes on any additional profits when you sell your shares. The ESPP tax treatment is varied depending on whether your stock sale is a qualifying disposition (QD) or a disqualifying disposition (DD).

Employee stock purchase plan tax example

  • Initial price in the offer: $20
  • Price on the purchase date: $25
  • Discount: 15%
  • Actual purchase price: $17 (= 20 x 85%)
  • Sales price: $50
  • No. of shares: 100
  • Sales commission: $10
Ordinary Income
Capital Gains
DD: <1 year after purchase date OR <2 years after offering date
($25 – $17) x 100 = $800
Short Term Capital Gains: $4990 – $2500 = $2490^
QD: >1 year after purchase date AND >2 years after offering date
($20 x 15%) x 100 = $300
Long Term Capital Gains: $4990 – $2000 = $2990#

How are the capital gains calculated?

^Total Sales Price minus Commission: ($50 x 100) – $10 = $ 4990
Cost Basis [Total Actual Price + Ordinary Income]: $17 x 100 + $800 = $2500
Short-Term Capital Gains: $4990 – $2500 = $2490

#Total Sales Price minus commission : $50 x 100 – $10 = 4990
Cost Basis [Total Actual Price + Ordinary Income: $17 x 100 + $300 = $2000
Long Term Capital Gains : $4990 – $2000 = $2990

Our ESPP tax rule post has more different tax scenarios. Make sure to have a read before selling your shares.

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Best time to sell ESPP shares

The best time to sell your shares (or 80% – 90% of your shares) is immediately on the same day you purchase them because it can:

  1. Secure a good return as you just bought the shares with the company discount of up to 15%
  2. Minimize risks by avoiding holding the stock for long
  3. Pay off your existing loans with this amount of free money as soon as possible

Although a QD allows you to get better ESPP tax advantages as the long term capital gains tax rates are usually lower than your ordinary income tax rate, this can be risky. This strategy requires you to hold your shares for at least one year after you purchase them. If the gains are significant at the moment, waiting to sell to reap the ESPP tax advantages could have a large impact on your stock portfolio.

But, of course, there is no right or wrong time to sell your ESPP shares because it depends on your personal/financial goals, e.g do you need cash urgently, do you want to pay off debt asap, are you confident that your company stock value will grow in the future?

Is an ESPP worth it for employers?

ESPP Pros & Cons for Employers​

Help Employee Retention
ESPP programs typically run over a number of years, and the total amount of stock employees accumulate over the lifetime of the plan. Seeing is believing, and an employee who sees the financial benefit of their investment after the first six months is more likely to commit and remain invested in the company in the long run.

Attract and recruit top talent
Offering one could make your company more attractive, help you land top recruits and deliver on your people priorities.

Create an ownership culture in your company
An ESPP offers employees a way to gain ownership in their company. When employees hold company stock, they will think and act in the long term interest of the company and have a greater stake in the success of the company, which can be a powerful motivator.

But…
Despite its benefits, having a plan in place can increase HR, accounting and administrative workload. You also need to create a comms plan to let your employees know about the ESPP benefits and keep them engaged. So, why not let an expert take care of everything from participant enrollment to trading and above board.

We, Global Shares, can take away the headache of managing your ESPPs thanks to our award-winning software platform and our team of 300 equity professionals. We’re trusted by hundreds of companies across a multitude of industries in more than 100 countries across the world.

ESPP Pros & Cons for Employees

Turbo-Charge your Savings
Since you are buying shares for a discount and then selling them for a normal price, you can earn money with this ‘’buy low and sell high’’ approach.

ESPPs offer you an easy and cost-efficient reward for pursuing a disciplined savings plan and allow you to make short term financial decisions such as buying a home and also increase your long term financial wealth for retirement.

LookBack Feature – You’re allowed to further increase your return
As mentioned in section 2, if your plan has an ESPP lookback feature, the company discount is then applied to the lower of 1) the price at the start of the offering period or 2) on the purchase date.

Flexible – You’re allowed to withdraw
Participation is voluntary, so companies commonly allow you to withdraw, even in the middle of an offering period. Most plans also allow you to withdraw during the purchase period.

Tax Benefits
As mentioned, if you hold your shares for a certain period of time, you will reap the benefits of tax-advantaged treatment as the profit is taxed as capital gains (taxed at lower rates than ordinary income) when selling the ESPP shares.

But…
Despite a number of benefits, there is a limit on ESPP max. contribution. Under a Section 423 plan, the IRS limits purchases to $25,000 worth of stock value (based on the fair market value on the offering date) for each calendar year in which the offering period is effective.

For example, the maximum no. of shares to purchase would be 2500 if the stock price on the offering date was $10. ($25,000 ÷ $10). To learn more about ESPP’s pros and cons, read our article here.

How much should I contribute to my ESPP?

Your ESPP max. contribution is $25,000 each year but it doesn’t mean you must maximize your contributions. 

If you have tight budgets due to high rent, childcare/healthcare costs or any other reasons, it’s important to keep enough cash flow for these necessary expenses. If you have credit card debt each month, make sure to pay off your debt first because credit card interest can accumulate much faster than the gain from your ESPP.

Of course, if you’re not in these categories and have a good saving habit, you can consider maxing out your ESPP as a way to build wealth.

So, to determine how much to contribute to an ESPP, you really need to understand your financial conditions. 

Other similar plans to an ESPP

Offering employee ownership schemes to your employees is beneficial to both employers and employees. Besides ESPP, there are other similar plans on the market. It’s worth spending some time comparing them to find the best one for your business.

ESOP vs ESPP : ESOPs (Employee stock ownership plans) like ESPPs are one of the most popular employee benefit plans, offering employees ways to grow their savings and build wealth. These two plans are a good way to attract good candidates when cash is limited. They can also increase employee morale and retention.

Let’s take a quick glance at their difference:

ESOP
ESPP
Do employees need to pay for the shares?
No
Yes
How many different types are there?
Always qualified plan
Qualified & disqualified plans
Do employees have access to stock accounts before retirement?
No
Yes
Costs to establish and administer
Higher
Lower
Used by public or private companies?
Common in private companies (can be used by public companies)
Publicly held companies
When are participants taxed?
Deferred until retirement
When shares are sold
How to Operate?
ESOPs offer employees stock without needing to purchase the shares. When they leave the company, they receive their ESOP benefits.
Employees to use after-tax wages to purchase stock at a discounted rate on purchase dates.

Unlike an ESPP, ESOP employees don’t purchase shares using their own money. Rather, the ESOP company allocates stock ownership to employees via an ESOP trust, which holds/sells the stock on employees’ behalf. Typically the ESOP employees won’t receive a distribution (or ESOP benefits) until leaving employment. At that time, the employee is taxed on the value of the stock.

ESOPs also have significant tax benefits to founders, including tax-deductible contributions and dividends. Compared to ESOPs, ESPPs however don’t require a huge cost to establish and are considered an ‘’immediate award’’ to employees.

RSU vs ESPP: Also as an employee benefit, RSU (Restricted Stock Units) provide an incentive for employees to stay with a company for the long term

Let’s take a quick glance at their difference:

RSU
ESPP
Do employees need to pay for the shares?
No
Yes
Used by public or private companies?
Both
Publicly held companies
When are participants taxed?
When shares vest and when shares are sold
When shares are sold
How to Operate?
Company to gradually transfer shares to an employee who then officially owns the shares at vesting
Employees to use after-tax wages to purchase stock at a discounted rate on purchase dates

Unlike an ESPP, you don’t have to pay for RSU. Rather, the shares of stock are granted by the company at a particular grant price. The shares will vest at some date in the future, at which point you will take ownership of the actual shares. At that time, you have to pay taxes.

Besides vesting, selling your RSU can have tax consequences:
Public companies: Similar to the case of ESPPs, you can sell yours at any time. If you want to enjoy tax benefits, consider holding shares for over a year before selling because it qualifies as a long-term capital gain that will be taxed less.

Private companies: Your shares can’t be easily sold. You’ll likely hope for your company to have a liquidity event such as IPO or SPAC.

FAQs about ESPPs

How does an ESPP work?

An ESPP (employee stock purchase plan) allows employees to use after-tax wages to acquire their company's shares, usually at a discount of up to 15%. Quite commonly, companies offer a ‘’lookback’’ feature in addition to the discount offered to make the plan more attractive. The lookback feature allows you to purchase the share price of EITHER the initial date of the offering period OR the purchase date, whichever is lower, to further increase the return.

Is an ESPP worth it?

The plan is valuable for both employers and employees. For employers, the plan can help attract and retain top talent. For employees, it is a valuable tool for accumulating wealth with a discount and a lookback feature. However, it is not 100% profit guaranteed. We can still lose money on ESPP if the stock price goes down.

Is an ESPP pre tax or post tax?

ESPP shares are post-tax. To put it differently, your shares are purchased with money that you’ve already paid taxes. You are not taxed until the ESPP is sold.

What is a disqualifying disposition ESPP?

An ESPP mainly has two types – Qualifying Disposition and Disqualifying Disposition. A disqualifying disposition occurs when ESPP shares are sold less than 2 years after the offering date. The disqualifying disposition is flexible because you can sell your shares right away after purchasing them but you won’t get ESPP tax advantages as your short-term capital gains will be taxed typically higher.

What happens to my ESPP when I leave a company?

The situation highly depends on your leaver status – Good leaver or Bad leaver. Read this article to find out more.

What is the difference between an ESOP and ESPP?

ESOPs (Employee stock ownership plans) like ESPPs are one of the most popular employee benefit plans. Unlike an ESPP, ESOP employees don’t purchase shares using their own money. Typically, they receive a distribution (or ESOP benefits) at retirement.

Request a free demo

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 us today for a free demo. 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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