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Qualified and Non-Qualified ESPPs. Know The Score.

Qualified vs Non Qualified ESPP

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

There are two major types of ESPP: 1) Qualified ESPP offering tax advantages and 2) Non-qualified ESPP offering flexibility. Before we highlight the distinctions between them, we need to first be clear on the core characteristics of ESPPs.

What is an ESPP?

An ESPP is an employee ownership scheme that enables employees to purchase company shares from their salary at a discount – usually up to 15%. Over time, they build up a savings pot, which is then used to buy company shares on the nominated purchase date. This is the basic sequence of events associated with an ESPP:
  1. The company makes an offer under the plan to its employees.
  2. There will usually be a maximum percentage of salary that can be used for the purpose of building the savings pot.
  3. Employees will decide the amount of their net salary to be allocated to the pot.
  4. At the end of the purchase period, the accumulated contributions are used to purchase shares for the employees, with the agreed discount applied.
Sometimes, an additional layer of reassurance will be offered, in the form of a lookback clause. With such a clause, employees get to “pick” the most favorable share price of – either A: the initial date of the offering period or B: the purchase date, whichever is  lower. See the example below:
espp-offering-period
An example illustrating a 12-month ESPP offering period with two 6-month purchase windows

An example of a Lookback Clause​

Initial Price: $10
Price on Purchase Date: $12
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
With a lookback clause, the employee will be able to purchase shares at $10 minus the 15% discount. You know what? ESPPs with a 15% discount and a lookback feature have a higher participation rate. If you want to know more about how to make your ESPP more attractive, Contact Global Shares Today.
An ESPP can give employees an easy and cost-effective reward for pursuing a disciplined savings plan to build financial wealth. It’s also beneficial to employers because workers who hold company shares will tend to think and act in the long-term interests of the company. More benefits to employees and employers can be found in our guide to  ‘’Understanding ESPP for Employers & Employees’’.

Qualified vs Non-qualified ESPP

Now, we can have a look at the key difference between the two types.

An ESPP qualified plan is designed and operates according to Internal Revenue Section (IRS) 423 regulations, whereas a non-qualified ESPP does not meet those criteria.

This means that there is more flexibility in how a non-qualified plan can be designed, but a qualified plan is treated more favorably on taxation as there’s no taxable event when shares are purchased. Indeed, the term ‘qualified’ is used to refer to its tax-advantageous status.

Qualified ESPP
Non-Qualified ESPP
Contribution made with after-tax dollars
Contribution made with after-tax dollars
Designed and operates according 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 whether you decide to roll out a qualified ESPP or a non-qualified ESPP, you can easily set it up in our equity admin section.

A Closer at Qualified ESPP - Qualifying & Disqualifying Dispositions

I know what you’re probably thinking, “There are different types of Qualified ESPP, too?” The answer is yes. There’re two classifications of sales for qualified ESPPs: qualifying and disqualifying dispositions.

Does it matter to know the type of sale of your ESPP shares? Yes again because they can have quite different tax implications. Use the flow chart below to quickly help you identify if the sale of your shares is an ESPP qualifying disposition or an ESPP disqualifying disposition.

ESPP Qualifying vs Disqualifying Disposition
ESPP Qualifying vs Disqualifying Disposition

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

A qualifying disposition occurs when employees hold their shares for a period of at least two years from the offering date AND at least one year from the purchase date. When you sell your shares after the holding period, the discount is taxed as ordinary income, and the rest of the gains is taxed at the long-term capital gains rate which is usually lower.

ESPP Disqualifying Disposition: Under this plan, you do not owe taxes at the time of purchase. Unlike the plan above, a disqualifying disposition occurs when employees don’t meet the holding period – EITHER hold their shares for a period of fewer than two years from the offering date OR less than one year from the purchase date.

When you sell your shares right away, the short-term gains are taxed typically higher.

• • • Situation 1: Disqualifying Disposition (DD)• • •

This example is a DD situation because you sold the shares less than 2 years after the offering date. It’s considered short-term because there was less than 1 year lapsed between the date you purchased the shares (June 30, 2020) and the date you sold them (January 20, 2021).
Information
Initial Price in the offering period (Start from 01/01/2020)
$20
Price on the Purchase Date (06/30/2020)
$25
Discount
15%
Actual Purchase Price
$17
Sales Price (01/20/2021)
$50
No. of Shares
100
Sales Commission
$10

First, you will pay ordinary income tax on the difference between the actual purchase price ($17) and the price on the purchase date ($25). It is sometimes called ‘’Bargain Element’’

Part A: Bargain Element –
($25 – $17) x 100 = $800

Also, you need to pay taxes on short-term capital gains for any additional profits.

Part B: Short-Term Capital Gains –
Total Sales Price minus Commission: ($50 x 100) – $10 = $ 4990
Cost [Total Actual Price + Amount in Part A]: $17 x 100 + $800 = $2500
Short-Term Capital Gains: $4990 – $2500 = $2490

In this scenario, the tax rates on any gains are typically at ordinary income tax rates which are typically higher. You won’t get tax advantages. Now, let’s look at the qualifying disposition situation where you can enjoy ESPP tax benefits.

• • • Situation 2: Qualifying Disposition (DD)• • • ​

This is a QD situation because you sold your shares at least 1 year from the purchase date AND at least 2 years from the ESPP offering date.

Information
Initial Price in the offering period (Start from 01/01/2017)
$20
Price on the Purchase Date (06/30/2017)
$25
Discount
15%
Actual Purchase Price
$17
Sales Price (01/20/2020)
$50
No. of Shares
100
Sales Commission
$10
First, the qualified ESPP tax rules say that you need to pay ordinary income tax on the lesser of:
  • Discount offered by the company : ($20 x 15%) x 100 = $300
  • The gain between the actual purchase price (with the discount applied) and the final sale price minus commission : ($50 – $17) x 100 – $10 = $3290
Part A –  Since $300 is less than $3290,
you will need to pay ordinary Income Tax on $300

Also, you will need to pay taxes on your ESPP long term capital gains for the gain in excess of the discount received, if any.

Part B: Long-Term Capital Gains – 
Total Sales Price minus commission : $50 x 100 – $10 = 4990
Cost [Total Actual Price + Amount in Part A]: $17 x 100 + $300 = $2000
Long Term Capital Gains : $4990 – $2000 = $2990

Since you held the shares for a long period of time before selling, you can enjoy a lower long-term capital gains tax rate. Congratulations!

Which One is Best - Qualified vs Non-qualified ESPP?

It isn’t possible to objectively rank one form of an ESPP above the other. Qualified and non-qualified can be 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 an employer perspective, the positive outcomes associated with ESPPs are broadly the same, whether qualified or non-qualified. Namely, an ESPP promotes employee ownership and will also help your retention rate.

From an employee perspective, an ESPP can generate substantial returns, which, it goes without saying, will always be attractive. Employees sometimes are attracted by an ESPP qualified plan because the tax isn’t due when they purchase their stock. Their ESPP long term capital gains can also be taxed at a lower rate.

However, a non-qualified plan offers 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 how we can help you with ESPP management, 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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