ESPP vs RSU – Making an informed decision

Are you looking to introduce an employee stock plan in your company or expand on your current offering? To help assist you in the process of making an informed decision we will explain and compare two of the more commonly used equity vehicles – restricted stock units (RSUs) and employee stock purchase plans (ESPPs).

When considering how best to proceed typically companies will, first and foremost, investigate the different equity options available, with a view towards making the choice that works best for their situation, i.e. a plan that should meet your needs while also proving attractive to employees.

RSU: The basics

When a company issues RSUs to employees, no shares change hands at the outset. Instead RSUs act as a promise, made by the company to employees that they will receive shares (or the cash equivalent) at some point in the future, as long as vesting conditions agreed by both parties on day one are met. RSU-related conditions might be time based, e.g. remaining with the company for a specified minimum period, and/or performance based.

The initial agreement between the company and participating employees will include details on the process through which individuals may receive the equivalent value of a specified number of RSUs in the future. Typically plans are designed to run for four years, with 25% vesting each year, assuming participants have met the relevant conditions.

In such an arrangement, the value of RSUs will be assessed based on the fair market value (FMV) of company stock.

Once employees come into possession of the shares linked to the RSUs, they are free to  hold or sell as they see fit, with no restrictions attached.

From the taxation perspective, RSUs are relatively straightforward. There is no liability at the outset. No actual shares are handed over until they vest, so no tax obligations kick in until that moment. At vesting the value of is taxed as ordinary income. When the shares are sold, any gain achieved above the FMV at the time of vesting will be subject to capital gains tax (CGT).

Companies who issue RSUs will normally be able to claim a corporate tax deduction for the year in which they vest.

ESPP: The basics

With an ESPP, employees are given the opportunity to purchase shares in their company, usually at a discount, with the cost of those shares deducted directly from after-tax pay.

Employees can normally decide whether to sign-up to the plan during a defined offering period.

The discount usually falls somewhere between 5% and 15% of FMV. The application of what is referred to as a ‘lookback feature’ can allow participants to choose whether to link their purchase to the FMV on either the first day or the last day of the offering period. In practical terms, this means participants will opt for whichever value is lower, so the discount can be calculated based on the more favorable figure.

Once an employee signs up monthly post-tax contributions are made for the duration of the offering period, typically between 12 and 24 months.

Within an offering period, there will normally be several purchase periods, during which accumulated contributions are used to buy company stock. In practice, shares tend to be bought at the end of a purchasing period.

Once the purchase has been completed, plan participants are free to choose whether to sell or retain their shares.

How shares purchased through an ESPP are taxed will depend upon whether the plan is qualified or non-qualified, and also when the participant chooses to sell.

The key difference between these is that a qualified ESPP is designed according to Internal Revenue Service (IRS) Section 423 regulations, whereas a non-qualified ESPP is not. In practice, this means companies have more flexibility in how they design non-qualified plans, but qualified plans are treated more favourably on taxation.

Specifically, with a qualified plan, no tax bill becomes due at the time of purchase and if shares are held for at least two years post-grant date and one year after purchase, then the profit associated with any subsequent sale will be treated as a long-term capital gain.

By contrast, with a non-qualified plan, the excess of the FMV at purchase is treated as ordinary income for tax purposes, and any gain when shares are eventually sold is dealt with as a short-term capital gain, i.e., no beneficial tax treatment.

Companies usually do not receive any corporate tax deduction arising from introducing an ESPP.

RSU vs ESPP: Key differences

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So, which will best meet your needs? There is no simple answer, and, depending upon your circumstances, it may even be the wrong question to ask, as it is possible that you might choose to go with an ESPP and RSUs.

The key is to understand the features of both and then make an informed decision.

J.P. Morgan Workplace Solutions can help you in that process. Reach out today and speak to our experienced personnel.

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