Employee stock purchase plans (ESPPs): How do they work?

Employee stock purchase plan (ESPP)

An employee stock purchase plan (ESPP) is an offering that allows employees to purchase stock in their company at a discount as an after-tax payroll deduction.

How does employee stock purchase work

Employers have two options for employee stock purchase plans: qualified 423 plans and non-qualified 423 plans.

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A qualified 423 ESPP plan allows employees to purchase company stock at a discount without owing taxes on the discount at the time of purchase. Some programs require a minimum holding period to ensure purchasers receive the most favorable capital gains tax treatment when the stock is sold. A non-qualified 423 stock purchase plan does not offer the same preferred ESPP tax treatment by the IRS, but otherwise works the same.

When employees choose to participate in their employer stock purchase plan, they can opt to contribute between 1% and 15% of their compensation each pay period to the 423 plan. These contributions accumulate over an offering period and are then used to purchase stock in the company. Under IRS rules, employees in qualified 423 ESPPs cannot purchase more than $25,000 in stock in a year, and no employee can own more than 5% of the shares in a company.

Once an employee purchases shares, they can hold on to them and allow value to accumulate, or sell the stock. If the plan stipulates a holding period, the stock can only be sold after that period has passed.

ESPPs and taxes

The tax implications of an ESPP depend on whether the company plan is qualified or non-qualified. With a qualified plan, you don’t pay taxes on the benefit (the discount on the stock) when you purchase the shares. You do, however, pay taxes when you sell the shares. The sale may be taxed as capital gains or ordinary income depending on whether there was a holding period and how long you owned the shares. If the plan is non-qualified, the difference between the amount you pay for the stock and the fair market value is taxed at the prevailing rate.

Benefits of employee stock purchase plans

An employee stock purchase plan is a type of retirement plan—the programs are governed by the same rules as 401(k) plans. However, they offer additional advantages to businesses as well as employees.

Some of these advantages include:

Greater workforce engagement
An improved culture of ownership within the company
An incentive for top talent to join the organization
Raising capital for the company
The ability to offer the benefit to global employees
Allowing employees to save money while still having access to their money
Possible tax advantages, including corporate tax deductions
Reduced compensation expenses

Disclaimer: This article and all information in it is provided for general informational purposes only. It does not, and is not intended to, constitute legal or tax advice. You should consult with a qualified legal or tax professional for advice regarding any legal or tax matter and prior to acting (or refraining from acting) on the basis of any information provided on this website.

FAQ’s

Who’s eligible for ESPPs?

Companies can define their own eligibility requirements, but most ESPPs are available to full-time employees after a set waiting period. For qualified Section 423 plans, the IRS requires companies to offer the plan to all eligible employees on equal terms.

Can employees sell their ESPP shares immediately after purchase?

In many cases, yes, but it depends on the plan. Some ESPPs allow employees to sell shares immediately after purchase, giving employees quick access to cash. Others include a holding period clause. Selling too soon may trigger a disqualifying disposition, causing employees to miss out on long-term gains and certain tax advantages.

What are the risks of participating in an ESPP?

Like any investment, ESPP stock carries market risk. Stock prices fluctuate, and there’s no guaranteed return, even with a discounted price. Employees should consider how ESPPs fit into their broader financial goals and consult a financial advisor to build a diversified investment portfolio.

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