The best way to invest your money may be right under your nose. If you work for a publicly traded company, you should check if they offer an ESPP, or employee stock purchase plan. These plans offer employees a great opportunity to buy stocks at a major discount.
How It Works
An ESPP is a company-run program that allows employees to purchase company shares at a discounted price. Depending on the company and its plan, employees can purchase stocks at up to 15% below market price.
Under a typical ESPP, employees are given the option to purchase their employer’s stock at a discount at the end of an offering period. A specified percentage, usually from 1% to 10%, of the employee’s compensation is deducted from their payroll. At the end of an offering period, usually six months, the employer takes the contributions and purchases company stock. Usually, the employer uses the stock price of the first or last day of the offering period, whichever is lower, and then takes the additional 15% discount. Under some plans, the purchase price is often the stock price on the purchase date.
Types Of Employee Stock Purchase Plans
There are two types of ESPPs, which are classified by their tax status.
Qualified employee stock purchase plans: These plans that meet certain conditions under the Internal Revenue Service code, section 423. Shares under the plan that are held for more than a year receive special tax treatment. These plans meet the following requirements:
- Only employees of the company, or its parent or subsidiary corporations, may participate.
- The plan must be approved by the company’s stockholders within 12 months before or after the plan is adopted.
- Any employee that owns 5% or more of the company’s stock may not participate.
- Other employees that may not participate include those who have been employed less than two years, work less than 20 hours per week, or receive high compensation.
- All employees who participate must have the same rights and privileges, except that the amount of stock that may be purchased is dependent on compensation.
- The stock price may not be less than either 85% of the fair market value of the stock at the purchase date or at the beginning of the offering period, whichever is less.
- The maximum offering period cannot exceed 27 months unless the purchase price is based on the fair market value at the purchase time, in which case the offering period can be up to five years.
- An employee may not purchase more than $25,000 worth of stock for each calendar year.
Non-qualified employee stock purchase plans: These are simply payroll deduction plans that allow employees to purchase company stock, sometimes at discount. Unlike a qualified plan, these do not receive special treatment and may not be available to all employees.
Selling Your Stocks
So you contribute to an ESPP, you get the 15% discount, and now you want to sell your stock. Before you do, you should consider the possible tax implications.
Your initial investment is non-taxable since you already paid taxes when you earned the money. However, when you decide to sell the stocks your earnings will be taxed as either compensation or capital gains. To determine how you will be taxed depends on whether your stock sale is a qualifying disposition or a disqualifying disposition.
If you sell your stock within two years after the offering date or one year or less from the purchase date, it will be considered a disqualifying disposition. In this case, most of your profits will be reported as compensation, so you will have to pay taxes on them as ordinary income.
If you sell your stock at least two years after the offering date and at least one year after the purchase date, it will be considered a qualifying disposition. In this case, some of your profits will be considered compensation and more of it will be considered long-term capital gain, which is taxed at lower rates than compensation income.
It can get a little tricky, but the good news is that most ESPP administrators will help you calculate your gains and determine how much to report as compensation and how much to report as capital gains. Regardless of whether or not you receive help, you should always be sure to keep excellent records to document your calculations. The important thing is to understand the difference between qualifying and disqualifying disposition in order to decide when to sell your stocks.
Too Much Of A Good Thing…
While an ESPP sounds like a great deal that should be fully taken advantage of, you should still exercise caution. As with any investment, be careful not to tie up too much of your money in one stock. Business may be booming, but things could go south fast (think Enron). If you decide to invest in an ESPP, do not contribute more money than what you are comfortable with.
Should You Participate In An ESPP?
In addition to the major discount, there are many advantages to ESPPs. They are easy and convenient to set up. They are usually easy to get out off and easy to make adjustments to. You do not have to commit to purchasing a specific amount of stocks each pay period. However, make sure you understand the rules specific to your company’s plan. If your company offers an ESPP, you should seriously consider it and determine whether it’s the right investment for you.