Many large employers offer an Employee Stock Purchase Plan (ESPP) as part of your compensation package. These plans are offered as an employment incentive, giving you an opportunity to share in the growth potential of your company’s stock.
You may be wondering what this means to you and whether this option is worth taking advantage of. In general, an ESPP is an excellent offering that gives employees the ability to purchase shares of a company’s stock. Still, there are some nuances to be aware of—especially as it relates to taxation.
By having a better understanding of what ESPPs are and how they work from a tax perspective, you can make the right decision for your own unique investing and financial needs.
What is an Employee Stock Purchase Plan?
Specifically, an ESPP refers to a benefit plan that allows employees to purchase shares of their employer’s stock easily and conveniently. Perhaps the biggest advantage of this type of plan is that these shares can be purchased using after-tax payroll deductions. Shares are also typically offered at a hefty discount of up to 15% of the actual market price. For employees taking part, these plans offer an excellent opportunity for employees to stake their own claim in a company’s short- and long-term success.
Understanding Qualified vs. Nonqualified Plans
For tax purposes, it is important to understand that there are two different kinds of ESPPs out there: qualified and non-qualified. Each has its own important rules and stipulations to follow, so you’ll want to be aware of which option your employer is offering.
Qualified ESPPs
A qualified ESPP (which is also the most common type) has to be approved by a shareholder vote before it can be implemented. From there, every employee participating in the plan has equal rights. There are also limits on offering periods and discounts on this type of plan; specifically, offering periods must be 27 months or less, and stock discounts to employees may not exceed 15%.
With qualified ESPPs, participating employees may also be subject to income tax or capital gains tax on their earnings here. In most cases, participants will pay income tax on either the discount offered based on the offering date price or the total gain between purchase and sale price(whichever is lower).
Nonqualified ESPPs
A nonqualified plan operates a bit differently. While these ESPPs are not as common as qualified plans, it is still worth being aware of the rules and tax regulations surrounding these plans. The main thing to be aware of is that with a nonqualified plan, it is possible for an employee to be subject to both income tax and capital gains tax.
Specifically, participants pay income tax on the difference between their original purchase price and the market price for that day. Likewise, employees may also owe a capital gains tax on the difference between the purchase price and final sale price.
With all this in mind, it’s easy to see why a qualified ESPP is typically the more ideal option for employees. In general, participants will pay less in taxes on their earnings from these shares with a qualified plan than they would with a nonqualified plan. Regardless of the type of ESPP you may participate in, being aware of these tax rules can help you make more informed investing decisions.
Other ESPP Tax Considerations
In addition to different taxation rules for qualified vs. nonqualified plans, ESPPs are also subject to some other complex tax rules. There are many factors that come into play when determining how an ESPP will be taxed, including:
- how long the stock has been held
- the original purchase price of the stock
- the closing price of the stock on the offering date
- the final closing price of the stock when purchased
In general, stocks purchased using an ESPP will be taxed at a lower rate when it is held for at least a year or two after purchase. Stocks sold prior to this may be taxed at a higher rate.
The Bottom Line on Employee Stock Purchase Plans
If your employer offers an ESPP, whether it be a qualified or nonqualified plan, this is certainly a benefit worth exploring further. Just make sure you fully understand your own tax requirements and potential tax burdens. Even though these plans allow you to purchase shares of a company with after-tax payroll deductions, there are still important nuances to be aware of that could affect your bottom line.
If you have any questions regarding this article, or if you need further assistance regarding your unique financial or tax situation, send us an email at info@zagmoutcpas.com, or call us at (312) 239-3716.
To learn more, visit Zagmout & Company CPAs at www.zagmoutcpas.com.
