What Is An ESPP?
An Employer Stock Purchase Plan is an benefit to purchase company stock at a discount. It’s suppose to be an incentive for the employee to work hard for the company and for the employee to benefit from the long-term growth of the company.
To get started with a ESPP, there is an enrollment period that an employee needs to decide how much of their income they want to have deducted from their paycheck to purchase discounted company stock. It depends on the company on how much stock can be purchased, but it’s typically $25,000 a year or 15% of someone’s salary, whichever is lower.
Once the amount is selection, then the employee enters the offering period. At Nike, the first offering period starts April 1st, and the purchase date is September 30. Followed by having next the offering period on Oct 1st, and the purchased date on March 30th.This will vary from company to company.
The discount on purchasing stock is typically 15%, which is the maximum allowed by the IRS. When an employee enters the offering period, they will be able to purchase stock at the lower price of either the offering price, which is the stock price on the first day of the offering period, or at the purchase date, which is the stock price on the last day of the offering period.
If we look at Nike in 2019 and 2020, this is a hypothetical example of how much stock an employee would have gotten if they contributed $10,000 towards their ESPP.
Nike Offer Period 10/1/2019 to 3/31/2020
- Offer Price – $92.28
- Discount Price – $78.44
- Purchase Price – $82.74
- Discount Price – $70.33
If an employee put $5,000 or $833.33/mo into Nike’s ESPP, they would have purchased 71.09 shares at a price of $70.33, which means the purchase price was used the acquire price. This stock on 3/31/2020 would be worth $5,881.99, which is a 17.65% return on the employee’s investment.
Nike Offer Period 4/1/2020 to 9/30/2020
- Offer Price – $79.23
- Discount Price – $67.35
- Purchase Price – $125.54
- Discount Price – $ $106.71
If an employee put $5,000 into Nike’s ESPP in this scenario, they would have have used the offer price to acquire the Nike stock. The employee would have acquired 74.24 stocks at $67.35. Since the stock appreciated significantly from the offer price, the stocks on 9/30/2020 are worth $9,320.09, which is a 86.41% return for the employee. A pretty good deal for the employee who participated during this period but shows that price of company stock is volatile from year to year.
An employee who participates in an ESPP program is guaranteed to make 17.65% return (before tax) if they sell the stock as soon they are able to. There is financial risk in holding the stock, but the decision to hold depends on someone’s goal, expectations about the company stock, and risk tolerance.
How Is An ESPP Taxed?
Participating in an ESPP is done with after-taxed dollars, so the only thing that is taxed initially is the discount that was received. The only taxes that apply to the discount amount are federal and state taxes. Social Security and Medicare taxes don’t have to be applied to the discount amount. To get an example of tax consequences, let’s look at the projected tax situation for the two scenarios above.
Nike Offer Period 10/1/2019 to 3/31/2020
- Discount Value Received:$881.99
- Federal Tax (24%) – $211.68
- State Tax (9.3%) – $82.03
- Profit – $588.28
Nike Offer Period 4/1/2020 to 9/30/2020
- Discount Value Received: $4,320.09
- Federal Tax (24%) – $1,036.82
- State Tax (9.3%) – $401.77
- Profit – $2,881.50
The savings from the discount will always get taxed as ordinary income (Fed and State Taxes), but if someone wants to hold onto the company stock, then the gain above the acquire price can be taxed at a capital gain rate (0%, 15%, 20%) or it can be taxed as ordinary income. It depends if the sale is a qualifying disposition or disqualifying disposition.
Qualifying Disposition
To have the gains of the sale above the discount gain, to get the capital gains rate, it must meet the following conditions:
- Hold the shares one year after the purchase price and two years after the beginning of the offering period
Disqualifying Disposition
If the sale of the stock doesn’t meet the conditions above, then the gain above the discount gain will be taxed as ordinary income.
If we look at the offering period of 10/1/2019 to 3/31/2020, the stock was acquired when the price of the stock was $82.74, so if someone decides to sell their shares on 9/30/2020 at a price of $125.54, they would have the following situation:
- Total Value on 9/30/2020 – $8,924.64
- Cost Basis – $5,881.98
- Profit – $3,042.66
Since this sale is a disqualifying disposition, here is what a projected tax calculation would be:
- Federal Tax (24%) – $730.24
- State Tax (9.3%) – $282.97
- Left Over – $2,029.45
In order for the sale to be qualifying disposition, the sale would need to happen after 10/1/2021. But let’s say the stock ends up selling at the same price of $125.54 just so we can make a comparison.
- Capital Gain Tax (15%) – $456.40
- State Tax (9.3%) – $282.97
- Left Over – $2,303.29
If someone chooses to go for the qualifying position, it’s crucial that good records are kept of the their stock discount, the acquire price, and all the dates. Having incomplete information will mean that the IRS will typically just put someone into the disqualifying disposition, or assume that the cost basis (money it took to acquire the stock) is $0, and end up paying more in taxes than necessary.
How Much Stock Should Be Held On To?
Most financial advisors would recommend selling the stock as soon possible for the following reasons:
- Holding on too much company stock can put someone’s eggs all in one basket and increase someone’s financial risk
- Administratively, it is easy to manage come tax time
If someone chooses to hold on to the stock, they are betting that the gains of selling later will be much higher then settling for the gains of today. There are no guarantees with investing, so people can lose money if they decide to sell later. So it is wise to look at your options and then see what is the best option to take in your individual situation.
Overall, participating in an employer’s ESPP is a great option to get a minimum 17.65% return on your money, but this is not really investing if someone decides to sell on the first day possible, because the value is derived from the discount of purchasing the stock. It’s when someone decides to sell later that they are turning into an investor or speculator.
Before you make any changes with your financial plan or situation, please do your own research, or contact a professional like myself.
