Introduction To Employee Stock Purchase

Plans
By Mark P. Cussen, CFP, CMFC, AFC AAA |
Outside of the wages and salaries, one common method of compensating employees in
today's corporate environment involves the purchase of company stock. The Employee
Stock Purchase Plan (ESPP) offers a very straightforward method of allowing
employees to participate in the overall profitability of the employer over time.
What Is an Employee Stock Purchase Plan?
ESPPs allow workers to buy shares of their employers' stock in a simple and convenient
manner by using after-tax payroll deductions. They are perhaps the simplest form of
stock purchase plan in use today.
Qualified Vs. Nonqualified Plans
ESPPs can be divided into two categories: qualified and nonqualified. Qualified ESPPs
are the most common type of plan and resemble their qualified cousins in the retirement
plan arena in that they must adhere to prescribed eligibility criteria per the IRS. Qualified
plans must be approved by a vote of the shareholders before they can be implemented,
and all plan participants have equal rights in the plan. Their offering periods cannot
exceed 27 months, and the discount on the stock price may not exceed 15%.
Nonqualified plans are much simpler and are not subject to the rules that pertain to
qualified plans, but there is no tax advantage of any kind in these plans. The remaining
sections of this article therefore pertain solely to qualified plans.
Key Dates and Terms
Employees who choose to participate in their company ESPP can only do so after the
offering period begins. This period always begins on the offering date, which
corresponds to the grant date for stock option plans. Payroll deductions then commence
for participants until the purchase date (the day on which the company stock is actually
bought). Offering periods can be either consecutive or overlapping; those in the latter
category will often have different purchase prices because of their staggered purchase
dates.

Most offering periods have several purchase dates that come at the end of several
purchase periods, such as a plan with a three-year offering period that is comprised of
four purchase periods that end in four purchase dates. Therefore, if the offering period
were to begin on Jan. 1, then the first purchase period would last for six months and
end on July 1, and the second purchase period would end on Dec. 31, with this pattern
continuing for the next two years.
Enrollment Process and Plan Mechanics
Employees must apply to enroll in the plan at the next available offering date. On the
application, they will state the amount that they wish to contribute to the plan (which is
usually limited to about 10% of their take-home pay). Contributions are also limited to
$25,000 per calendar year by the IRS, regardless of any restrictions imposed by the
employer. After each pay period, the employee deferrals are placed in separate
accounts until the purchase date. The stock is then held in separate accounts for each
employee by a transfer agent or brokerage firm until they sell their shares and collect
the proceeds.
Potential Gain
Many ESPPs allow their employees to purchase their stock at a 10 to 15% discount
from its market value, thus providing them with an instant capital gain when they sell.
Furthermore, many plans also have a "look back" provision that allows the plan to use
the closing company share price of either the offering date or the purchase date,
whichever is lower. This can have an enormous impact on the amount of gain that
participants realize. Employers can set their own policies about allowing employees to
withdraw their funds from the plan between purchase dates or change their contribution
levels.
Eligibility
Qualified ESPPs prohibit any person who owns more than 5% of the stock in the
company from participating in the plan, and the plan is allowed to disallow certain
categories of employees from plan participation as well, such as anyone who has
worked for the company for less than one year. All other employees must be made
unconditionally eligible for the plan.
Tax Treatment
The rules that govern the taxation of proceeds from ESPPs can be quite complex in

some cases, and only a simplified version of them is covered here. In general, the tax
treatment of the sale of ESPP stock is governed by four factors:

The length of time the stock is held

The price the stock is actually purchased at, factoring in the discount
The closing price of the stock on the offering date
The closing price of the stock on the purchase date

ESPPs use holding periods that closely resemble those of other stock option plans. For
qualified ESPPs, stock that is not sold until at least a year after the purchase date and
two years after the offering date will receive favorable tax treatment. Stock sales that
meet these criteria are known as qualifying dispositions, while those that don't meet
these criteria are labeled as disqualifying dispositions.
Qualifying Dispositions
Participants who meet the holding requirements for qualifying dispositions will realize
two types of taxable income (or losses), but none of it is reported until the year of the
sale. The amount of the discount allotted in the plan (such as 15%) is reported as
ordinary income. The remainder is classified as a long-term capital gain.
Disqualifying Dispositions
This type of disposition counts a great deal more of the sale proceeds as ordinary
income. The seller must count the difference between the closing price of the stock as
of the purchase date and the discounted purchase price as ordinary income. This is an
extremely brief summation of the tax rules pertaining to ESPPs. The mechanics of how
these work can be fairly technical in many instances, and participants should not
hesitate to consult a tax professional for advice on this topic.
Other Advantages of ESPPs
Like all other types of employee stock ownership plans, ESPPs can help to motivate the
workforce and provide employees with an additional means of compensation that does
not come entirely out of the company's own pocket. ESPPs are also relatively simple to
administer and maintain, and can get employees in the habit of saving money regularly,
especially since all contributions into these plans are exempt from Social Security and
Medicare tax. They also allow employees to sell the stock before retirement, which can
prevent their portfolios from becoming heavily weighted in company shares.

The Bottom Line

Employers that are looking for a relatively simple way to get their employees to buy
company stock should take a close look at ESPPs. These plans offer simplicity and
liquidity with minimal administrative costs. For more information on these plans, contact
your tax or financial advisor, or your HR representative.
TAGS: Compensation Employee Benefits Stock Compensation WM-Executive Compensation WM-Fringe Benefits

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