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Let’s discuss Employee Stock Purchase Plan (ESPP)! 🏊‍♂️

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An Employe Stock Purchase Plan (ESPP) can be a valuable benefit depending on your financial situation and the specific terms of your company’s plan.

What is ESPP?

An ESPP is a corporate benefit that allows eligible employees to purchase company stock at a discount, usually up to 15%. 

This benefit is not offered by all publicly traded companies, but based on a 2021 study, roughly 38.5% of Russell 3000 companies offered this benefit

Rules

The rules are generally different across companies.

Some might offer a 5% discount. Some might offer a 10% discount. Some might have a required holding period. Some might not.

So, it’s a good practice to review your company’s benefits to understand exactly what they offer in your case.

What can make an ESPP beneficial?

• Potential discount on the current fair market value of shares

• Potential lookback periods (the company will generally apply the discount to either the price at the beginning or the end of the offer period, whichever is less, so you're effectively getting the lowest share price during the period)

• Potentially no holding period (the time required to pass before you can dispose of the purchased shares

Hypothetical example

Say you work for a company that offers an ESPP with a 15% discount, and the current market price is $100/share. Your company doesn’t offer a “lookback provision” and purchases shares at the market price ($100).

• You can buy the stock at $85 during the ESPP period.

• If you sell immediately for $100 (assuming no required holding period), your pre-tax gain is $100 – $85 = $15 per share.

• $15 pre-tax gain ÷ $85 purchase price = 17.64% pre-tax return on your money.

This is just an example (often called a “flip” strategy), and actual returns and tax implications will depend on your plan's rules and your specific situation. We’ll discuss specifics below.

Maximum contributions

ESPP plans are highly specific to each company. This means that different plans could have different limits.

However, if your company has a qualified ESPP (under §423), you are allowed to purchase a maximum of $25,000 of stock in a year.

The limit is based on the value of the stock on the first day of the offering period, not your purchase price.

For example, if the share price at the start of the offering period is $100, the maximum purchase limit is 250 shares.

Keep in mind, though, that your company’s limit may differ from the IRS $25,000 limit depending on your plan, so be sure to check your offering documents.

Taxes

This is the most confusing part of ESPP. How do you pay taxes? When do you pay taxes? How much?

First, taxes will depend on the type of ESPP plan. There are 2 main types:

• Qualified ESPP

• Unqualified ESPP

Approximately 79% of ESPPs are qualified, so let’s focus on the qualified ESPP taxation.

If you have a qualified ESPP plan, taxes will depend on whether the sale is a:

> Qualifying Disposition or
> Disqualifying Disposition

Here’s a simple chart to help you figure it out:

If you have a disqualifying disposition (don’t meet the holding period), per IRS, “the ordinary income that you should report in the year of the sale is the amount by which the FMV of the stock at the time of purchase exceeds the purchase price. Treat any additional gain or loss as capital gain or loss.

Going back to our hypothetical example, if $100 is the FMV, and $85 is the purchase price, the $15 discount is taxed at the ordinary income tax rates only when you sell. Any additional gain or loss will be a short term or long term, depending on the holding period.

If you have a qualifying disposition, the ordinary income is:

(1) the amount by which the stock's FMV on the date of grant exceeds the option price or (2) the amount by which the stock's FMV on the date of sale or other disposition exceeds the purchase price. 

If the gain is more than the amount you reported as ordinary income, the remainder is a capital gain.

In simple terms, you will need to pay ordinary income tax on the lesser of the discount offered or the gain between the actual purchase price (after the discount) and the final sale price. The remainder will be treated as a capital gain.

Wrap up

Overall, an ESPP can be a valuable benefit, but it’s important to understand the specific rules and tax implications of your plan, and consider seeking professional advice to determine how it fits with your broader financial goals.

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If you want more resources on building wealth as a solopreneur/entrepreneur, check these out:

• The Solo 401k handbook

• The Roth IRA handbook

• The Self-Directed IRA handbook

• The Guide to Paying Less in Taxes

• What is a Solo 401k?

• How to Open a Solo 401k