You may be wondering what an employee stock purchase plan (ESPP) is. To answer this question, we will discuss what an ESPP is, how it works, what its eligibility limits are, and its benefits. So, to find all the answers, let’s dive in.
What Is an Employee Stock Purchase Plan?
An employee stock purchase plan (ESPP) is a benefit that some publicly traded companies offer their employees. Participants are eligible to purchase company stock at a discount during an offering period.
Deductions are taken from the employee’s paycheck and are invested in the company’s stock. Some employers even offer a lookback period. A typical ESPP lets employees buy up to $25,000 in company stock for a 15% discount.
Participation in an employee stock purchase plan begins on the Offer Date. The employee is notified of their eligibility on that date. The plan generally lasts a specified period. Employees can buy shares of stock at the beginning of the Offer Period and during Purchase Dates.
This gives them the opportunity to accumulate a significant amount of company stock over time. There are a few important rules to follow.
You should read the plan documents carefully before participating in an Employee Stock Purchase Plan. For example, you should not be able to own more than 5% of a company’s voting power or stock.
How Does an ESPP Work?
An employee stock purchase plan is a company benefit that allows employees to purchase a certain amount of company stock at a discounted price.
Companies typically offer this plan at a discount of between five and fifteen percent.
For example, an employee can purchase one share of company stock for eight dollars and receive a profit of $1.50. This profit decreases if the share price drops, but grows if it increases.
An ESPP involves payroll deductions. The employee selects an amount to contribute each pay period. Once accumulated, these payroll deductions are deposited into the ESPP account.
The ESPP then purchases the shares at a discounted price, typically 15% off the current market value. In an ESPP with a “Lookback Period,” the employee can use this discount to buy a share of the company at a later date.
ESPP eligibility and limits
Employee stock purchase plans are a great way to align the interests of employees and company shareholders. They encourage increased employee effort and motivation, which boosts loyalty, retention, and organizational pride.
However, employee stock purchase plans are not without their own drawbacks. They require extensive HR functions and are subject to legal issues and security regulations.
The ESPP will usually have an enrollment period that comes around twice a year. Participants will decide how much they want to contribute to their account each pay period.
After the enrollment period, the company will fund the account with money directly from employees’ paychecks. When the account balance reaches the “purchase date,” employees can use their funds to purchase company shares for a discounted price. The enrollment period is typically six months.
The Benefits of Employee Stock Purchase Plans
A company may offer an employee stock purchase plan to its employees. The employee can participate in the plan without incurring any cost, and the company can buy the shares at a discounted price.
The employee has two main options in this plan: purchase or opt-out. A company may have a limited time to offer the plan to employees, and the employee may choose to participate during that time.
In general, employee stock purchase plans have an offering period and a purchase period. The offer period ends on the purchase date.
Tax deductions
An ESPP is an equity-based compensation program that allows employees to buy company stocks in return for a percentage of their salary. While participating in an ESPP is optional, it is important to know the limits of an employee’s ability to buy and contribute.
The IRS does not allow employees to purchase more than $25,000 of company stock per year. However, employers can provide their employees with an incentive to participate in an ESPP that offers a tax break.
Usually, ESPP discounts are in the range of five to fifteen percent. While an employee stock purchase plan can have a range of limitations, it is always better to use qualified plans because of their favorable tax consequences.
The company must also provide an equal opportunity for all employees to participate in the program. In addition, the plan’s offering period must not exceed three years.
Share Price
This discount on the ESPP can be as much as 15% below the market price. You can accumulate this discount over a specified period. And the employee can opt to purchase shares during this period or not. Employees can also opt to make matching contributions to the company in lieu of discounts.
The discount is accounted for twice so that the total cost of the purchase is less than the original price.
Assuming Alex has already enrolled in the ESPP of his company, he will receive a discount of 15% on the cost of the shares he buys through the plan.
This discount relies on the share price at the start of the enrollment period and the price at the time of purchase. A typical ESPP timeline looks something like this:
Lookback provision
Many tax-qualified employee stock purchase plans (ESPPs) include a lookback provision. This allows participants to purchase shares at a lower price at any time during the plan’s offering period.
If the market value of a particular company falls over time, the lookback provision can prevent employees from incurring a loss by buying the shares at a lower price.
The lookback provision allows participants to purchase shares at a discount, and it provides a timeline for the purchase.
Most ESPPs allow employees to buy the stock at a discount, usually ten or fifteen percent below the current market value. The resulting capital gain is often significant.
In addition, many ESPPs have a “look back” provision, which uses the closing share price of the offering or purchase date to determine the amount of gain that participants can realize.
Another important benefit of an ESPP is that contributions are not subject to Social Security or Medicare taxes.
Tax treatment
These plans get the funding typically through after-tax payroll deductions. When the employees eventually sell the stock, they will be subject to the tax treatment based on whether the sale was a qualified or nonqualified disposition.
A qualified plan lets employees buy a stock at a discount, but also requires a holding period that is long enough to generate favorable long-term capital gains tax treatment.
An ESPP payoff profile shows a $10 price at the start of the offering period, as well as the guaranteed minimum gain and potential upside.
The program is simple in theory, but it becomes complicated when taxation is involved. If an employee or investor sells their shares, they must pay taxes on the difference between the price at the purchase date and the price at the time of the sale.
Discounted buying
An employee stock purchase plan is a type of retirement investment where the company buys shares on an employee’s behalf. Sometimes, employees require to pay a certain percentage or flat amount out of their paychecks that includes in the plan.
When choosing an ESPP, clients should consider the maximum allowed ESPP contributions, simultaneous sales, high-basis shares, and investment of the proceeds in tax-advantaged accounts.
These features can help a highly compensated client obtain a 17.6% instant return on investment while replacing the employer stock with discounted shares. The investor should also consider the cost basis of the stock and whether the discount can be used to buy more shares.
Saving for Retirement
Saving for retirement with an ESPP is a great way to supplement your current income and can help you save for your future. Although tax advantages do exist, GESPPs are not available to everyone.
For example, you may not be able to access your shares until you reach age 59 1/2, but if you can access them now, you’ll be better off than you were a decade ago.
When investing in an employee stock purchase plan, you should prioritize its contribution after employer matching and other retirement plans.
Remember that it is risky to invest too much of your money in employer stock – one of the most famous examples of a company that went bankrupt is Enron. To reduce the risks of a concentrated position, limit your employee stock holdings to ten percent of your total portfolio. That way, you can make sure you have more money in other areas of your portfolio.
Short-term Saving
The shares can then be sold immediately for a profit. These plans usually get their funding by withholdings of 1% to 10% of an employee’s income.
Employees receive chunks of stock every six months, and they have the option of completing the investment at any time, or they can hold on to the stocks until a certain deadline.
An ESPP can provide a substantial amount of liquidity after the basic holding period, which is usually 18 months.
In one survey, nearly three-quarters of participants had already tapped their accounts for immediate cash needs. Others sell out to diversify their savings or wait for a particular stock price to reach a predetermined target.
But it is important to understand those short-term savings from an ESPP get a lower tax rate than long-term savings from other types of investments.
Better Employee Performance
An employee stock purchase plan is an excellent way to increase employee loyalty, create an ownership culture, and provide a competitive edge for a company.
While employee stock ownership is not the right solution for every business, it can benefit all involved. Committed employees can make their company successful and work harder and accomplish more. This in turn will help the company’s bottom line. Ultimately, this is a win-win situation for all.
In addition to offering a competitive compensation package, an ESPP can boost employee performance and engagement. Studies show that employees with ESPPs are more likely to work longer hours, report higher job satisfaction, and quit less frequently.
ESPPs also provide a steady stream of cash to the company since they get the deduction from salaries. Furthermore, they can reduce compensation costs, as the employee stock purchase plan is typically priced lower than other forms of equity compensation.
Raise Capital
While an Employee Stock Purchase Plan can be a beneficial part of a financial plan, it’s important to consider all of the risks, associated with holding stock. Employees who participate in an ESPP are given a large chunk of stock every six months at a discount.
While some companies offer lookback periods, these can be a deal-breaker when engaging with potential employers.
Conclusion
Employee stock purchase plans are not mandatory, so employees do not have to participate. However, participating employees are not disallowed from the plan if they meet certain criteria.
Employees are responsible for understanding their income allocation when they participate in an ESPP.
They must specify how much they want to deduct from their paychecks between the date of the plan’s offering and the day they purchase stock. The accumulated funds are then used to buy shares of company stock.