Most conversations about company equity start with RSU’s or stock options, but the sometimes overlooked benefit of an Employee Stock Purchase Plan (ESPP) should definitely be on your radar and a part of your strategy. While all financial decisions need to be based on your unique circumstances and situation, the ESPP strategy that makes the most sense in the vast majority of cases is the following:
- Participate at the maximum level allowed by your company’s plan (i.e. if your company has a contribution limit of 10% of salary up to $25k per year, you should choose this limit) or as much as your monthly cash flow allows for.
- You should sell your shares immediately after they are purchased on each 6-month purchase date.
I suspect that you won’t question point #1. If something of value is on sale, loading up as much as you can get seems pretty straightforward. Based on other investing principles of “buy and hold” and tax efficiency, #2 likely will require some explaining.
To provide some insight on why this strategy makes sense in most cases, let’s walk through the following list of questions, starting with the basics and working our way up to more complex tax and strategy issues:
- What is an ESPP?
- What are some important ESPP terms to understand?
- Should you participate?
- How are ESPP Gains Taxed?
- When should you sell your ESPP shares?
What is an ESPP?
An Employee Stock Purchase Plan (ESPP) is a valuable benefit that allows you to purchase shares of your employer’s stock. In most cases, employees are provided both an automatic payroll deduction process and a discounted price as incentives to participate in the Plan.
Many companies believe that employee ownership will provide several long-term benefits like higher retention and a more motivated workforce, to name a few.
Even though ESPP doesn’t meet the strict definition of equity “compensation” since it is more a choice to use cash compensation to purchase the equity, I still place ESPP in the equity comp bucket because it involves purchasing (and potentially holding) your company’s stock. It’s also important to account for other forms of company equity (RSU’s & options) on your personal balance sheet when forming your strategy. You can’t make these decisions in isolation.
How does an ESPP work?
Let’s start with some important terms:
Contribution limitations: In most plans, you are limited to the lesser of 15% of your salary or $25,000 per year.
Offering Period: Typically a period of 12-24 consecutive months that is broken down into 6-month purchase periods. The elected % of salary is withheld and set aside until shares are purchased on two dates each year (i.e. April 30th & October 31st).
Purchase Date: The date at the end of each 6-month purchase period in which the purchase price is determined and the accumulated funds are used to purchase shares.
Offer Price: The price that the employee discount is applied to. In most cases, this is the lesser of the stock price at the start of the Offering Period or the price on the Purchase Date.
Bargain Element: The % discount that is applied to the Offer Price. This discount varies by each plan but can be as high as 15%.
Lookback provision: The common name of the policy where the ESPP compares the current stock price to the price at the beginning of the Offering Period and uses the lower of the two prices.
In order to participate, you simply have to enroll and select the % of your salary that you want to be withheld from your paycheck. The company will administer the withholding through regular payroll and the Plan Administrator (i.e. ETrade) will execute the order to purchase the shares and deposit them into your brokerage account.
The Offering Period is broken down into 6-month purchase periods in order to maximize the value of the benefit. If your ESPP provides a 15% stated discount, the lookback provision means you get to buy the shares at 85% of the closing price on either the first day of the Offering Period or the last day of the current Purchase Period, whichever is lower. In a rising market scenario, this means you can apply a 15% discount to a price which is already lower than the current market price (and perhaps considerably so).
The following graphic, as presented on ETrade, shows a share price that starts the Offering Period at $20 and ends at $25. When a 15% discount is applied to the lower of the two price points ($20), the purchase price drops to $17. Purchasing shares at $17 on the same day that the market is at $25 results in a 32% discount ($8/$25).
Instead of exchanging $1,000 / $25 for 40 shares, the employee exchanges $1,000 / $17 for 58 shares.
What if the market declines during a 6-month purchase period? Take the example above and flip it around. If the Offering Period starts at $25 and ends at $20, you would still take the lower of the two prices ($20) and apply the 15% discount and land at the same $17 actual purchase price. The added benefit in this scenario is most ESPP’s reset the Offering Period when a 6-month purchase period ends with a lower stock price than it began. So, instead of carrying forward $25 as the Beginning Offering Period price into the next 6-month purchase period, a new Offering Period begins and uses the $20 price. ESPP is like golf…the lower the number is the better because it means a lower purchase price.
Should you participate?
The opportunity to purchase shares at a stated discount of as much as 15% by itself makes participating in your company’s ESPP a “no-brainer” and as you’ll see shortly, the actual results can be much better than advertised.
This decision is very much in the same bucket as whether or not to participate in your company’s 401k plan where your employer is matching a portion of your contributions. Unless your monthly cash flow is very tight and you can’t afford the drop in take-home pay, YES you definitely should participate!
Don’t leave free money on the table.
What does the profit equation look like under various market conditions?
To get a sense for the range of possible outcomes from your ESPP, below we’ll evaluate a wide range of scenarios and calculate the pre-tax profit on both an absolute $ and semiannual rate of return:
Contribution Limit: 10% (capped at $25,000)
Bargain Element: 15%
Share Price at the beginning of the Offering Period: $100
In this case, $10,000 will be invested at the end of the 6-month purchase period ($200k x 10% = $20k annually)
The chart below will include the following 5 market return scenarios. It’s important to note that the observation window is the 6-month period from the beginning of the Offering Period to the Purchase Date. You don’t hold any shares during this time, but you are making contributions that will be used to purchase shares at the end of the 6-month period.
(1) Major Decline: Shares decline from $100 to $50
(2) Decline: Shares decline from $100 to $80
(3) Flat: Shares start and finish at $100
(4) Increase: Shares increase from $100 to $120
(5) Major Increase: Shares increase from $100 to $200
|Major Decline||Decline||Flat||Increase||Major Increase|
- In most cases, a decline or flat stock price isn’t expected to have a happy ending, but in all 3 ESPP scenarios, the 15% discount is taken from the lower ending stock price and an 18% semiannual return is the consistent result. This also marks the floor or ‘worst case’ scenario for investment return across all scenarios. As a side note, the long-term average return of the stock market (as measured by the S&P 500 Index) is between 9-10%.
- In the 2 scenarios of increasing stock price, the lookback provision to the $100 price at the beginning of the Offering Period drives a much larger true discount than the advertised 15%.
Now, imagine if the 6-month purchase period that we just analyzed was the first of 4 consecutive purchase periods within a 24 month Offering Period. The share price just finished at $150 (Major Increase scenario) and continues to steadily increase over the next 18 months. There will be 3 more opportunities to purchase shares at $85 (15% lower than the $100 Offering Period price) while the market is somewhere north of $150.
How Are ESPP Gains Taxed?
The tax treatment on shares acquired through an ESPP have some unique twists that determine what portion of the profit is treated as ordinary income and what gets more favorable capital gains treatment.
Let’s start with the simplest of all possible scenarios, which also happens to be the strategy that I recommended at the start of this discussion: You sell your ESPP shares immediately after they are purchased at a discount.
You will pay ordinary income tax rates on the full discount received. Taking the “Major Increase” scenario above, you purchased at $85 and immediately sold at $150. The entire $65 gain will be treated as ordinary income.
What are the requirements to get more favorable tax treatment?
You have to hold your ESPP shares for at least (1) a year after the Purchase date and (2) at least 2 years after the start of the Offering Period. If you meet both of these criteria, the sale will be considered a Qualified Disposition and will receive favorable tax treatment.
According to ESPP tax rules, for Qualified Dispositions you will pay ordinary income tax on the lesser of:
- The bargain element or actual discount (Offer Price – Actual Purchase Price)
- The gain between the actual purchase price and the sale price. Price – Actual Purchase Price)
You will pay long-term capital gains on any portion of the gain that exceeds the discount, if any.
In plain English, the idea here is the initial discount is on the basis of your employment (ie non-employees don’t get this benefit) and thus the company is providing something of value to you. This value is taxed as ordinary income.
This is precisely what happens with your RSU’s as well, the difference being your RSU’s come with a much larger discount…as in 100%! You don’t pay anything, they simply add shares to your brokerage account on the vesting date. For tax purposes, this value is treated the same as if they deposited an equivalent amount of cash (ie salary) into your checking account….the number of shares x the market price on the vesting date is ordinary income.
Now that you have been taxed on this initial income, this value becomes your basis. Any increase/decrease in value from that point forward is a capital gain/loss. For RSU’s, you simply need to hold the shares for more than 1 year to obtain long-term capital gains treatment. For ESPP’s, you have the added hurdle of holding for at least 2 years from the Offering Period.
When Should You Sell Your ESPP Shares?
The most common response to personal finance questions starts with “Well, it depends……”
So, while tax planning should always be a central part of the broader financial planning process, pursuing a strategy solely based on a lower expected tax rate is not something that I advocate with my clients. Be careful that the tax “tail” doesn't wag the strategy “dog”.
In this case, the primary risk that needs to be accounted for and balanced against tax efficiency is the investment risk of holding a concentrated position in your company’s stock.
In a perfect world, perhaps you might be able to lock in the current price and defer the sale for 1+ years to maintain the profit position while also getting the most favorable tax treatment. Back on planet Earth, your portfolio and net worth could be exposed to material volatility (good and bad) during the 1+ years that you hold the shares in order to achieve a Qualified Disposition.
Aside from this risk, you likely already have a large portion of your net worth and investable assets exposed to the risk/rewards of your company based on your RSU’s and options. You can’t do anything to diversify unvested shares/options. You have to wait, in many cases multiple years, before the shares are yours to do as you wish. You are also relying on your company for your salary and benefits.
A good investment strategy has both a rationale for getting in AND a planned exit strategy. For ESPP, the rationale for getting in is the discounted price. That’s the ‘free lunch’ part of the story. Once you have this in hand, holding the shares is no longer risk free.
Lock in the generous return and sell the shares. Enjoy a rare free lunch. Rinse and repeat every 6 months.
After reading this, if you still feel that holding the shares in pursuit of favorable tax treatment is the right strategy for you, I will drill down into the details of the tax treatment for both Qualified and Non-Qualified Dispositions in an upcoming post.