An employee stock purchase plan (ESPP) is a benefit plan, like a Roth 401(k), that allows employees to make after-tax deferral contributions that can be used to purchase shares in the company they work for. Using an ESPP, employees can typically buy shares at a discount that they can hold until retirement or sell.
How an ESPP Works
When a company offers an ESPP, they must first structure the plan. This is done by working with a provider to put together plan documents that outline the details of the plan. This plan documents outline when employees can purchase shares and how shares are priced, including any discount.
Once an employer adopts a plan document, eligible employees are given the option to participate. Using an ESPP, employees make contributions themselves that are used to buy company stock. These ESPP contributions are after-tax, but company stock can often be purchased at up to a 15 percent discount.
If your employer decides to structure an ESPP, they will set an offering date that lets employees know they will be able to buy stock. Employees then have time during the offering period to make contributions that can be used to buy stock on the purchase date. There is no vesting in an ESPP. Once you purchase company shares through an ESPP, they are yours. You get to keep or sell them even if you leave the company immediately after buying them.
Qualified vs. Nonqualified ESPPs
There are two types of ESPP: qualified and unqualified. Tax-qualified ESPPs offer several tax advantages to participants including that employees aren’t taxed on any discount they receive on stock purchases. You can read more about the tax benefits in the ESPP Tax Rules section below.
Characteristics of a tax-qualified ESPP include:
- Shareholder approval: In order to institute an ESPP, the company must first get formal approval from shareholders
- No taxes on stock price discount: In a tax-qualified ESPP, employees who are offered shares at a discount are not taxed on the difference
- Limited offering period: Under a qualified ESPP, the purchase date must be within 3 years of offering date; for more information on ESPP timing and deadlines, be sure to check out the Deadlines section below
In addition to tax-qualified ESPPs, there are also some ESPPs that are unqualified and have fewer restrictions. However, these plans also don’t have the same benefits as tax-qualified ESPPs. For example, employees who are able to purchase stock at a discount through a nonqualified ESPP are taxed on their discount.
Some of the different tax consequences for nonqualified ESPPs include:
- Income taxes on discount: 15 to 35 percent of value of discount
Employees who have a nonqualified ESPP and get a discount when they purchase shares through an ESPP must pay income taxes on any discount they receive when they purchase shares.
- Capital gains taxes at sale of shares: 15 percent of gains
As with a qualified ESPP, employees who participate in a nonqualified ESPP plan must pay taxes on any gains in the value of their ESPP shares between when they bought and when they sold.
How an ESPP Works for Business Owners
When a company formally adopts an ESPP, the company sets a stock purchase date as well as an offering date for employees to enroll and start contributing through salary deferrals. Once the purchase date arrives, the company uses employee contributions to purchase stock and allots each employee’s shares to each personal account.
When shares are purchased on the purchase date, it’s common for ESPPs to purchase shares at a discount. In addition, many plans have look-back provisions that based the purchase price for employees on the share price at either the beginning or the end of the offering period — whichever is lower. Employee discounts are then applied to the lower of those two prices.
After shares are purchased on the purchase date and allotted to individual employees based on their contributions, those shares belong to employees and are unrestricted. Employees can sell them whenever they’d like or keep them if they leave the company.
Benefits of an ESPP
If your employer offers an ESPP, this gives you a great way to build some ownership in the company you work for and potentially make a profit off of the discounted shares you purchase. Under an ESPP, you’re able to make after-tax contributions, similar to a Roth 401(k). Those contributions accumulate and be used to purchase shares in the company you work for, typically at a discount.
Some employee benefits of an ESPP include:
- Invest in the company you work for: Employees with an ESPP can buy shares to own part of the company they work for
- Share price discounts: Employees can usually buy shares with up to a 15 percent discount
- Immediate vesting: Shares purchased in through an ESPP aren’t subject to vesting schedules; they belong to employees immediately
Employees in tax-qualified ESPPs also get to benefit from ESPP tax rules as well. Although their contributions are still after-tax, employees who are given a discount when buying shares in a qualified ESPP are not taxed on their discount.
ESPP Benefits for Small Business Owners
An ESPP can be a great way for employers to transfer ownership in their companies to employees without having the company finance the buyout like in an ESOP. Instead, ESPPs align employee interest with the company’s, encourage employee savings through salary deferrals and reward them for staying with the company through the offering period.
Some cases where an ESPP can be helpful for business owners include:
- Encouraging employee saving: Businesses can offer discounts on employee stock purchases, which encourages them to contribute
- Aligning employee interests with yours: Using an ESPP, employees are invested in the success of your company
- Transferring control of business: ESPPs can be used to fund a gradual buyout by employees
- Reward employees: Employees get to keep shares if they leave but an ESPP can encourage loyalty
ESPPs are much more common among publicly traded companies than private businesses. Private businesses can still use ESPPs, and there are benefits for owners who use them. However, private businesses that use ESPPs must be careful to avoid violating any SEC rules.
While ESPPs can be beneficial, they don’t work in all cases including:
- Small private companies: Using an ESPP for small private companies can trigger an SEC inquiry or an audit
- Few employees or high turnover: If you have few employees or employees frequently leave you may suffer from low participation in an ESPP
- Lifestyle businesses: If your business is your biggest asset and you depend on it for your income or sales proceeds for financing your retirement, an ESPP probably isn’t your best option
One of the biggest EPPP benefits is that it gives you a way to recruit talented employees and reward long-time workers with discounted stock purchases in your company. Under an ESPP, employees can make up to $25,000 in after-tax contributions that are used to buy shares in your company at up to a 15 percent discount. For more information on the benefits of ESPPs, be sure to check out the Pros & Cons section below.
To use an ESPP, employees must be sure to follow certain rules. Not everyone can participate, and employees must be sure that they don’t contribute more than $25,000 per year. Employees are also prohibited from deducted ESPP contributions from their taxable income, similar to a Roth 401(k).
Some ESPP rules include:
- 5 percent company owners can’t participate in an ESPP: ESPP eligibility is limited, included that you can’t own more than 5 percent of the company already
- ESPP participants may be required to contribute at least 2 percent of income: Plans can also require that employees defer at least 2 percent of their income in order to participate
- Employees can’t exceed ESPP contribution limits: Employees can only contribute $25,000 per year to an ESPP
- Employees must pay appropriate taxes when they sell ESPP shares: ESPP tax rules vary in qualified or nonqualified plans; ESPP contributions are after-tax, but any discount on share purchases are tax-free in tax-qualified ESPPs
If you have an ESPP through your work, be sure that you follow these rules and that your employer does the same. This is especially true when you want to take an ESPP qualifying disposition. Failing to follow these rules can your cause your plan to be disqualified or for your employer to incur penalties.
ESPP Qualifying Dispositions
In order to get favorable tax treatment, employees typically need to sell their ESPP shares through an ESPP qualifying disposition. A qualifying disposition is when an employee sells shares that they’ve held for at least a year after the purchase date or at least 2 years after the offer date.
The holding periods for an ESPP qualifying disposition are:
- At least 1 year after the purchase date, or
- At least 2 years after the offer date
Employees can still sell ESPP shares that they haven’t held long enough to sell through a qualifying disposition. However, employees who sell outside of a qualifying disposition won’t get as many tax advantages as those who hold their shares long enough for an ESPP qualifying disposition.
ESPP Rules for Business Owners
There are strict rules for employers who use ESPPs. Employers get to structure pricing when they set up a plan including any discounts and look-back provisions. However, employers must also ensure that all employees have the same rights under the plan and that employee stock purchased through the plan is vested immediately.
Some important ESPP rules for business owners include:
- Each ESPP sets a procedure to price shares for employees: Employers can give employees the ability to purchase stock for up to a 15 percent discount through an ESPP; plans can also include look-back provisions so that pricing is based on the price of the stock at either the beginning or end of the offering period, whichever is lower
- All employees must be treated the same within an ESPP: All employees must be subject to the same eligibility criteria and have equal rights under the plan
- Immediate vesting: When employees purchase company stock through an ESPP, they can sell the stock whenever they want; they also get to keep the stock even if they leave the company
There are several important deadlines that employers and employees must follow in order to use an ESPP. Failure to follow deadlines may cause you to miss the opportunity to buy shares. Your plan could also be disqualified, or you could encounter unforeseen tax liability. Be sure to follow ESPP deadlines to use your plan effectively.
The four ESPP deadlines to be aware of are:
1. ESPP Offering Date — Decided by Company
Once an ESPP, the company selects a purchase date and an offering date for employees to enroll and start contributing. Employees can’t start contributing to an ESPP until after the offering date. If an ESPP has look-back provisions, employees may be able to buy shares at or below the share price on the offering date.
2. ESPP Offering Period — Period Between Offering and Purchase Dates
The offering period of an ESPP is the period between the offering date when employees can enroll and start contributing and the purchase date when shares are purchased for employees. During this time payroll deductions are collected in preparation for share purchases. Companies may have multiple offering periods running at the same time.
3. ESPP Purchase Date — Decided by Company
When a company sets a purchase date for an ESPP, that date can’t be more than three years after the offering date in a tax-qualified plan. Purchase dates are typically 6 to 24 months after the offering date. However, companies using ESPPs can also have multiple purchase dates, each with its own offering date and offering period running concurrently.
4. Minimum Holding Period for ESPP Shares — 1 Year for Tax Advantages
There is no minimum holding period for shares purchased through an ESPP. However, in order to qualify for advantageous long-term capital gains employees must hold their shares for at least one year. Gains sold on any shares sold in less than a year are taxed as ordinary income.
ESPP Tax Rules & Benefits
When deciding whether to use an ESPP, it’s important to understand several important ESPP tax rules. Employee contributions to an ESPP are not tax-deductible. Employees also typically get to purchase shares at a discount, and this discount isn’t taxed in a qualified plan. However, there are taxes once you sell your shares.
Some ESPP tax rules include:
- Contributions are after-tax: When you contribute to an ESPP, these contributions aren’t deducted from your taxable income
- Taxes due after sale of shares: If you sell your shares in the first year any gains are taxed as ordinary income, but if you hold your shares for a year or longer then you paid lower long-term capital gains rates on all gains from the price you paid, including your discount
- No taxes on your discount: In a qualified ESPP, Employees who are able to buy shares at a discount aren’t taxed at this discount until they sell their shares; however, in nonqualified ESPPs employees are taxed on their discount
- No taxes as stock prices change: Employees have no tax liability so long as they hold their shares, even as the price of their shares fluctuate
ESPP tax rules for employees are minimal. ESPP distributions are subject to the same taxes as an ordinary brokerage account. There are few tax advantages for employees. Contributions are after-tax, and employees must also be taxes on gains. However, employees don’t have tax liability on their share discount or any gains until after they sell their shares.
ESPPs are not taxed like a 401(k) plan where you can change investments without pay taxes. However, money invested in shares through an ESPP also isn’t locked up until age 59 1/2. You can sell your shares to withdraw and use the money whenever you want.
The costs for employees who participate in an ESPP are minimal. These costs are limited to the cost of their contributions, which are after-tax, as well as taxes they incur on any gains in the price of their shares. However, once employees accumulate ownership in their company, they do incur some additional costs indirectly as shareholders of the company.
ESPP Costs for Small Business Owners
Employer costs for an ESPPs are minimal – ESPPs are considered far more cost-effective than many other employer-sponsored retirement benefits. The typical employer costs for an ESPP include legal fees for setting up the plan, costs for regular appraisals of the business and possibly the cost of selling employees discounted shares.
- Setup costs: $5,000+ one-time
Companies that want to use ESPPs must be costs including legal fees to structure and adopt their plan documents
- Appraisal fees: $500+ per appraisal
Private companies using ESPPs must be regularly appraised to determine their value and share price
- Employee discount: Discretionary for employers
Employers decide whether employees will be offered shares at a discount, which is set forth in plan docs. This cost is not a cash outlay but is a cost for employers selling shares for less than they’re worth.
ESPPs are relatively very cost effective compared to other employer-sponsored retirement plans. This is especially true when ESPPs are compared to other company stock plans including employee stock ownership plans (ESOPs).
ESPP vs. ESOP
In an ESOP, employees don’t make contributions. Instead, companies make discretionary contributions to the plan which are used to buy the business owner’s shares over time or to pay back loans that were taken to buy shares. Using an ESOP, business owners effectively finance their own buyout through tax-deductible contributions.
From an employee perspective, there is no deciding between an ESPP or ESOP. Business owners decide whether to offer one of these plans and employees decide whether to participate. However, ESPPs are considerably cheaper than ESOPs even though they require employees to make contributions to buy shares.
Business owners that are weighing an ESPP vs. ESOP should expect far higher participation in an ESOP since employees don’t have to contribute. Instead, all eligible employees are enrolled and start receiving their shares over time.
Tips on Investing in an ESPP
Employees thinking of participating in an ESPP or employers thinking of implementing a plan should be careful in deciding how and when to use a plan. ESPPs aren’t for everyone, and they can be misused easily. Employees need to be confident in their employer, and companies need to be cognizant of plan options and securities laws.
Five tips for investing in an ESPP are:
1. Don’t Contribute More Than You Can Afford
ESPPs are different from many other employer-sponsored retirement plans because ESPP contributions are tax-deductible. Unlike a Traditional IRA or 401(k), after-tax contributions to an ESPP are more expensive because employees still have to pay tax on that income. As a result, it’s important to be aware of the increased cost and be careful not to contribute more than you can afford.
2. Don’t Participate If You’re Not Confident in Your Company
Before participating in an ESPP, it’s very important for employees to be confident in the financial and operational viability of their employer. It’s a bad idea to participate in an ESPP and purchase company stock — even if you plan to sell it immediately — if you aren’t confident in your company’s future.
“Employees should not participate in an ESPP if they’re concerned about the financial viability of their company.”
— Levar Haffoney, Principal, Fayohne Advisors
3. Consider Company Stock as Part of Overall Portfolio
Any stock that you purchase through an ESPP should be just part of an employee’s overall investment strategy. Employees rely on their employer for their livelihood, so it’s important for them not to invest in their entire life savings in company stock as well. If the company encountered legal or financial difficulty, employees who overinvest could be doubly impacted.
4. Nonqualified ESPPs Offer More Flexibility
Employers who are thinking of setting up an ESPP need to be aware of different types of plans and their options. Employers can set up either a qualified or nonqualified plan, each of which offers its own benefits and drawbacks. Plans can also offer different length offering periods and varying discounts for employee stock purchases.
5. Be Aware of Securities Laws
Employers who are thinking of offering an ESPP need to be careful not to avoid U.S. Securities and Exchange Commission rules about issuing stock. This is especially important for private companies that haven’t previously been through the process of issuing stock or established a value for their company.
“ESPPs are formal plans are very rare in non-public companies because they are based on employees buying shares, and that triggers securities law requirements.”
— Corey Rosen, Ph.D., Founder, National Center for Employee Ownership
Pros & Cons of an ESPP for Small Business Owners
ESPPs are a great benefit for eligible employees in some companies. Employees get to acquire an ownership stake in their business with little cost aside from the cost of contributions. Employers get to encourage demand for their stock and employees get to keep their stock without any vesting.
Pros of an ESPP
ESPPs offer a number of advantages that employers should consider when deciding whether to structure a plan. Employees who enroll in ESPPs are required to contribute rather than having employers finance their own buyout. ESPPs also offer employee tax advantages and can benefit company shares prices by encouraging employees to invest.
Some ESPP pros include:
- Employees contribute: Shares purchased through an ESPP are financed with employee contributions rather than contributions from the company like an ESOP
- Built-in buyer for stock: Under an ESPP, employees are encouraged to purchase company stock which can boost the share price of the business
- Tax advantages: Employees make after-tax contributions to an ESPP, but there are no taxes on shares until they’re sold
- Great recruiting tool: ESPPs are a great way for employers to attract and retain talented employees
Cons of an ESPP
In addition to the advantages, there are several drawbacks to consider when deciding whether to use an ESPP. While ESPPs have initial and ongoing costs, are harder for private companies to use, and have limited eligibility. Employers who want to offer ESPPs must also vest employee stock purchases immediately.
Some cons of an ESPP include:
- Upfront cost: Companies using ESPPs have costs for legal fees to structure their plan and costs for continual appraisals of the company
- Difficult for private companies: ESPPs are much harder for private companies to use; they must have repeated appraisals to track the company’s value and can run into problems with SEC because of stock issuances
- Immediate vesting: Shares purchased by employees through an ESPP can’t be subject to vesting schedules
- Limited eligibility: Employees can’t participate in an ESPP if you own 5 percent of company or more
- No employee preference: All eligible employees must be given the option to participate in an ESPP and have the same rights under the plan
ESPP Frequently Asked Questions (FAQs)
If you still have questions about ESPPs after reading this article, here are some of the frequently asked questions about ESPPs. If you still don’t see an answer to your question, you’re welcome to post it in the comment section. Alternatively, you can visit the FitSmallBusiness Forum and post questions there.
Are ESPP Contributions Taxable Income?
Employee contributions to an ESPP are not tax-deductible. However, there are no taxes on shares purchased through an ESPP — or an employee discount — until the shares are sold. If you hold your shares for a year or longer, the gains are taxed as long-term capital gains rather than income.
How Long Are You Required to Hold ESPP Shares?
Shares purchased through an ESPP are not subject to a vesting plan. Employees are allowed to sell any shares they purchase through an ESPP whenever they want. However, shares must be held for at least one year in order to benefit from advantageous long-term capital gains rates.
What Is an ESPP Disqualifying Disposition?
If an employee sells shares purchased through an ESPP, this is considered a disqualifying disposition because the sale is not eligible for preferential tax treatment. Instead of taking advantage of long-term capital gains taxes, any gains on shares sold in under a year, including an employee discount at purchase are taxed as ordinary income.
Is an ESPP Subject to ERISA?
ESPPs are not subject to the Employee Retirement Income Security Act (ERISA), unlike other types of employer-sponsored retirement plans including 401(k)s. Some ESPPs are considered qualified, but they aren’t qualified in the sense that they’re subject to ERISA. Instead, these plans are considered qualified because they’re eligible for favorable tax treatment.
The Bottom Line
ESPPs are extremely valuable for both employers and employees. ESPPs can be a great recruiting tool for employers but are also an ideal way for employees to accumulate ownership. Using an ESPP, employees can contribute up to $25,000 per year to purchase stock in their employer, typically at a discount.