Employee stock purchase plans (ESPPs) have been a popular benefit, especially within the technology sector. While they are relatively new to the biopharma and healthcare sectors, I’ve been coming across them more often as part of companies’ benefit packages.
An ESPP allows you to purchase company stock at a discount from the current market price. ESPPs are considered to be tax-qualified plans if they meet the requirements of Section 423 plans under IRC rules.
With most ESPPs, you are able to purchase company stock at a 15% discount (the maximum discount the IRS currently allows) of the market price of the stock. You start contributing to the ESPP through payroll deductions, anywhere between 1%–15%. Your company will buy into the stock twice a year.
Here are the top features of ESPPs and how to make the best of this benefit:
“Lookback” Feature: Know How Your Purchase Period Works
If your company offers a qualified ESPP, called a Section 423 plan, you not only can buy the stock at a discount, but with appropriate holding periods, you can also gain further tax benefits. This is called the lookback feature. It essentially allows the company to buy you discounted stock either at the beginning or end of the purchase period — whichever is lower — giving you further opportunity for a discount. The purchase period usually runs for six months.
Within Section 423 plans, you can also qualify for tax-deferred benefits if you know the key dates of your plan and hold the shares for the required holding periods. You contribute to the ESPP with after-tax dollars, and you need to hold the shares for at least one year from the purchase date and two years from the beginning of the purchase period. If you are able to meet these two holding periods, the tax liability on the stock will be deferred until the stock is sold and, most importantly, only the purchase price discount will be taxed as ordinary income. The rest of the gain will be taxed at the capital gains tax rate.
Learn the ESPP Cycle
In order to realize all the benefits of tax deferral and the lookback feature, you need to understand the timeline for your company’s ESPP:
- Enrollment/Offering Date: This is also called the grant date, the first day of the offering period. This is the start date for tax purposes, as well as the price for the lookback feature.
- Enrollment Period/Purchase Period: This is the time when your payroll deductions are ongoing, and you are accumulating dollars within the plan. This period lasts for 12 months in most cases and shares are purchased twice — every six months.
- Purchase Date: As your payroll contributions accumulate over the purchase period, your company uses this money to buy the stock for you at a discount on the designated purchase date.
Here are a few other points to note:
- You can opt out and get your money back: You need to check how this process works at your company, but in most cases, you can change your mind and opt out of the plan and get your money back anytime. This flexibility is a nice feature of ESPPs.
- The power of dollar-cost averaging: We all know the power of dollar-cost averaging. As the ESPP buys the stock periodically — usually twice a year — fluctuations in the price of the company stock may allow you to accumulate more shares over time.
Finally, even though ESPPs allow you to further invest in your company stock at a great discount, it is always important to monitor what other equity compensation plans are offered to you by your company, including RSUs, performance shares, or stock options. Over-concentration in company stock can be risky, especially if you are earmarking some of those assets for more immediate financial goals, such as educating your child within the next three to five years. Diversification is one of the most important ways you can control risk within your portfolio.
As always, please be sure to consult a tax advisor before making any decisions around your ESPP, and contact Freedom Trail Financial with any questions you may have.
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