Businesses offer benefits to help attract and retain talent. Many employees expect benefits like medical and dental insurance and a 401(k). So how can your company stand out from the competition? One option is an employee stock purchase plan.
What Is an Employee Stock Purchase Plan?
An employee stock purchase plan, or ESPP, is a program that allows employees to use after-tax payroll deductions to buy their employer's stock, usually at a discount.
Typically, employees make contributions to a purchase fund via payroll deductions over a period of time—usually six months. Then, at designated points during the year, the employer uses the accumulated funds to purchase stock on the employee's behalf.
The IRS limits employee contributions to an ESPP to $25,000 per calendar year. Employers can further restrict contributions to either a percentage of the employee's salary or a flat dollar amount. For example, the employer might cap contributions to an ESPP to 10% of the employee's gross salary.
Advantages of an Employee Stock Purchase Plan
ESPPs offer several benefits for employees and employers.
- Tax advantages. Contributions to an ESPP are exempt from FICA taxes, and employees don't owe income taxes when they buy the shares.
- Discount to purchase stock. Depending on the terms of the plan, employees may be able to purchase stock at a 10% to 15% discount.
- Motivation to save. Because employees fund the ESPP with regular, automatic payroll deductions, they're motivated to save.
- Simple. Employee stock purchase plans are relatively simple for companies to administer and maintain.
- Affordable. Companies can provide additional compensation for employees without negatively impacting cash flow.
- Motivational. According to a study conducted by Computershare and the London School of Economics, employees who participate in an ESPP tend to work longer hours, have less frequent absences, and stay at their jobs longer.
- Tax advantages. Companies that offer a discount on ESPP purchases may be eligible to take a corporate tax deduction for the discount.
What are the Tax Implications of an ESPP?
Employees don't owe income taxes when they buy shares but selling the stock can create two kinds of taxable income:
- The difference between the stock's fair market value at the time of purchase and the discounted price (known as the offer or grant price) is considered compensation. This compensation is taxed at ordinary income rates, ranging from 10% to 37%.
- If the employee sells the stock within two years after the offering date or one year or less from the exercise date (the day they purchase it), any gains are considered additional compensation and taxed at ordinary income rates. This is known as a disqualifying disposition.
- If the employee sells the stock at least two years after the offering date and at least one year after the exercise date, any profits are taxed at long-term capital gains rates, ranging from 0% to 20%. This is known as a qualifying disposition.
For example, say an ESPP participant pays $5,000 for shares of stock that are currently worth $5,500. Then, six months later, the employee sells the stock for $6,000.
On that year's tax return, the employee would have taxable compensation of $1,000 ($500 for the discount when they purchased the stock and $500 for the short-term sale). On the other hand, if the employee waited to sell the stock until two years later, they would have taxable compensation of $500 for the discount when they purchased the stock. They would also have a long-term capital gain of $500 for the increase in the stock's value since they purchased it.
Employee stock purchase plans can be a good way to incentivize employees and provide tax benefits for both employees and employers, but every plan is different. Be sure to talk to your accountant or tax advisor to determine which approach to equity compensation makes the most sense for your organization's goals.