Concentrated Stock Position Series, Part 3: Employee Stock Purchase Plans (ESPPs)
Written by Marcus Dusenbury, Financial Advisor
So, your employer offers an Employee Stock Purchase Plan . . . now what?
Employee Stock Purchase Plans (ESPPs) have continued to gain prominence over the past 20 years. As with many stock incentive programs, they first gained popularity in the tech and biotech sectors, but can now be found in many industries. Like the other incentive stock programs we discussed in the first two parts of this series (ESOPs and RSUs), the basic concept is fairly simple, but their impact on your tax and financial planning can be varied…and more complex than you might think.
Let’s start with the basics. Employee Stock Purchase Plans allow employees of a company to purchase shares of the employer’s stock, usually at a discounted price. ESPPs are not mandatory, but employees who choose to participate pay for the purchase of shares via payroll deductions.
The key attraction of an ESPP is that shares can be purchased at a price lower than the open market price of the stock. A typical structure is for shares to be offered to employees at a 15% discount, meaning 15% below the price at which the stock is currently trading on the ESPP’s designated “purchase date.” Some plans, however, base their ESPP purchase price on the date the shares are offered to employees (the “offer date”), and some plans may even take the lower of those two dates’ prices.
Another variable is the required holding period. Many ESPPs require participants to hold the company shares they buy via the ESPP program for a certain time period. Other plans allow participants to sell the shares immediately.
The bottom line is that Employee Stock Purchase Plans can be quite different from one company to another, so don’t assume that your current ESPP is the same as the one offered by your previous employer(s). Read up and know the details of your plan before deciding on the best way to utilize it.
The discount your company gives you is considered taxable income.
Because each plan is different, there is no universal tax strategy, but one thing ESPPs have in common is the fact that the discount your company gives you is considered taxable income, just as if you got paid a bonus. In fact, some ESPPs automatically sell enough of your shares at the time of purchase to cover a portion of the income tax they know you will owe. For example, a company offering a 15% discount might immediately sell—and apply the proceeds to employees’ tax withholding—a fixed 3% portion of all ESPP shares purchased; that would pay the full tax for an employee in a 20% tax bracket (i.e., 20% of 15% = 3%), and a good portion of the tax for those in higher tax brackets.
When shares are offered at a discount and the participant is allowed to immediately sell them, many employees try to maximize their ESPP contributions, selling the shares as soon as they are received, and thereby pocketing the 15% discount. This is a good strategy for two main reasons:
1. It exposes the participant to very little risk of the stock going down in value;
2. In many cases (depending on the pricing date and if little or no holding period is required), it almost guarantees employees a 15% (minus taxes) “bonus,” which is a great, “instant” investment return, especially if your plan’s requirements mean there’s little or no market risk is involved.
An alternative strategy—if you are confident and optimistic about your company’s future prospects— is to hold onto some or all of the shares as a longer-term investment. This, too, can have advantages:
1. If the stock price increases over time, the shares could earn a lot more than just 15%;
2. Any gains above the stock’s market value on the purchase date will be taxed as capital gains, and if the shares are held more than a year, they’ll be long-term capital gains, which are usually taxed at considerably lower rates than ordinary income.
Of course, if you accumulate ESPP shares over many years, that one company’s stock can become a large part of your total investments. This is especially true if you are simultaneously accumulating shares via an Employee Stock Option Plan (ESOP) and/or Restricted Stock Units (RSUs), which we discussed in the first two articles in this three-part series. It is important to work with a financial advisor to make sure that your concentrated position in your employer’s stock doesn’t become too large a part of your net worth. While it’s great to have lots of money in one stock when it’s doing well, it is important to adequately diversify, so that your financial future won’t be devastated if your employer someday has problems and its stock price drops.
An Employee Stock Purchase Plan can be a very valuable employee benefit, and it is usually advisable to take advantage of it in one way or another. As you can tell from the above information, however, working with good financial and tax advisors can be invaluable in deciding how an ESPP program fits within your overall financial and tax planning.
About the author: Marcus Dusenbury is a founding shareholder and fiduciary advisor with Viridian Advisors. He has 20 years of experience working with corporate stock benefit plans including those for Intel, Expedia, Amgen, among many others. Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, asset management, employee benefits advice, as well as tax services through its sister company, Viridian Tax and Accounting.