What is an ESPP?
Employee Stock Purchase Plans (ESPPs) give employees an easy and cost-effective reward for pursuing a disciplined savings plan to build financial wealth, and invest in their company.
Workers who hold company stock think and act in the long-term interest of their company – the perfect building blocks which will underpin the future and continued success of your organization.
How do ESPPs work?
Employee Stock Purchase Plans offer employees the right to purchase stock in their company through payroll deductions. Once enrolled in the plan, a company collects an agreed amount of an employee’s salary on a monthly basis. This combined figure is then put towards company stock at a future date.
Typically, and most significantly, the employee receives a discount on the market value of the stock on either the first or last day of the offer period. The discount, which is linked to an important principle known as fair market value, is applied to the price of the stock on whichever day had the lower value. Typically, the offer period is six months.
Generally, there is a maximum percentage of salary that can be invested in the plan, but the employee can decide how much net salary or wages they wish to contribute which allows flexibility in how much they put aside according to what suits them.
When an employee purchases stock through their ESPP, they own the stock immediately which can be used as a short-term cash-out, or a long-term investment.
What’s the difference?
A qualified ESPP is a plan which is designed and operates according to Internal Revenue Section 423 regulations.
Under a qualified ESPP, employees purchase stock at a discount from the fair market value, yet do not owe taxes on that discount at the time of purchase.
Furthermore, if employees hold their stock for a period of two years post-grant date and one year from purchase date, they can further reduce their tax obligations. When the stocks are held for a time period as above, the profits of the sale price over the purchase price is taxed as a long-term capital gain when and if the employee decides to dispose of their investment.
If the purchase price is less than 100% of the fair market value of the stock on the purchase date, then the discount is taxed as ordinary income at that date.
Non-qualified ESPPs are plans that do not meet the criteria outlined in Section 423 of the Code.
A non-qualified ESPP may look exactly like a qualified ESPP, but it doesn’t generate the same tax benefits to employees as a qualified plan. Under a non-qualified ESPP, when the stock is purchased, the excess of the fair market value of the stock at the time of purchase over the purchase price is taxed as ordinary income.
Any additional gain or loss when the employee sells the stock is taxed as capital gain or loss.
Which one is best?
Like most things in life, one plan type isn’t necessarily better than the other.
However, qualified plans are almost always more attractive to employees because the tax isn’t due when they purchase their stock.
Non-qualified plans offer more flexibility in terms of plan design – such as allowing matching shares and offering a larger discount etc, but as the tax on the discount is due upon purchase that it can result in lower levels of employee participation.
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Read more about employee stock purchase plans here.