Employee Stock Purchase Plans are a no-brainer. The taxes? not so much.

This article is an excerpt from Big Later's Employee Equity Compensation content. Reach out to Will Steiner directly to learn more.

Let's kick this off with a thought experiment.

How would you feel if I offered to sell you $100 for $85?

If you answered "skeptical" I would say, "get over yourself and take the money," because that's what an Employee Stock Purchase Plan is. Kind of. There are a few details... actually there are a lot of details, but that's the general drift: your employer gives you the opportunity to purchase company stock at a discount. It's a good deal.

However, it's the kind of deal that is usually only offered to employees of publicly traded companies (that may be you right now, it may be you in the future, it may never be you... but good to learn about in any case).

This will be a bit of a longer read, so I want to prep you on how this is gonna go down.

I'll start by providing a slightly more accurate definition of ESPP, move into how money goes in (there are some key dates and timelines to be aware of), how money comes out (i.e. what happens when you sell), and finish with some simple strategies to make the most of the plan. Then I'll bid you adieu and go back to yelling at the kids who walk past my house.

Defining ESPP

Like I said before, Employee Stock Purchase Plans give employees the opportunity to buy company stock at a discount. Now, it's not exactly as simple as the employee saying, "hey, I'm ready to buy some stock can I get my 15% discount now?" There are eligibility requirements, timelines, and tax implications to be aware of, etc., but complexity aside... like a 401k match, ESPP presents the opportunity for you to seize some free money. There's nuance (like always), and we'll get to that momentarily. Before we go there, let's talk about how these plans are structured.

Four dates and a funeral

Employee Stock Purchase Plan operate around four key dates (timeframes? temporal parameters??):

1. the eligibility period
2. the offering date
3. the purchase date(s)
4. the sale date

The eligibility period is when people can enroll to participate in the upcoming offering. If you miss the eligibility window, you are stuck waiting until the next one rolls around (and you miss out on the deal!). So make sure you know when this starts (and ends).

The offering date kicks off the period during which money from your paycheck gets put aside (via payroll deduction) to buy company stock. Those are after-tax dollars FYI. A standard offering period is usually 12 months.

The purchase date or dates are when the company takes the money that's been put aside, buys the stock on your behalf (at the discounted price), and moves the shares into your account. This account is provided through whatever brokerage the company is using to manage the plan — the last company I worked at used E*Trade. Purchase dates can happen multiple times within a single offering period. For example, the offering might be 12 months with the purchase dates occurring every 6 months.

And the sale date is whenever YOU decide to sell the stock. This will be relevant when we talk about taxes — oh, you thought maybe today you'd get an email that didn't involve taxes? How naive.

It all looks a little something like this — assuming the offering period is 12 months and the purchase dates happen every 6 months:

Let's talk about this "discount" for a moment here

The industry-standard discount for ESPP is 15%. So let's say you enroll in December and the offering period starts on January 1st. At that time, the company stock price is $20. You diligently contribute a portion of every paycheck*, and when the purchase date rolls around on June 1st the stock price has risen to $25. The question now is, do you get to purchase the stock at a 15% discount on $25 per share? Or a 15% discount on $20 per share? Well, that all depends on whether your company has something called a "lookback" provision.

*Quick note: the IRS caps ESPP contributions at $25k in a given calendar year (your company might restrict contributions even further. Or not)

Lookback provisions are awesome

A lookback provision allows the company to set the purchase price at the lower of either the price at the offering date OR the price on the purchase date. So in the example above, if your company has a lookback provision, you'd be buying the stock at $17 per share (15% off $20) and now those shares are worth $25 — which is a 47% return on investment over a 6 month period!!! LET THAT SINK IN.

Now, if the stock was $30 at the start of the offering and went down to $25 by the time the purchase date rolled around, you be purchasing the stock at $21.25 (15% off of $25). That's still a 17.65% return on investment if you sell immediately (that's a big "if" and I'll come back to this in a second).

Note: Math is weird sometimes. You'd think it would be a 15% return, but put (25 / 21.25) - 1 into your TI-89 and you'll see what I mean.

The Big If

Should you sell right when the shares are purchased? Should you hold? Should I stop writing pithy questions and just tell you what goes into that consideration?

As always, any decision to sell an investment involves taxes, and friends, the tax treatment of ESPP is a real doozy.

We spent all that time talking about important dates to tee ourselves up for THREE potential tax scenarios that hinge on when you decide to sell your ESPP shares (the "sale date"). Let's break 'em down.

Scenario 1: pay the least in taxes but play with the most risk.

This scenario is called a "qualifying disposition" — why is it called that? Because they intentionally wanted to confuse you (I'm pretty sure). Here's how it works...

You are subject to qualifying disposition tax treatment IF you sell your ESPP shares

• at least 2 years after the initial offering date, and
• at least 1 year after the purchase date

If these conditions are met, you'll pay ordinary income tax on the lesser of the difference between the discounted price from the offering date price OR the difference between the purchase price and final sale price. Additionally, any gains outside of the scope of the discount are subject to capital gains tax. Clear as mud? Thought so. Let's look at an example (and for simplicity's sake, we'll assume there's only one purchase date, not two).

• Stock price on offering date:?$20
• Stock price on purchase date:?$25
• ESPP Discount of 15%:?15% * $20 = $3
• Price Paid:?$20 – $3 = $17
• Number of total shares purchased: 100
• Price shares are finally sold:?$40
• Earnings: $4,000

Remember, in this instance, when you finally sold the shares, you had held them for at least 2 years after the initial offering date and 1 year after the purchase date (e.g. if the offering date was January 1st, 2020, and the purchase date was June 1st, 2020, you would need to hold through January 1st, 2022). These get "qualifying disposition status". Here's how you'd be taxed:

What gets taxed as income?

Since the difference between the discount price and the offering date price ($20 - $17 = $3) is less than the difference between the purchase price and the final sale price ($40 - $25 = $15), that $3 difference gets treated as income (it's really $3 * 100 shares, so $300 get treated as income). For the rest of the example, let's assume you're in the 24% marginal tax bracket and the 15% long-term capital gains tax bracket.

Income = $3 * 100 shares = $300

Income Taxes = 24% * $300 = $72

Long Term Capital Gains = ($40 - $20) * 100 shares = $2,000

Long Term Capital Gains Taxes = $2,000 * 15% = $300

Total Taxes Paid = $300 + $72 = $372

Earnings After Taxes = $4,000 - $372 = $3,628

Net-net you made $3,628 on a $1,700 investment! That's a 113% return!

Scenario 2: pay more in taxes but deal with pretty much the same amount of risk.

This is the first of two kinds of "disqualifying dispositions". You are subject to this particular disqualifying disposition tax treatment IF you sell your ESPP shares

• less than 2 years after the initial offering date, and
• at least 1 year after the purchase date

So in this example, you sold too early to get the "qualifying" status that comes with holding ESPP shares for at least 2 years after the initial offering date, BUT you still qualify for long term capital gains treatment on a portion of the gains because you held for more than a year.

You’ll owe ordinary income tax on the difference between the discounted purchase price ($17) and the price on the date you purchased the stock ($25). Then you'll pay capital gains on the difference between the stock price on the purchase date ($25) and the price the shares are finally sold at ($40). It breaks down like this:

Income = ($25 - $17) * 100 shares = $800

Income Taxes = 24% * $800 = $192

Long Term Capital Gains = ($40 - $25) * 100 shares = $1,500

Long Term Capital Gains Taxes = 15% * $1,500 = $225

Total Taxes Paid = $417

Earnings After Taxes = $4,000 - $417 = $3,583

Net-net we're talking about a 110% return (not quite 113%, but not too shabby). I said that this scenario deals with a similar amount of risk because you are still sitting on the shares for at least 1 year before you sell. The market could be up, down, or sideways. Final scenario, let's go...

Scenario 3: pay the most in taxes but minimize your risk

This is the second type of disqualifying disposition. It's similar to the first, except in this version you sell your ESPP shares...

• less than 2 years after the initial offering date, and
• less than 1 year after the purchase date

The difference between this disqualifying disposition and the previous? You're now paying short-term capital gains on the difference between the stock price on the purchase date ($25) and the price the shares are finally sold at ($40). Still on the hook for ordinary income tax on the difference between the discounted purchase price ($17) and the price on the date you purchased the stock ($25). Here's what we're looking at:

Income = ($25 - $17) * 100 shares = $800

Income Taxes = 24% * $800 = $192

Short Term Capital Gains = ($40 - $25) * 100 shares = $1,500

Short Term Capital Gains Taxes = 24% * $1,500 = $360

Total Taxes Paid = $552

Earnings After Taxes = $4,000 - $552 = $3,448

Which, to be fair, is still a 102% return on investment. (My example is a little bit oversimplified in the sense that I'm just parking the final sale price at $40 for each scenario, but I think I illustrated my point.)

Too many numbers, not enough takeaways!!!

I agree. So now I'm gonna share with you why I personally (not financial advice), usually sell immediately after my ESPP shares are purchased.

1. I don't know where the market is going and I want to lock in my gains
2. I don't want to be too concentrated in my company's stock (especially if I also have RSUs)
3. I can put the money to use elsewhere and don't have to worry about blackouts or trading windows

Now... do I know a TON of people who have made life-changing money by holding onto their ESPP for like 10 years? I certainly do. So, as always, you have to assess the risk for yourself and how it aligns with your financial goals.

True story: I used a big chunk of ESPP to pay off a ton of credit card debt one time. I'm not proud of the fact that I had it, but participating in the plan was an amazing way to lock in immediate gains and put a dent in my debt (FYI even if the price doesn't move at all, you're still guaranteed at 17.65% return before taxes if you sell immediately, so long as your company has the lookback provision).

Alrighty folks, that's enough on ESPP!

In my opinion, it's a total no-brainer if you can participate (so long as your budget allows!). It's another one of those free money scenarios if you can lock in the gains. If you let it ride, you might be in for even MORE upside... but that doesn't come without risk.

Have a lovely rest of your day