Employee Stock Purchase Plan: The ability to buy stocks is one of the most cogent benefits that employees can be offered by any publicly traded organization. The Employee Stock Purchase Plan (ESPP) is one of the most undemanding ways of doing this amongst several other ways that exist. The ESPP plans provide an uncomplicated, easy method for employees to help ameliorate their net worth and flow of cash during the course of time by purchasing their company shares.
Employees are able to purchase stocks of their company without impacting the transactions by themselves through employee stock purchase plans which are fundamentally a type of payroll deduction plan. Each pay period, every participant’s pay check automatically deducts some amount of money automatically on a post-tax basis. This money taken out amasses in an escrow account which has to be used by the employees on a six-month periodic frequency to purchase shares in the company. Just like other kinds of stock option plans that stimulate ownership of employees in the company, stock option plans do the same but do not pose as many limitations as put forth by more conventional stock option arrangements. Additionally, they are constructed in such a way that they tend to be more liquid by nature.
Eligibility Criteria
The eligibility criteria for qualified employee stock purchase plan is any employee who owns less than 5% of the company stock. Those who own greater than 5% of the stock are prohibited from plan participation. Additionally, the plan also has the liberty to dismiss some categories of employees from participating in the plan, for instance, people who haven’t been around for more than a year. Other categories of employees qualify for unconditional eligibility in the plan.
Qualified Plans vs. Non-Qualified Plans
Employee stock purchase plan can be categorized either as qualified or non-qualified. The more commonplace plans are the Qualified ones which must also abide by the rules laid out. But it should be noted that ESPP’s are not equivalent to tax-deferred qualified retirement plans which are contingent upon the regulations of ERISA (Employee Retirement Income Security Act). Participants can proceed with these plans as soon as they meet the eligibility criteria noted below:
Qualified Employee Stock Purchase Plan (ESPP):
- Majority of shareholders must vote in favour of the plan before one year of the plan’s estimated start date begins.
- This plan is applicable and can be offered only to full-time employees of the company. It does not apply to independent contractors or consultants working with the company.
- Except for those employees like those who have worked for less than a year with the company who need to be excluded from the plan, any other employee not excluded in particular in the charter of the plan shall be allowed to participate in the plan.
- As mentioned earlier, those owning greater than a share of five percent of the voting stock of the organization cannot be allowed to participate in the plan.
- All participants are unconditionally granted rights equally.
- In a given calendar year, the purchase limit of the stock worth for employees is $25,000.
- Periods of offering the plan cannot exceed the 2-year 3-month mark.
- The current stock price limit that can be discounted is only 15% or lesser than that.
Non-qualified Employee Stock Purchase Plan (ESPP):
Employee Stock Purchase Plan that are not qualified are not lay open to these restrictions and rules, however, the shareholders and board of directors need to approve these plans as well. Participation is allowed on a prejudicial basis for these plans, just like their non-qualified counterparts deferred compensation and executive bonus plans which belong to the same retirement plan sphere. Adding to this, under any situations, they do not receive favourable tax treatment either.
Going forward, the remainder of the sections of this article will exclusively talk about qualified ESPPs except in cases where non-qualified plans are specifically pointed out.
Employee Stock Purchase Plan- How They Work
Qualified and non-qualified ESPPs are essentially identical in design in spite of their differences. There is an offering period present in all plans which begins specifically on a day known as the offering date. Typically, there are many purchase periods which result in purchase dates within the offering period.
For instance, January 1st could be an offering date during an offering period and there could be nine purchase periods that last four months each. In this case, after 36 months, the offering period would then come to an end.
At this time, the employees would cast their vote to have a specific amount deducted from their pay checks which would then be utilized or directed to buy share of the company on each purchase date within the offering period. In most cases, employees impose a 10% after-tax pay limit. This implies that employees who were a part of the complete cycle of the offering period would have purchased the stock nine separate times.
The employees’ ability for fund withdrawal and a rise or drop in their contribution level to the plan during purchase periods depends on the respective employer’s individual policies. While the automatic price discount or the look-back feature is offered by most Employee Stock Purchase Plan, the IRS does not specifically require this.
ESPP Shares & Selling Them
Once you own the ESPP shares, you are allowed to sell them anytime you wish to by most plans. There is a possibility of your company restricting you to sell certain securities or wanting approval on their sale. You will need a confirmation from the compliance department or your Human Resources department to ensure the same. You can end up selling the shares anytime you want if there are no constraints.
ESPPs Pricing
There are two ways in which ESPPs provide a pricing advantage to employees:
Built-in Discount: An automatic discount is provided by Employee Stock Purchase Plan to most employees on the share price of all their procurements such as 12% or 14%. This leads to an instant boost at purchase time for all participants.
Lookback Provision: This provision allows the employee to choose between two options – stock can be purchased at its closing price on the date of buying or on the real date of offering the stock, whichever option works cheaper.
This can clearly make a lot of difference in the profit margins of employees from their plans. If on the original offering date, the stock of the company had closed at $15, but rises to trading up to $40 on the purchase date when the market closes, then the stock can be purchased by the plan at its offering price. Hence, the stock would be available to an employee at $12.75 in this scenario provided a 15% built-in discount was also offered by the plan.
There are more than one offering schedule running in conjunction which are typically excluded from employee participation in more than one schedule time.
The Limit of Shares That is Available to Participants
The $25,000 limit on purchases has a further precondition implying that the share price that remains at closing on the offering date is the amount that gets divided and the amount then translates to the max share number that can be purchased by a participant for that year irrespective of whether there is a rise or fall in the price.
Employee Stock Purchase Plan (ESPP) Tax Treatment
A qualified ESPP offer two types of stock, one of them being a qualifying arrangement which is positively treated under the tax code. The other being a disqualifying arrangement which is not treated favourably.
Two criteria must be met by qualifying dispositions:
- From the purchase date, the stock should have been held at least for a year.
- The stock must have been held for a minimum period of two years beginning from the date of offer.
Upon satisfying the conditions mentioned above, the participant receives a discount off the purchase price which is indicated as ordinary income. A capital gain is considered if there is any extra gain between the sales price and purchase price.
On the other hand, disqualifying dispositions have a separate requirement. They are contingent upon the fact that the stock’s closing price on date of purchase and purchase price has a spread which is considered as ordinary income taking into account the discount component regardless of a look-back period being there or not.
Reporting
The employee’s W-2 form is used by employers to report any ordinary income that the ESPPs generate.
Under certain circumstances, the employee must separately report this on Form 1040 if the employer does not do this. Form 3922 generally published by the employer after the purchase date reports the information on purchase from ESPPs. Losses and gains are carried to Schedule D after reporting them in Form 8949.
Tax Forms You Will Receive From Your ESPP
The W-2 form’s Box 1 which includes tips, other compensation and wages usually reports ordinary income from the ESPP. Your ESPP transactions from your taxes can be included if you provide these forms to your tax preparer. You would also receive an additional form that contains the price of purchase of the ESPP which is called Form 3922. One should also get Form 1099-B Proceeds from Broker and Barter Exchange Transactions provided they sold their shares via a broker.
Tax-Return Blunders you should be careful to prevent from happening
There is a huge possibility of confusion and errors on tax returns especially for those who acquired ESPPs (Employee Stock Purchase Plans) shares and sold them. The fundamental taxation is muddled for these plans and stocks. Overpaying your taxes or incurring underpayment complications can be prevented by getting to the root cause and understanding of important issues.
Alert: Although all of your ESPP stock has been sold out at purchase and you have all your resulting earnings or income on form W-2, the sale must still be reported on Schedule D and Form 8949. There is a possibility for the Internal Revenue Service to think that you failed to report a sale gain if they receive a report from your broker about your gross sale proceeds on Form 1099-B but there is no corresponding sale report on Form 8949. The computers at Internal Revenue Service would send out an automatic notice to you for the taxes pending assuming a tax basis of $0.