Things Every Employee Needs to Know About ESPPs

In recent years, there has been a rise in companies offering employees the option of equity participation. It is an excellent way to compensate and retain employees. ESPP or Employee Stock Purchase Program is one of the most popular company equity plans.

According to 69% of companies, the primary reason for implementing an Employee Stock Purchase Program (ESPP) is to recruit and retain better employees by aligning their interests with those of the company’s shareholders. Considering how challenging it is to acquire and retain talent, companies are using the entire gamut of options at their disposal.

What is Employee Stock Purchase Program?

An employee stock purchase program (ESPP) is a method used by many public companies to reward or remunerate their workforce. Employees who participate in ESPP, have the option of purchasing shares at a reduced price or at a discount. The discount varies between 10% and 20%. For example, if a stock is trading at $100, an ESPP participant might acquire the stock for $80 if the applicable ESPP discount is 20%.

ESPPs are company programs that allow employees to buy company stock at a discounted price. Employees contribute to the plan through payroll deductions that accumulate between the time the plan is offered and the time it is purchased. The company then uses the funds accumulated to buy shares on the purchase date on behalf of the employees.

1. Qualified Employee Stock Purchase Program (ESPP)

Employees who participate in a qualified ESPP buy the stock at a discount from the fair market value (FMV) and do not pay taxes on the difference at the time of acquisition.

Employees can further decrease their tax obligations by holding their stock for two years after the grant date and one year after the purchase date. When shares are held for the period described above, after which the employee decides to sell them, the difference between the sale price and the purchase price is considered a long-term capital gain.

In addition, before qualified plans can be implemented, they must be authorized by shareholders’ vote.

2. Non-Qualified Employee Stock Purchase Program

Although a non-qualified ESPP may appear to be identical to a qualified ESPP, it will not provide employees with the same tax benefits as a qualified plan.

When employees buy shares through a non-qualified ESPP, the difference between the stock’s fair market value at the time of purchase and the purchase price is taxed as ordinary income. When the employee sells the stock, any further gain or loss is taxed as capital gain or loss.

Non-qualified plans, on the other hand, allow more flexibility in terms of plan design, as previously indicated. This could, for example, entail enabling matching shares and providing a higher discount. Because the tax on the discount is required at the time of purchase, employees may not be motivated to participate in the ESPP.

Advantages of Participating in an Employee Stock Purchase Program (ESPP)

Participating in your employee stock purchase plan offers four advantages:

1. Discounted buying

Employee stock purchase programs, both qualified and non-qualified, give employees the opportunity to purchase company shares at a discount. This discount might be anywhere between 2% and 15% for qualified ESPPs. Employees in non-qualified ESPPs receive a discounted stock price that typically ranges between 2% and 25%.

2. Cash options

A combination of good management and an increase in market value can result in more income for employees. Non-qualified ESPPs typically cap contributions at 10% to 30% of an employee’s salary, while qualified ESSPs have a maximum contribution of $25,000 per year. Selling shares at a discount can result in increases in earnings or gains.

3. Savings for retirement

Employees can put the money they get from selling their shares into a Roth IRA or a 401k retirement plan. Depending on the type of retirement plan they have, employees may pay taxes on the funds as they go into their account, or they may pay taxes when they take the cash later,

Employees can use their ESPP to enhance their retirement savings if their workplace offers a contribution matching scheme.

4. Short-term savings

Shareholders (employees) can benefit significantly from an increase in the market value of the company’s shares. They can deposit any money they get from selling their shares into a savings account. Unlike rolling earnings into a 401k, when employee move their earned income to a savings account, the gains are deemed realized and are liable to taxes.

Things to know about Employee Stock Purchase Plan

1. By making employees shareholders and giving them ownership of the company, ESPP is one of the strategies to attract and retain employees.

ESPP gives employees a stake in the company, which may encourage them to stay longer to maximize earnings. Individual employees will benefit instantly from a company’s success and will have a sense of ownership because an ESPP gives employees a portion of the company. As a result, they will gain confidence and can work more effectively toward the company’s growth.

2. The ESPP allows an employee to purchase discounted shares of the company that is listed on the stock exchange from his salary.

An ESPP allows employees of a company to purchase the company’s capital shares at a discounted price. Employees contribute to the plan through payroll deductions that accumulate between the time the plan is offered and the time it is purchased.

The company uses the accumulated cash to purchase shares in the company on behalf of the participating employees on the purchase day. The amount of the discount varies by plan. Many employee stock purchase programs offer up to a 15% discount on the purchase of company stock. Buying something at a 15% discount and immediately selling it for full market value could mean locking in a gain.

3. Once registered in the ESPP, the employee will contribute a certain percentage of his salary for a set length of time to buy company stock.

Employees can choose to postpone a certain percentage or cash amount of their paycheck when they enroll in the employee stock purchase program. This makes contributions simple and convenient, which is a popular aspect of ESPPs among employees. Keep in mind that the IRS limits ESPP stock purchases to $25,000 per calendar year for some qualified plans.

Once employees have enrolled, the company will deduct a portion of their pay into the ESPP, similar to how 401(k) contributions are done. ESPP contributions, however, are made after-tax, unlike typical 401(k) contributions. Payroll contributions can most likely be turned on and off at predetermined periods, according to the regulations of the ESPP design.

4. The stock price discount is a portion of the salary and falls under perquisite, so it is taxed according to the tax slab in effect at the time of purchase.

When the employee acquires the stock, they don’t have to pay taxes. They are simply exercising their ESPP rights.

When an employee exercises the right to acquire stock through an ESPP, the employer is not required to withhold FICA or Social Security taxes. When the employee sells the shares, the employer is not compelled to withhold income tax. Employees, on the other hand, must pay income tax on any profit they make from selling the stock.

When employees sell the stock, the discount received when employees bought the stock is usually considered additional compensation. Hence, employees must pay taxes on it as ordinary income. Depending on whether the profit is long or short-term, it is taxed at the moment of sale.

5. At the time of sale of ESPP,  the profit is taxed under Capital Gains as short term or long term depending on the holding period.

The tax requirements for ESPPs are complicated. Taxes are not owed until you sell your shares in an ESPP, but the tax treatment differs depending on whether the sale results in a profit or a loss. The following are the two sorts of dispositions:

Shares that have been held for two years from the date of grant and one year from the date of purchase are considered qualifying shares. These standards are not met by disqualifying shares. Shares must be kept for two years after the grant date and one year after the purchase date.

Qualifying dispositions are generally taxed in the year in which the stock is sold. The difference between the original stock price and the discount is taxed as ordinary income, while the remaining gain is taxed at lower long-term capital gains rates. Unqualified dispositions are subject to regular income tax rates on the entire gain.

The Bottom Line

Employee stock purchase plans can provide a number of perks, including reduced stocks, tax savings, and more. If you’re an employer considering offering an employee stock buy plan to your employees, you’ll reap a slew of benefits, and it’s something to consider if you’re just starting a business.

trica equity is a trusted partner of over 600 startups when it comes to ESOP and cap table management. Book a demo to understand more about our offerings.