Employee stock purchase plans (ESPPs) and taxation: An overview of the rules and regulations
This article will help you understand more about ESPPs, types of ESPPs and also important AMT considerations on employee stock purchase plan taxation.
To retain top workers and attract new ones, organizations need to provide competitive compensation packages that include the benefits that employees value most. It is now common practice, at least among businesses of a certain size, to provide employees with health insurance, a 401(k), and maybe even dental coverage.
Developing successful programs to recruit and engage the people you need now and in years to come, and to support all facets of your personnel strategy, is a top priority for every HR executive. To do this, you might make use of an ESPP, or employee stock purchase plan. This article will help you understand more about ESPPs, types of ESPPs and also important AMT considerations on employee stock purchase plan taxation.
Employee stock purchase plan and taxation
The employee stock purchase plans that companies provide are key instruments in the process of profit sharing. They provide a way for workers to easily buy shares in the firm at a discount via payroll deductions made after taxes have already been taken out.
What are Employee Stock Purchase Plans (ESPPs)?
An employee stock purchase plan is a plan that lets employees buy company shares at a discount, usually between 5 and 15 % off the stock’s current market value. If the share’s fair market value is $10 on that particular date, and your plan provides a discount of 15%, you would pay $8.50 for the share. If your plan permits you to sell right away, that’s the same as making an instant “profit” of $1.50 for a share. That gain might shrink, vanish, or turn into a loss if you retain the shares and then their value falls over time, but it could increase if the price of the shares rises.
Importance of taxation of ESPP
There are few if any regulatory hurdles involved with purchasing shares via an employee stock purchase plan, but you should be aware that the sale of these shares will result in a taxable event. Your ESPP’s tax treatment of realized gains on discounted shares will depend on several circumstances, including whether or not your plan is tax-qualified.
You need to be aware of the market value and any price reduction you obtained on the date of purchase as well as the date of the share sale to comply with ESPP tax laws. Your circumstance will be either a qualifying or disqualifying disposition depending on the order in which these events occur.
Benefits of ESPP
There are several benefits an Employee Share Purchase Plan offers a company. Some of the most prominent ones are:
- Higher levels of productivity in the workplace
- This means finding and hiring the best people
- Establish a sense of company-wide ownership.
- ESPPs are a wide, international benefit.
- Creates a reliable source of revenue for the business.
- Reduced costs compared to other forms of equity compensation
- Boosts the savings of employees.
Types of ESPPs
To a large extent, you will have little say over whether or whether the employee stock purchase plan you are eligible to join is qualified or non-qualified. It is necessary to be aware of the status of your plan concerning taxes and determine whether it qualifies or not.
- Non-Qualified ESPPs – The shares acquired via a non-qualified ESPP are subject to taxation both at the time of acquisition and again upon sale. Like NSOs, the proceeds from the sale of shares acquired via a non-qualified ESPP are subject to ordinary income taxes at purchase and capital gains or losses upon sale. The regular income component is subject to obligatory withholding for federal income, Social Security, and Medicare.
- Qualified ESPPs – Qualified employee stock purchase plans, on the other hand, are more sophisticated than non-qualified plans, with the major distinction being the deferral of the regular income element until the stock options are sold. Some states may demand withholding from eligible ESPPs even while federal law does not.
Due to government oversight, the rules governing qualified employee stock purchase plans are substantially more stringent than those of non-qualified plans. The implementation of a qualified plan also requires the consent of all shareholders. Tax-wise, however, qualifying ESPPs are preferred since neither the discount nor the shares purchased are subject to taxation.
Taxation of qualified ESPPs
Dispositions of qualified ESPPs may be split into two categories: qualifying and non-qualifying. If you want to sell your shares as part of a qualified disposal, you must wait until more than two years have elapsed since the grant date and more than one year has passed since you first acquired the shares. Any sale that doesn’t adhere to the two-year/one-year rule is considered a disqualified disposition, which results in differing tax treatment.
The regular income portion of an eligible employee stock purchase plan is deferred until the plan is sold, regardless of whether the sale is a qualifying or disqualifying disposition. When selling an asset, you must also account for any capital gains or losses. It’s important to distinguish between qualifying and disqualifying dispositions because the reference price used to calculate ordinary income and the price used to determine the capital gain basis are different in each case.
Non-qualified stock purchase plans have less stringent rules and can be tailored to the needs of individual businesses. The discount rate can be greater than 15%, and the corporation may even match the employee’s investment in the form of shares. However, workers are taxed when they buy the shares, which is a major deterrent for employees to take part.
Taxation of non-qualified ESPPs
Your tax position would be simple if your firm provides you with a non-qualified ESPP. The date of purchase is used to determine the amount of ordinary income, whereas the date of sale is used to determine the number of capital gains or losses. For purposes of calculating ordinary income and establishing a basis for any subsequent capital gains, the purchase date price is used as the point of reference.
Taxation of ESPPs
Depending on regular earnings and capital gains taxation, the kind of plan your employer provides, the length of time you retain the shares until selling, and if there is a capital gain or loss, the tax treatment of employee stock purchase plan is more complex than the typical purchasing and selling of stock.
Three dates are very crucial to remember: the initial day of the offer, the day of purchase, and the day of sales. The day you enroll in the plan is not the same as the grant date and you will not see any payroll deductions for the purchase of shares until the exercise date, or purchase date.
- Purchase discount – If you sell your shares over 24 months and 12 months following your offering date and acquisition, respectively, you will have made a qualified disposition. In this case, the value that constitutes the discount you got (to be subject to tax as ordinary income) will be determined as the lower of:
- Stock’s FMV on the offer date multiplied by the ESPP rate of discount
- The offering price, or the stock’s fair market value as of the day of the sale
- Holding period requirements – The time that passes between an investor’s acquisition of security and his or her eventual selling of that asset is known as the holding period. The length of time an asset is held after an acquisition is called its “holding period” in the context of a long position. The holding period in a short transaction is the period between the short seller’s purchase of the securities and the delivery of those securities to the lender, so closing the short position. To a large extent, employee stock purchase plan holding periods mirror those of other types of stock option programs. Qualified ESPPs provide preferential tax treatment for shares held for a minimum of a year following their purchase and for a minimum of two years following the offering date. Any sale of stock that satisfies these requirements is considered a qualifying disposition, while any sale that does not is considered a disqualifying disposal.
- Taxation of a qualifying disposition – If an employee stock purchase plan is qualified, neither the grant of an option to acquire shares nor the purchase of those shares will result in taxable income to the participant. Any sale, transfer, or other disposals of shares obtained under the ESPP must occur no earlier than later of twelve months from the time of purchase. Unless the sale or transfer is due to the participant’s death, it must take place within two years of the commencement of the offering period or the date of the award.
- Taxation of disqualifying dispositions – The acquisition of shares via a qualified ESPP does not have any tax consequences. There is no way to determine whether or whether the sale would cause the employee stock purchase plan to lose its “qualified” status, even if it is a transaction that would have that effect. The difference between the purchase price and the lowered purchase value is the ordinary income element of a disqualifying disposition.
- Alternative Minimum Tax (AMT) considerations – Unlike ISOs, ESPP shares do not qualify as an eligible item for alternative minimum tax (AMT) as the amount by which their fair market value exceeds the amount paid for them.
Tax planning considerations for ESPPs
If you’re planning to sell shares acquired via an employee stock purchase plan, you should familiarize yourself with the relevant tax requirements. To get your desired results, you will need to experiment with different approaches. As your personal and financial priorities evolve, you may find that you need to adjust your strategy for selling.
When deciding how to effectively approach your ESPP investments, it is important to first examine each transaction. ESPP tax considerations may be complex for a variety of reasons, and the nuances of each unique circumstance might lead to misinterpretations.
- Timing of ESPP purchases and sales – You may have to pay taxes both when you buy and sell shares, or only when you sell. For a tax-qualified employee stock purchase plan, the kind of taxation you owe varies depending on when you buy and sell your shares, as well as the type of plan your employer offers. If your firm provides a tax-qualified ESPP, you may be eligible for favorable tax treatment when selling your shares if you wait over a year following the day of purchase (when you get the shares) or longer than 2 years from your offering date.
- Impact of ESPPs on overall tax liability – Selling shares acquired via an ESPP may have significant tax consequences that might be difficult to understand. When you acquire shares after each buying period, you won’t have to pay any taxes. However, it might be more difficult to predict what will occur during a sale. The tax benefits of an ESPP may be maximized if the investment is held for a minimum of 18 months.
- Use of tax-deferred retirement accounts to manage ESPP taxation – Investing in a retirement plan like a 401(k) plan, 403(b), or IRA allows your savings to accumulate tax-free until you withdraw them in retirement. Within a retirement account, you are exempt from paying tax on any profits made on the purchase or sale of assets. Gains from conventional retirement accounts are taxed as regular income when you take the funds, although your tax band could be lower by the time you remove the money. However, if you have a Roth IRA and you remove the funds per the regulations, the withdrawals will be completely tax-free.
Get professional advice for your ESPP taxation with Eqvista!
Whether you have a qualifying or non-qualified ESPP, the choice of whether to sell the shares should be guided by your objectives and risk tolerance. Don’t allow your instinct to pay as little in taxes as possible to cloud your judgment. To ensure you make the best decision possible, Eqvista will provide you with further information on the tax treatment of your employee stock purchase plan and the consequences of both dispositions. Our trained staff is happy to help you with services from compliant tax filing to accurate valuation studies. To learn more about our services and offers, give us a call now!