Employee Stock Purchase Plans

Definition

The term employee stock purchase plan refers to a non-compensatory program that allows employees to purchase common stock in their company through regular payroll deductions.  An employee stock purchase plan, or ESPP, will typically allow employees to purchase stock at a discount that can be as high as 15%.

Explanation

Unlike stock option plans, which are used to compensate employees, stock purchase plans are considered non-compensatory.  Instead, companies will use these plans to increase common stock ownership among employees and enhance loyalty.

Section 423 of the tax code allows employees to participate in a stock purchase plan, and enjoy the markdown from the stock's fair market value, without paying income tax on the discount.  If the company's plan meets these requirements, it's considered a qualified Section 423 plan.

To qualify under Section 423, stock purchase plans must contain the following features:

  • Any employee that meets the minimal eligibility rules established by the company can participate in the program.  Restrictions can include:
    • Employees that have been employed by the company for less than two years
    • Part time employees working 20 hours or less each week
    • Seasonal or temporary employees that do not work for more than five months in a calendar year
    • Highly-compensated employees
  • Employees owning 5% or more of the voting power in all classes of stock are not eligible to participate in the program.
  • The purchase price of the stock cannot be lower than 85% of the fair market value, effectively capping the discount at 15%.
  • Payroll deductions can range between 1% and 15% of the employee's compensation each pay period.
  • Purchases cannot exceed $25,000 in common stock annually.

Employees are typically granted the right to change payroll deductions, as well as join and withdraw from the plan at any time.  Companies can require employees to hold this stock for a certain length of time before selling.  Depending on the holding period, gains on the sale of this stock can be taxed as ordinary income or as a capital gain.

For income tax purposes, participants in non-qualified plans need to treat the difference between the fair market value of the stock and its purchase price as ordinary income.

Related Terms

common stock, stock warrants, stock compensation plans, stock option plans, stock grants, Section 83(b) election, common stock equivalentcontingent issuance agreement, appreciation and phantom rights