If you work at a large, tech company, there’s a good chance they offer an Employee Stock Purchase Plan (ESPP) as one of the company benefits. The question is, should you actually participate and if so, how do you manage it?
I’ll be honest, I have a love-hate relationship with ESPPs. Sure, they are a great benefit and they are essentially “free money”. But darn if they aren’t complicated and they do require some active management. There are plenty of cases where I do not recommend participating, despite the fact that some people think participating is a “no-brainer”.
How does it work?
First of all, I want to explain how they work and what the actual benefit is. Essentially, you can buy your company’s stock at a discount, and then turn around and sell it for the actual market value. The difference is yours to keep (less taxes due). But how it’s actually structured is a bit more complicated.
Let’s use the Salesforce plan as an example. Suppose your salary + bonus is $150,000. You can contribute between 2% and 15% of that income – Salesforce caps ESPP contributions at $21,250 (or $25,000 stock at Fair Market Value, less 15% discount). Each pay period, Salesforce will withhold that percentage which you elect and hold it until the end of the “offering period”. For most companies, the offering period is 6 months and Salesforce has their 2 offering dates as June 15 and December 15. On these two dates, they use the total amount withheld over the prior 6 months, and purchase shares for you, which are then transferred to an account in your name.
The amount you pay for the shares is the lower of two prices—the date at the beginning of the offering period or the purchase date price—plus an additional 15% discount.
In this example, if you had withheld the maximum amount, $10,625 between June and December 2020, the lower price would be that on June 15, 2020. On December 15, Salesforce would use the $10,625 withheld and purchase CRM stock at 15% less than the June 15th price of $178.61 (70 shares of CRM). If you sell immediately, at the market value on 12/15 ($220.15), you gross roughly $15,400. You’ve immediately gained over $4,700, which will be taxed at whatever your ordinary income tax rate is. For the sake of simplicity, I’ll assume you’re in the 32% tax bracket, so you’ve netted about $3,200. Not bad!
| Money withheld from your paycheck | $10,625 |
| Share price on June 15 | $178.61 |
| Share price on December 15 | $220.15 |
| # of shares purchased on December 15 | 70 |
| Sales proceeds (70 x $220.15) | $15,407 |
| Gain | $4,782 |
| Estimated tax @ 32% | $1,530 |
| Net proceeds | $3,252 |
What if the stock price had actually gone down from June to December? You would still get a discount on the lower stock value, but it would be worth less and you would only gain the 15% discount. Let’s imagine the stock prices were reversed- $220.15 on June 15 and $178.61 on December 15th. You would still receive 70 shares of CRM stock, but you would only be able to sell it for about $12,500. Again paying 32% tax on the gain, you would net about $1,300. Still better than nothing but quite a bit less than the first example.
| Money withheld from your paycheck | $10,625 |
| Share price on June 15 | $220.15 |
| Share price on December 15 | $178.61 |
| # of shares purchased on December 15 | 70 |
| Sales proceeds (70 x $178.61) | $12,500 |
| Gain | $1,875 |
| Estimated tax @ 32% | $600 |
| Net proceeds | $1,275 |
But does it make sense?
One REALLY big factor here is- can you afford to have that reduction in every pay check for the 6 month period before reaping the benefits at the end? For some folks this is a fantastic way to automate savings. It enforces a certain behavior and then at the end of 6 months you can sell your company stock and invest how you see fit. In other cases, you just can’t afford to take a reduced salary.
The other huge downside is having too much exposure to your company stock. If you’re already receiving Restricted Stock Units or stock options, you are starting to face a potentially large portion of your portfolio in one stock. Add to this the fact that your salary and benefits are tied to this same company, it can get pretty risky.
One of the tricks to successfully taking advantage of an ESPP is to manage the risk as much as possible, which often means selling the stock as soon as you’re able. There are also, as you might be wondering, some tax considerations to think about.
In the above examples, I assume you sell the shares as soon as you’re able (which is very close to immediately after the end of the offering period). This is considered a non-qualifying disposition, and you’re required to pay ordinary income tax rates on whatever the discount amount is.
If you hold the shares for a full year, and two years after the plan becomes available to you, you now have a qualifying disposition. In a qualifying disposition, you still pay ordinary income tax rates on the discount amount, but you only pay long-term capital gains tax rates on the growth, if any. Your long-term capital gains rate could be as low as 0% (highly unlikely if you work in tech!) or it could be 20%, but is almost certainly lower than your ordinary income tax rate.
The huge downside to holding the shares in order to receive this preferential tax treatment is- you guessed it- again, too much exposure to company stock. There is always risk withholding any one stock due to increased volatility and in this case, having too many of your eggs in one basket. I almost never recommend that clients hold shares long enough to be a qualifying disposition.
Taxes on ESPP get very complicated and the above examples are a huge oversimplification. If you plan to participate in your ESPP, you’ll definitely want to run it past your tax preparer.
So should I participate or not?
To recap, some pros of participating:
- Enforced savings
- Free money! (Who doesn’t like free money??)
And cons:
- Concentration risk
- Increased tax complexity
- Reduced cash flow
- Potential volatility if you hold the stock
- The manual process of selling and then reinvesting into some other vehicle (or as I like to call it, the “hassle factor”).
Like I said, I do not consider participation to be a no-brainer and there are definite downsides to be aware of. But ESPPs can be a fantastic benefit if you manage them properly. Consider working with a financial planner to decide if it’s the right option for you.
