US Companies offer all sorts of benefits and incentives to motivate and retain employees. You may be most familiar with 401(k) and 403(b) plans.
There are also:
Some of these programs are “qualified”. Meaning they that there may be associated tax benefits if the program meets the criteria of Section 401(a) of the Internal Revenue Code (“IRC”) including stipulations relating to plan documentation, coverage, eligibility, vesting and non-discrimination rules.
The IRC also provides special rules for specific programs like the aforementioned 401(k) or 403(b) cash balance pension programs that we are so familiar with (the names of these programs actually refer to the IRC section for which they are named).
An ESPP is a broad-brush benefit offered by many public companies to their employees. ESPPs are outlined in Section 423 of the IRC. Employees who are eligible to participate in the program are given an opportunity to invest beneficially in their company’s stock during a set period. During that period they can have a set amount of post-tax dollars deducted each pay cycle from their paychecks.
The accumulating proceeds of this deduction are put in a trust. At a defined date, the trust proceeds are used to purchase company stock at the fair market value (“FMV”) as defined in the program.
If the program is “qualified”, and the employee has held the stock for the statutorily mandated period, and they have been an employee of the company up to 90 days before the sale of the ESPP stock, then the gain on the sale of the stock is called a “Qualifying Disposition” and it is treated in a special way as follows:
For example, let’s say you invest in your company’s stock via an ESPP. The FMV of the stock is $100 when you bought it and the ESPP offers you a 15% discount on the purchase date. The share price to you then is $85. If in this example, you had $850 in paycheck deductions then you were able to purchase 10 shares of company stock at the purchase date.
If you hold these shares long enough for a qualifying disposition and the share price on the date of sale is $125, then your gain is $400 ($1,250 less the $850 purchase price). The first $150 of the gain (the 15% discount) is treated as additional compensation for tax purposes and the next $250 is treated as a capital gain which for most taxpayers would be 15% in 2018.
In order for a tax effective Qualifying Disposition to take place:
If the employee sells the stock before the mandated holding period ends, then all of the gain is treated as ordinary compensation and taxed like any other regular earnings you have.
This is referred to as a “Disqualifying Disposition”.
There is some flexibility in the design of ESPPs. Some important common variables include: