Many large companies offer Employee Stock Purchase Plans (ESPP) that let you buy your employer’s stock at a discount. These plans are offered as an employment incentive, giving you an opportunity to share in the growth potential of your company’s stock (and, by implication, work hard to keep the stock price soaring). Usually, you make contributions to a stock purchase fund for a certain period of time through payroll deductions. At designated points in the year, your employer then uses the accumulated money in the fund to purchase stock for you.
In many plans, the price that you pay for the stock is the stock price at the time you started contributing to the fund, or the stock price at the time you purchased the shares (whichever is lower) with a discount of up to 15 percent. Either way, you get to buy the stock at a price that’s lower than the market price. Your discounted price is known as the offer or grant price, because your employer has offered it to you, or granted it to you.
A common ESPP would work the following way:
For six months you contribute certain percentage of your salary and compensation (up to a maximum). At the end of the six months that money is used to purchase company stock. The price at which you buy is usually discounted at 85% of the LESSER between the price at the beginning of the period and the one at the end.
You can sell it the next day after the ESPP period concludes, and you will most probably get around 100% of the value of the stock at the end of the period. You will incur a gain for doing nothing more than electing an automatic contribution to the plan. Free Money.
Chances are you will earn at least 17.6% in 6 months (17.6% = 15/85, and 6 months is a common ESPP period). That is the equivalent of an anualized 35.2%. Not too many investment opportunities give you that kind of return. There is no bank account that offers it. And most stocks can’t support that kind of growth. It is one of the best investments you can get, and many people don’t make use of it.
Let me illustrate the example better:
Situation 1: (great company)
Beginning of period price: $10.00
End of period price: $12.00 (20% gain)
Day after ESPP period price: $12.00
Purchase price: $ 8.50
Your Gain: $ 3.50 (or 41.2%)
Situation 2: (bad company)
Beginning of period price: $20.00
End of period price: $10.00 (50% drop)
Day after ESPP period price: $10.00
Purchase price: $ 8.50
Your Gain: $ 1.50 (or 17.6%)
Situation 3: (worse company)
Beginning of period price: $20.00
End of period price: $10.00 (50% drop)
Day after ESPP period price: $ 9.50 (Another 5% drop)
Purchase price: $ 8.50
Your Gain: $ 1.00 (or 11.8%)
But What About Taxes?
The company keeps the stock in your name until you decide to sell it. At that point you have to begin thinking about taxes.
When you sell the stock, the discount that you received when you bought the stock is generally considered additional compensation to you, so you have to pay taxes on that as regular income.
And, depending on when you were granted the right to purchase the stock (the grant date), and how long you have held the stock, any profit that you make, over and above the compensation, may be considered a long-term capital gain, which can be taxed at lower rates than the compensation.
How Much of the Sales Price is Compensation?
That depends on whether your sale of the stock is a “qualifying disposition” or a “disqualifying disposition”. Selling the stock is thought of as disposing of it, but the question is, what makes the sale qualify as a capital gain, at least in part?
* Qualifying Disposition: You sold the stock at least two years after the offering (grant) date and at least one year after the exercise (purchase) date. If so, a portion of the gain is considered ordinary income and will need to be reported as earned income on your Form 1040, as “compensation”. Any additional gain is considered capital gain and should be reported on Schedule D, Capital Gains and Losses. (The capital gain rate is usually less than the rate you pay on ordinary income.)
* Disqualifying Disposition: You sold the stock within two years or less after the offering (grant) date or within one year or less from the exercise (purchase) date. In this case, your employer will report the bargain element as compensation on your Form W-2, so you will have to pay taxes on that as ordinary income. The bargain element is the market price at the exercise date minus the actual price you paid for the stock, multiplied by the number of shares. Any additional gain is considered capital gain and should be reported on Schedule D.
Words of Caution:
It is never a good idea to have any one investment (stock or mutual fund) make up more than 10% – 15% of your portfolio, even your own company’s stock. Just look at Enron, or more recently Marsh & McLennan for examples of what can go wrong. When those companies ran into trouble many employees lost their jobs and their retirement savings which were primarily invested in company stock.
Selling the stock as soon as you can reduces your risk and prevent your from getting an unbalanced portfolio, but some companies require a holding period before they allow you to sell, so make sure your understand the rules of your plan.
Conclusion:
ESPPs offer free money and it’s probably foolish not to take advantage of them. The only real question is should you sell the shares immediately? You may want to ask yourself the following questions: if I had an extra money, and I didn’t worked for this company, would I buy the stock? If I keep the shares, would my stock portfolio be balanced? If the answer is yes to both, then by all means keep the stock, if not, you may want to sell immediately.