The following column was contributed by Alex Greer. 
 
Employee Stock Purchase Plans (ESPPs) are a common workplace benefit that allows employees to purchase company stock. When utilized thoughtfully, they can be a fantastic way to participate in the growth of your company and can be a valuable part of your overall financial plan.  

 In this article we’ll cover how ESPPs work, some of the key items to consider, and how to utilize them as a part of your broader financial picture.  

How ESPP Works 

An Employee Stock Purchase Plan is a systemized way for employees to purchase shares of the company they work for, typically through payroll deductions. A key benefit is that shares are normally purchased at a discount, with 15% being the most common. If your company is valued at $100 per share, you’d be able to purchase shares at $85. 
 
Employees enroll in the plan prior to the offer date, which is the day that the ESPP begins. After each pay period, employee deferrals are placed into separate accounts and held there up until the purchase date. Once the purchase has been completed, the shares are held in a separate account until sold by the employee.  

The Lookback Feature 

It’s common for the share price to change between the offer date and the purchase date. Many plans offer a ‘look back’ provision This feature allows the purchase price to be based on the lower of: 

• The stock price at the beginning of the offering period, or  
• The stock price at the end of the purchase period 

This can be a significant benefit for employees when the share price increases rapidly.  
For example, if the stock price is $40 per share on the offer date, then increases to $80 per share on the purchase date, employees would buy the stock at $40 a share, then apply the discount rate. At 15%, employees would pay $34 for a share that’s worth $80 immediately.

Tax Considerations

Most ESPPs allow you to sell shares at any time. Typically, ESPPs are qualified plans that offer preferential tax treatment, and tax treatment for ESPPs depends on how long the shares are held before being sold. There are two types of sales: qualifying dispositions and disqualifying dispositions. ESPPs are subject to income tax and capital gains tax. 

Qualifying Disposition: 

For a sale to be a qualifying disposition, shared must be sold: 

• At least one year after the purchase date  
• At least two years after the initial offering date.  

If both conditions are met, ordinary income tax is the lesser of: 

• 15% of the fair market value (FMV) on the offering date of the shares purchased 
• OR the gain, which is the difference between the sale proceeds and the purchase price  

Disqualifying Disposition 

If you have a disqualifying disposition, meaning shares are sold before meeting the holding requirements: 

• Ordinary income tax is the difference between the fair market value on the purchase date and the total purchase price. 

In addition to income tax, ESPPs are subject to capital gains taxes. To calculate the gain or loss, first, you have to establish the cost basis. 

To determine cost basis on ESPP shares, first add the ordinary income to the purchase price to establish “adjusted cost basis”. The difference between the sale proceeds and adjusted basis is taxed as a capital gain or loss. If the sale is a qualifying disposition, gains and losses are always long-term. For disqualifying dispositions, the gain or loss can be short or long, depending on how long the shares were held from the purchase date. If held longer than a year, the gain or loss is long-term. You can read more about capital gain taxes in this article from Investopdedia. 

Employee Stock Purchase Plan FAQ 

What is an Employee Stock Purchase Plan (ESPP)? 
An Employee Stock Purchase Plan (ESPP) allows employees to purchase company stock through payroll deductions, often at a discount to the market price. 

How does an ESPP discount work? 
Most ESPPs offer a discount of up to 15% on the stock price. This means employees can purchase shares below the current market value, depending on plan terms. 

What is a lookback provision in an ESPP? 
A lookback provision allows the purchase price to be based on the lower of the stock price at the beginning of the offering period or the purchase date, potentially increasing the effective discount. 

How are ESPPs taxed? 
ESPPs are subject to both ordinary income tax and capital gains tax. The tax treatment depends on how long the shares are held before being sold. 

What is a qualifying disposition? 
A qualifying disposition occurs when shares are held at least one year after purchase and two years after the offering date. This may result in more favorable tax treatment. 

What is a disqualifying disposition? 
A disqualifying disposition occurs when shares are sold before meeting the required holding periods, which typically results in more income being taxed as ordinary income. 

Should I participate in my company’s ESPP? 
Participation depends on your financial situation, cash flow, and how the plan fits into your overall financial strategy. It’s important to consider both potential benefits and risks. 

How do ESPPs fit into a financial plan? 
ESPPs can be one part of a broader financial plan. It’s important to consider factors like diversification, taxes, and long-term goals when deciding how to use them. 

The Bottom Line on ESPP 

ESPPs can be a valuable component of your compensation and financial plan. Like any financial decision, it’s important to be aware of the rules and tax impact of selling shares, while also balancing the total amount of company stock owned.  

At Pathfinder Wealth Consulting, we help people navigate the complex decisions around equity compensation as part of a coordinated financial strategy, If you would like to better understand how ESPP fits into your financial plan, we’re here to help. Contact us today!  

This material is intended for informational and educational purposes only and should not be construed as specific investment, tax, or legal advice. Tax laws are subject to change and may vary depending on individual circumstances and state of residence. Hypothetical examples do not represent the experience of any specific client. Investment involves risk, including the possible loss of principal. Please consult with a qualified tax professional regarding your specific situation before making any financial decisions. To learn more about how we work with clients and our fiduciary commitments to you, view our Form CRS Client Relationship Summary