Your Guide to Employee Stock Purchase Plans

Feb 21 2025 | Back to Blog List

Equity compensation has become a powerful tool for attracting, retaining, and incentivizing employees, particularly in the kinds of startups and high-growth companies that comprise the Corridor’s tech and biosciences sectors.

But how exactly does equity (aka stock-based) compensation work? Aren’t these just “stock options?” As is often the case with these questions, the answer is: it depends.

We previously wrote about the wide range of equity compensation arrangements that one might describe as “stock options.” However, for this blog we will explore Employee Stock Purchase Plans (ESPPs), which is another popular way to give employees access to company ownership.

Remember that understanding how equity compensation works is crucial for making informed financial decisions, as the devil is always in the details. Vesting schedules, exercise windows, and tax implications can significantly impact the ultimate value of an equity package, which is why you should always consult with a trusted financial adviser or tax/legal professional who can help you navigate the complexities of your specific compensation package.

What is an Employee Stock Purchase Plan?

An ESPP is a program offered by some publicly traded companies that allows employees to purchase company stock at a discounted price—sometimes as much as 15% lower than the market value.

Employees usually contribute to the program through post-tax payroll deductions, which accumulate between the offering date of the shares and the actual purchase date. Once stock has been purchased on your behalf through an ESPP, it’s generally yours to hold or sell as you see fit (with a few exceptions, more on that in a bit).

Note that privately held companies can also implement an ESPP, but these come with their own liquidity and regulatory challenges. For the purposes of this article, we’ll focus on the logistics and benefits of an ESPP at a publicly traded firm.

How Does an ESPP Work?

ESPPs are fairly straightforward compared to other forms of equity compensation, with just a few details to understand and manage your stock purchases.

• Offering Period: Occurring two or four times each year, offering periods are when you can enroll in the ESPP and determine how much you want withheld from your paycheck (either a flat dollar amount or a percentage). This can typically be adjusted during every offering window, but not outside of it.
• Grant Date: The first day of the offering period. This matters for some plans as it may be used to set the price you pay when the ESPP purchases stock on your behalf.
• Purchase Period: After enrolling, your company opens an ESPP account and funds it via automatic paycheck deductions. Your contributions grow in a special account until the purchase date.
• Purchase Date: At the end of the purchase period, the accumulated funds are used to purchase company shares at the pre-determined discount, which are typically held in a designated account set up by your company.

Many ESPPs also include a lookback provision, which gives employees the option to purchase their stock at the lower of two prices: the price at which the stock closed on the first day of the offering period, or the price on the purchase date. This is key for employees, because it means that if the stock price increases over the offering period, they can still buy shares at a lower price plus the discount offered by the company; if the share price falls, the lower price plus the discount offers some protection of any potential profit.
 
Some ESPPs may also offer “reset” or “rollover” provisions, which take effect if your company’s stock price declines continuously from the beginning of the offer period to the end. In this instance, instead of selling you stock at the (now higher) grant date price, the company will re-offer it at the lower current price, plus your discount. This is an incredible deal, which may explain why it’s relatively rare compared to lookback provisions.

ESPP Sale Timelines and Tax Implications

With most ESPPs, once you receive your stock, it’s yours to sell or hold. Some programs may have short holding periods of six months to a year, and/or may restrict when your stock can be transferred to external brokerage accounts, but those hurdles are relatively low compared to some of the vesting periods required with more traditional stock options.

Indeed, the biggest consideration for equity purchased through an ESPP is when to sell, as that is what will determine your tax treatment. The IRS will classify your sale in one of two ways:

• A qualified disposition is the sale of ESPP shares one year after the purchase date and two years after the grant date (offering date). Selling as part of a qualified disposition earns you a more favorable tax treatment, but your sale must meet both of the qualifying conditions.
• A disqualified disposition is the sale of ESPP shares within one year of the purchase date or within two years of the grant date (offering date). These sales do not receive preferential tax treatment.

If you sell ESPP shares as a qualified disposition, the discount you received at the time of purchase (based on the offering price) is taxed as ordinary income, while any additional gains (if the stock price has increased beyond the purchase price) are taxed as long-term capital gains, which have lower tax rates than ordinary income. If your shares decrease in value and you sell them at or below the purchase price, you may have a capital loss, which can help with tax loss harvesting efforts.

Selling your ESPP shares before meeting the qualified disposition requirements will result in any gain on your investment being taxed at short-term capital gains rates, which can be substantially higher.

Let’s look at an example of the tax implications for a simplified qualified disposition sale.

The Fair Market Value (FMV) was $100 when Dana purchased a share of her company’s stock through an ESPP. She received a 15% discount as part of the ESPP, so her purchase price was $85. After holding the stock long enough to be considered a qualified disposition, she sells at $200. Her total gain is $115, but only her $15 discount is taxed as ordinary income (higher rate). The remaining gain of $100 ($200 minus the non-discounted purchase price) is taxed at a lower rate as long-term capital gains.

Note that there are regulatory limits to how much stock you can purchase via ESPPs in a given year. The IRS restricts the total dollar amount to be contributed to $25,000 per calendar year. That limit is calculated pre-discount, so if you receive the full 15% discount, you are capped at purchasing $21,250 in stock for the calendar year. Some companies further restrict contributions, with caps that range from 10-20% of your salary.

Making the Most of Your ESPP

Equity compensation plans, including ESPPs, provide employees with a unique opportunity to build ownership in their company at a discount—an advantage that retail investors simply don’t have. By participating in an ESPP, employees can benefit from both discounted stock prices and potential long-term appreciation, making it an excellent way to accumulate wealth over time.

However, even though ESPPs are simpler than other equity compensation models, they still require careful planning to maximize their benefits. Factors like tax treatment, holding periods, and the timing of stock sales all play a critical role in determining the ultimate value of your investment. Without a clear strategy, you could miss out on tax advantages or take on unnecessary risks.

That’s why it’s essential to take a holistic approach to your financial plan. Equity compensation should be viewed as one piece of your broader investment portfolio, and it’s important to ensure that it aligns with your overall financial goals and risk tolerance. Working with a fiduciary financial adviser can help you navigate these complexities, ensuring that your ESPP participation is optimized to work in your best interest—not just in the short term, but as part of a long-term wealth-building strategy.

Are you ready to get a handle on your equity compensation package? Give us a call and let’s grow together.

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