Understanding the Different Types of Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) are a popular form of equity compensation used by companies to attract and retain talented employees. These plans allow employees to purchase company stock at a discounted price, increasing their ownership and stake in the company. While most people are familiar with traditional employee stock options, there are actually several types of employee stock purchase plans available. In this article, we’ll break down the different types of ESPPs to help you better understand the various options available to employees.

The Basics of Employee Stock Purchase Plans

Before we dive into the different types of ESPPs, it’s important to have a basic understanding of how they work. In general, ESPPs allow employees to set aside a portion of their paycheck to purchase company stock at a discounted price. The discount can range from 5-20%, and employees usually have the option to contribute up to a certain percentage of their salary. The stock is typically purchased at the end of a set offering period, and employees can either hold onto the stock or sell it immediately for a profit.

One of the main benefits of ESPPs is that they provide employees with a way to invest in their company’s stock without having to come up with a lump sum of money. It also aligns their financial interests with the company’s success, as they will benefit from an increase in the stock price.

Qualified vs. Non-Qualified Plans

The first distinction to make when discussing ESPPs is between qualified and non-qualified plans. Qualified plans, also known as Section 423 plans, must meet certain requirements set by the Internal Revenue Service (IRS). These include offering the same terms to all eligible employees and limiting the amount of stock an employee can purchase to $25,000 per calendar year.

Non-qualified plans, on the other hand, do not have to meet these requirements and can be tailored to meet the specific needs of the company. While qualified plans offer tax advantages to employees, non-qualified plans may have more flexibility in terms of stock purchase price and eligibility requirements.

Offering Periods

The most common type of offering period for ESPPs is the six-month period, where employees can enroll and contribute for the first six months, and then purchase the stock at a discounted price at the end of that period. However, some companies may offer annual or quarterly offering periods as well. It’s important to understand the offering period for your company’s ESPP so you can plan your contributions accordingly.

Eligibility Requirements

ESPP eligibility requirements vary from company to company, so it’s important to know the specifics of your company’s plan. Some common requirements include being employed for a certain length of time, working a minimum number of hours per week, or being in a specific job title or department. Employers may also limit eligibility to only full-time employees or exclude certain categories such as non-resident aliens.

Lookback Provision

The lookback provision is an added feature that allows employees to purchase company stock at a discounted price based on the lesser of the stock price at the beginning or end of the offering period. This can result in a larger discount for employees and is a popular incentive for companies to offer. However, not all ESPPs have a lookback provision, so it’s important to check your company’s plan details.

Two-Year Holding Period

In order to receive favorable tax treatment, employees under qualified ESPPs must hold their purchased stock for at least two years from the offering date and one year from the purchase date. This is known as the two-year holding period, and after this requirement is met, any gains on the sale of stock will be treated as long-term capital gains, which are typically taxed at a lower rate than ordinary income.

In Conclusion

Employee stock purchase plans are a valuable benefit for employees, and it’s important to understand the different types available. Employers may offer qualified or non-qualified plans, with varying eligibility requirements and offering periods. Understanding the different elements of ESPPs, such as the lookback provision and two-year holding period, can help employees make informed decisions about their participation in the plan. So take the time to review your company’s ESPP details and consider taking advantage of this valuable benefit.