An employee stock purchase plan (ESPP) is a program that allows employees to purchase company stock at a discounted price.
From an employee perspective, this is an attractive perk as it allows them to benefit from their contribution to company growth while making a profit at the moment they purchase the stock.
Additionally, certain ESPP provisions offer tax advantages to the employees depending on the specifics.
From an employer perspective, ESPPs have been shown to improve employee motivation, measured by an increase in employees working beyond contractual hours, monitoring colleagues’ work, and a decrease in employee turnover.
Additionally, ESPPs can reduce the necessary competitive salary for a given position when offered as an additional employee benefit, freeing up cash flow and improving employee morale for existing employees.
In this article, we dive into the considerations for designing an effective ESPP for a mid-sized company, including the various ways you can structure your plan and some considerations for effective administration, including managed Stock Plan Administration services.
Understanding the Basics of ESPPs
ESPPs break down into two primary categories: qualified and non-qualified stock purchase plans.
Qualified Stock Purchase Plans
Qualified ESPPs are designed and operated according to the Internal Revenue Section 423 regulations. Some of the regulations include: purchase discount rate cannot exceed 15%, annual qualified purchases are limited to $25,000, only employees can participate and the plan must be approved by shareholders.
Provided the employee holds the shares for at least two years from the offering (grant) date and one year from the purchase date, the discount is taxed as ordinary income, but any additional gain from the stock growth is taxed at the long-term capital gains rate.
When an employee sells the stock, it will either be a qualifying disposition (holding period met) or a disqualifying disposition (holding period not met). Both of these transactions are required to be reported by the company on an employee W2.
Non-Qualified Stock Purchase Plans
Non-qualified purchase plans lose the tax advantages of deferring the discounted price as income until the date of sale.
What this means is that the “profit” associated with the purchase discount is withheld at the time of purchase and taxed as ordinary income, even though the employee won’t realize their gains until they sell the stock.
With that said, non-qualified ESPPs have more flexibility and fewer limitations as far as the benefit itself.
Since there are no IRC requirements, employers are not limited to offering $25,000 per year and can also increase the discount beyond 15%.
In many cases, companies will offer both forms of ESPP, qualified in the US and non-qualified in non-US locations.
Additionally, each individual participant must consider their own tax situation when deciding which plan makes more sense, assuming they have the choice.
Assessing Company Eligibility and Readiness
For a company to be eligible to offer an ESPP, they must be public. The timing of the plan roll out usually occurs near an IPO and must be approved by the Board of Directors and the shareholders.
Additionally, companies must decide whether to offer Evergreen options. An Evergreen option adds a certain number of shares per year automatically to the plan to replenish the shares.
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Structuring Your ESPP
Deciding on your ESPP structure is a key step when designing the plan. The following are some key considerations for ESPP structure.
Offering Period
The offering period is the time window where employees can choose to purchase stock under the plan at a specified discount. There may also be overlapping offering periods with potentially different purchase prices, or consecutive offering periods where a new offering begins immediately after the previous offering ends.
Purchase Period
Purchase periods are shorter windows within the offering window and include a specified purchase price. Purchase periods can match the duration of shorter offering periods, or there may be multiple purchase periods within a given offering.
Look-Back Provisions
The inclusion of a look- back provision allows an employee to purchase shares that have gone up or down in value between the offering date and the purchase date at the lower of the two stock prices with the applied discount, which is a highly attractive feature for participants.
Setting Discount Rates
While qualified stock purchase plans have a discount limit of 15%, companies can reduce this rate when designing their plans or increase it if offering a non-qualified plan. This must be determined by the Board of Directors and existing shareholders.
Aggregate Share maximums
Plan designers must consider an aggregate share maximum, which is the maximum number of total shares that can be issued under the plan and will determine the individual limit for each participant.
Legal and Regulatory Compliance
Qualified plans must be structured in accordance with IRC Section 423. However, all plans require legal documentation and disclosures including plan documents, prospectus, an offering document, and a Form S-8 registration statement with the SEC.
Administration of the Plan
Once the plan has been designed, you must choose an ESPP provider. Most equity software platforms generally offer ESPP as an added service for organizations already on them. Without experienced stock plan administrators, internal management can be a challenge, so it's worth considering managed services and implementation when rolling out your ESPP. It's often not worth hiring an entirely separate position to manage an ESPP rollout, but the workload can be excessive for existing administrators.
CompIntelligence’s Managed Services are a good way to fill this gap as well as handle ongoing administrative needs without the overhead of additional in-house staff.
Communication with Employees
Employee education prior to their participation is imperative when implementing a stock plan. Because ESPPs have many implications when it comes to tax and total income, administrators must provide ample resources to ensure participants can make an educated decision about what's best for their individual circumstances. CompIntelligence’s consulting services will assist in this education process to ensure a smooth rollout.
Monitoring and Adjusting the Plan
Monitoring and adjusting the plan is vital for ensuring its long-term success. Administrators need to know the percentage of eligible employees enrolling and can consider adjusting incentives up or down in response to enrollment rates, or focusing on additional employee education to increase participation. While major changes to ESPPs are not particularly common, they do occur and typically data-driven based on the status of the company and rate of participation. Administration is also needed to assist with employee exit strategies and plan termination.
Designing Your ESPP : the Bottom Line
ESPP's play a key role in aligning your company’s interest with that of your employees. For growing organizations that want to attract and retain talent, they are an incredibly powerful tool. To learn more about how you can smoothly roll out an ESPP for your company, contact CompIntelligence today.
Learn More About ESPPs:
https://www.plansponsor.com/study-finds-espps-motivate-employees/
https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/stocks-options-splits-traders/stocks-options-splits-traders-5
https://www.investopedia.com/terms/e/espp.asp
