Employee stock purchase plans (ESPP) are a great attention-grabbing compensation benefit for your business. Computershare, a global financial services company, found in a recent survey of about 600 business leaders that 76% of respondents anticipated an increase in ESPP participation this year. However, there are complications to consider.
Who Can Sponsor One?
Under Section 423 of the Internal Revenue Code, a qualified ESPP is a formal written plan that enables employees of the employer corporation (or its parent or subsidiary corporation) to buy stock in that corporation. Thus, in practice, C corporations are the clearest candidates for such a plan.
S corporations may theoretically offer one, but their ownership and shareholder restrictions often make qualified ESPPs impractical. Other business entities (such as sole proprietorships, partnerships, and limited liability companies), as well as other kinds of employers (such as non-profits), should consider alternative compensation strategies.
How It Works
Under a typical qualified ESPP, employee-participants elect to have a percentage of their pay withheld during an offering period. At the end of that period, the aggregate payroll deductions may be used to buy the employer’s stock. Some plans allow participants to buy shares at a limited discount from fair market value. Others may include a lookback feature that bases the purchase price on the lower of the stock’s value at the beginning or end of the offering period, making the plan more attractive when the employer’s stock rises in value.
From a tax standpoint, participants generally buy shares with after-tax payroll deductions, so there’s no immediate tax benefit. Indeed, for qualified ESPPs, no taxable event occurs when the option to buy stock is either granted or exercised. The tax impact occurs when the shares are sold, and the ultimate result depends on whether participants meet specific IRS holding-period rules. In short, selling too soon can reduce the plan’s tax advantages.
Plan Requirements
Although its concept is relatively simple, a qualified ESPP must comply with complex rules. First, to qualify under Section 423, the plan must typically be approved by the corporation’s shareholders within 12 months before or after adoption.
Furthermore, the price of shares must be at least 85% of their fair market value when the option to buy is either granted or exercised. And no employee may acquire the right to buy more than $25,000 worth of stock annually (valued at the time the option to buy is granted).
Also, a qualified ESPP generally needs to be offered on substantially equal terms to all employees with at least two years of service, though certain exclusions may apply. For instance, an employee who already owns 5% or more of the employer’s stock generally can’t be granted an option to buy shares. In addition, employees who log fewer than 20 hours a week and seasonal employees who work fewer than five months in a calendar year are generally ineligible.
Potential Advantages & Risks
Under the right circumstances, a qualified ESPP can play a starring role in a compensation and benefits package. By tying participants’ performance directly to the company’s, it reinforces a culture of ownership and teamwork. An ESPP may strongly appeal to executives, managers, or other key employees who believe they can make a difference in the business’s success. As a result, the plan can support recruitment and improve retention.
But a qualified ESPP comes with risks. As the plan sponsor, you’ll face considerable legal, administrative, tax, and payroll complexity. And there may be reporting obligations. For example, when legal title to stock acquired through an ESPP is first transferred, the corporation may have to file IRS Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c).”
Plan communication is critical. Employees need to understand, going in, that stock values can fall as well as rise. You might need to reinforce the fact that your business, like any, is subject to forces you can’t control. In addition, some participants may face concentration risk if too much of their portfolio becomes tied to the company that pays them.
Careful Evaluation
For corporate employers, a qualified ESPP can be a valuable compensation benefit that differentiates the business from its competitors. But careful evaluation is needed to weigh the many requirements, administrative burdens, and risks involved. We can help you explore the finer points and decide whether one of these plans is right for your company.
