What is an ESPP?
An Employee Stock Purchase Plan (or “ESPP”) allows you to purchase shares of your employer’s stock at a discount.  ESPP’s are only available for employees of publicly traded companies.

How does an ESPP work?

The ESPP has an enrollment period during which you decide what percentage of your paycheck you would like deducted to purchase the company stock at a discount. Most plans allow you to contribute the lesser of 15% of your salary or $25,000 per year. Some plans have a minimum contribution (like 2% of your salary) to participate. Your ESPP contributions are withheld from your after-tax income.

ESPPs typically have a 12- or 18-month offering period comprised of two or three six-month purchase periods. Once you enroll in the plan, your payroll contributions accumulate until the last day of a purchase period, when your employer uses the funds to buy the company stock on your behalf.

An offering period is broken down into six-month purchase periods to maximize the value of the plan’s benefit. You’re able to buy the company’s stock at 85% of its closing price on the lower of (a) the first day of the offering period and (b) the last day of each purchase period.

As an example only, let’s consider the stock of Nike (ticker symbol NKE). Nike is one of the world’s leading sporting goods and apparel companies, and is headquartered near Portland, Oregon.

Nike’s ESPP has a series of six-month offering periods, with a new period starting on April 1 and October 1 each year. Let’s say that the NKE closing price on April 1, 2015 was $49.78, $61.49 on September 30, 2015, $61.47 on March 31, 2016, and $55.56 on April 1, 2017.

If you earn $100,000 and Nike lets you invest up to 10% of your pre-tax income, then you can invest up to $10,000 each year or $5,000 in each six-month offering period.

Payroll deductions would start with your first paycheck after the start of the first offering period on April 1, 2015. On September 30, 2015 – the last day of the first six-month offering period – you would buy shares of NKE at $42.31, which is 85% of the lower of the two prices in the first six-month offering period. At a share price of $42.31, you could buy a maximum of 118 shares ($5,000 divided by $42.31 per share).

For the second six-month offering period, beginning on October 1, 2015 and ending on March 31, 2016, you would buy shares at $52.25, which is 85% of the lower of the two prices in the second six-month offering period. This period, you could buy a maximum of 95 shares.

After one year, on April 1 2016, you own 213 shares of NKE worth about $13,093, for which you paid only $9,956.

Should I participate?
The opportunity to buy company stock at a significant 15% discount makes participation almost a “no-brainer”, unless you can’t afford to live on the smaller paycheck that results from the ESPP payroll contributions.

What should I do with the stock?
There are two options once you receive the company stock – you can hold onto it, or you can sell it. If you choose to sell it, then you will owe taxes.

How are ESPP gains taxed?

The amount of tax you’ll owe depends on how long you own the stock before selling it.

Qualifying Disposition
If you hold your shares for more than one year after the purchase date and more than two years after than the beginning of the offering period, then any profit above the gain from the discount will be taxed at capital gains rates. The gain from the discount is considered compensation and is taxed at ordinary income tax rates.

Disqualifying Disposition
If you don’t satisfy both of the requirements for a qualifying disposition, then any profit above the gain from the discount will be taxed at ordinary income tax rates. Again, the gain from the discount is considered compensation and is taxed at ordinary income tax rates.

Let’s return to our example, and the NKE shares purchased during the first offering period at $42.31 per share. April 1, 2015 is considered the purchase date for the stock. If you hold the NKE stock until April 1, 2017, and then sell it, how much tax would you owe?

Because this is a qualifying disposition (remember that you held the stock for two years from the beginning of the offering period), the tax you owe can be split into two parts. First, there is the ordinary income tax owed on the gain due to the discount, which is $881 (118 shares, times the 15% discount of $7.47 per share). Then there is long-term capital gains tax owed on the difference between your sales proceeds of $6,556 (the share price on April 1, 2017 of $55.56, times 118 shares) and your cost basis of $5,874 (which is the discounted price you paid to buy the 118 shares of $4,993, plus the $881 you reported as income due to the discount).

Simple, right?

When should I sell the stock?
The opportunity to benefit from a lower capital gains tax rate under a qualifying disposition may make it tempting to hold onto the stock for a year after the purchase. We generally encourage our clients to resist that temptation! The stock price can always go down (in fact, in the case of NKE, between September 2015 and April 2017, it did!), and you effectively end up risking even more of your compensation and wealth on your employer’s stock.

Instead, we generally recommend a disciplined strategy of locking in a riskless gain by selling immediately on the same day you buy your stock. You’ve then already made an attractive return, and there is no need to take additional risk by holding the stock longer than necessary. Don’t get greedy – paying taxes means you made a (risk-free) profit!

You should always consult with your financial advisor and tax professional before deciding whether to participate in an ESPP or other investment program.