Employee Stock Purchase Plans

What is it?

An employee stock purchase plan allows your employees to purchase a specific amount of stock at a specific price (usually at a discount from the stock’s fair market value (FMV)). The employee usually purchases the stock through a salary deduction program. Funds are withheld from your employee’s after-tax salary and accumulate in an account. The employee can then make stock purchases from the account.

Example(s): Richard works for XYZ Company. XYZ offers its employees the opportunity to purchase XYZ stock through an employee stock purchase plan. XYZ also offers each employee 1,000 shares at a purchase price of $9 per share. The FMV of XYZ stock is $10 per share. Richard wishes to purchase 500 shares at $4,500 (500 times $9) through a salary reduction program. XYZ withholds the money from Richard’s salary and assigns it into an account. Richard can then use the funds in the account to purchase the 500 shares. Richard elects to purchase 500 shares for $9 per share; on the date of purchase the FMV of the stock is $10.50 per share.

Tip: An employee stock purchase plan has tax consequences similar to an incentive stock option (ISO). However, an employee stock purchase plan must be made available to most employees whereas ISOs can be limited to selected key employees.

Section 423 requirements

An employee stock purchase plan must comply with Section 423 of the Internal Revenue Code. Generally, Section 423 requires the following:

• The plan only offer employees of your company the opportunity to participate
• Stockholders approve the plan within a year of the plan being adopted
• The plan cannot allow an employee to participate if he or she owns 5 percent or more of the voting power or value of your company’s stock
• The plan allow all employees to participate (with the exception of employees who have worked less than two years, work 20 hours or less per week, don’t work more than five months per year, or are highly compensated employees)
• The plan treats all employees similarly (except that the amount of stock the plan grants to employees can bear a uniform relationship to their compensation)
• The purchase price can’t be less than 85 percent of the FMV of the stock at the time of the grant or exercise of the right
• If the plan doesn’t allow the exercise price to be less than 85 percent of the FMV of the stock at the time of the exercise, the right can’t last more than five years (for any other limitation, the right cannot last more than 27 months)
• The plan can’t grant an employee the right to purchase more than $25,000 of stock at its FMV each year
• The right can’t be transferable by the employee other than by will or intestacy laws

Federal income tax treatment of employee stock purchase plans

Employee tax treatment

The initial purchase of the shares does not result in any recognition of income to the employee. Then, if your employee doesn’t sell the stock until at least one year after acquiring the shares and two years after you grant your employee the purchase right, a disposition of the shares will result in long-term capital gain and ordinary income. The amount your employee must realize as ordinary income is the lesser of either: (1) the amount by which the FMV of the stock at the time of the grant of the right exceeded the purchase price, or (2) the amount by which the FMV of the stock at the time of the sale exceeded the purchase price.

Example(s): Richard doesn’t sell of the stock he purchased from XYZ Company within one year after acquiring the shares or within two years after XYZ granted him the opportunity to participate in the plan. Then Richard sells all of the stock for $11 per share. Richard must realize as ordinary income the lesser of either: (1) the amount the FMV of the stock at the time of the grant of the right exceeded the purchase price ($10 per share – $9 per share = $1) or (2) the amount the FMV of the stock at the time of the sale ($11 per share – $9 per share = $2) exceeded the purchase price. Since the alternative based on FMV of the stock at the time of the grant of the right is the lesser of the two amounts, Richard must realize $1 per share as ordinary income. The rest of Richard’s income ($1 per share) is long term capital gain.

Disqualifying disposition

If an employee disposes of the stock within the time periods specified by Section 423 of the Internal Revenue Code (referred to as a disqualifying disposition), the employee must recognize ordinary income in an amount equal to the difference between the value of the stock at the time he or she exercises the right and the purchase price.

Example(s): Richard makes a disqualifying disposition of the stock he purchased from XYZ Company by selling of the stock he purchased from XYZ (for $11 per share) within Section 423 time periods. Richard must realize as ordinary income the amount equal to the difference between the value of the stock at the time he exercised the right and the purchase price ($10.50 per share – $9 per share = $1.50 per share). Richard must realize $1.50 per share as ordinary income. The rest of his income ($.50 per share) is capital gain, long-term or short-term, depending on whether Richard held the stock for more than one year before selling it.

Employer tax treatment

Unless there’s a disqualifying disposition, you can’t receive a tax deduction. If there’s a disqualifying disposition, you can deduct an amount that is equal to the amount of ordinary income that your employee realizes.

Example(s): Richard makes a disqualifying disposition of the stock he purchased from XYZ Company and realizes $1.50 per share as ordinary income. XYZ can deduct an amount that is equal to the amount of ordinary income that Richard realizes–$1.50 per share.