ESPPs allow employees to purchase company stock (usually via a payroll deduction) at a discount that does not exceed 15%. For purposes of federal income tax, this discount does not result in immediate compensation, provided that the statutory holding period requirements and the requirements of IRC Section 423 are met. For a plan to qualify as an ESPP, it must meet the following requirements:
- ESPPs may only be offered to employees of the employer or related corporations.
- ESPPs must be granted to all employees on an equal basis.
- ESPP shares may be purchased only by an individual who is an employee from the grant date to three months before the purchase date.
- An employee who has voting power that is greater than 5% may not participate in the plan.
- Certain employees may be excluded from participating in an ESPP, including
- Employees who have been employed for less than two years.
- Employees who customarily are employed 20 hours or less per week.
- Employees who customarily are employed no more than five months in a calendar year.
- Highly compensated employees, as defined in IRC Section 414(q).
Because ESPPs must be granted to all employees of US companies to qualify for favorable treatment under IRC Section 423, multinational companies should generally be careful not to exclude those employees who work for overseas branches or representative offices of US companies.
ESPPs must also comply with the following conditions:
- The plan is approved by the shareholders of the company within 12 months before or after the plan is adopted.
- The plan designates the aggregate number of shares that may be issued.
- The awards granted under the ESPP are in the stock of the employer.
- The term during which a participating employee has the option to purchase the employer's stock cannot exceed 27 months, unless the option price is not less than 85% of the stock's fair market value at the time that the option is exercised.
Further, an employee cannot accrue a right to purchase more than $25,000 (valued at the grant date) of stock each year under any ESPP of the employer, its parent company, and subsidiary corporations.
If the ESPP designates a maximum number of shares that may be purchased by each employee during the offering, or establishes a fixed formula to determine that number (such as $25,000 divided by the fair market value of the stock on the first day of the offering period), the first day of the offering period is deemed the "option grant date." Establishing this date is critical to avoiding issues under IRC Section 409A. If no maximum is set, the option grant date for purposes of establishing the minimum exercise price is deemed to be the exercise date.
In the case of a qualifying disposition, if an option has an exercise price that takes advantage of the IRC Section 423 discount feature, the employee must include in ordinary income, at the time that the stock is disposed (assuming that the statutory holding-period requirement is met), the lesser of the following two amounts:
- The amount of the fair market value of the shares at the time of the disposition or the employee's death that exceeds the exercise price of the option.
- The amount of the stock's grant-date fair market value that exceeds the option's exercise price.
Any additional gain upon selling the stock should be treated as a long-term capital gain.
If the stock is sold through a disqualifying disposition, the employee will recognize ordinary income that is equal to the difference between the purchase date fair market value and the purchase price. This amount is considered ordinary compensation income in the year of sale even if no gain is realized on the sale. The difference between the proceeds of the sale and the employee's basis in the stock will be treated as a capital gain or loss. Ordinary income that the employee recognizes upon a disqualifying disposition of ESPP shares constitutes taxable income and should be reported by the employer on the employee's Form W-2; however, taxes do not have to be withheld.
Unlike ISOs, ESPPs provide that even in a qualifying disposition some amount of ordinary income will be recognized at the time of sale. However, the amount of ordinary income in a qualifying disposition is generally lower than the amount of ordinary income in a disqualifying disposition.