It will come as no surprise to regular readers of the monthly updates that I publish that a goodly chunk of BITA household income comes in the form of company stock grants from our employers. Mr. BITA’s company gives him Restricted Stock Units (RSUs), my company also gives me RSUs and affords me the opportunity of participating in an Employee Stock Purchase Plan (ESPP). YTD in 2017 we have made $112,184.09 (post-tax) across our various stock compensation plans.
In part 1 and part 2 of the ESPP Bible series, I am going to discuss all things ESPP. For those of you who are impatient for the punch line, here is the TL;DR:
- If your company offers an ESPP without a lock-in period, you absolutely must sign up for it, and contribute the maximum allowed, if you can afford it.
- Sell the stock the day that it vests, preferential tax treatment be damned. The risk of holding on isn’t worth it, so don’t let the tax tail wag the dog.
- Pay close attention to the cost basis at tax time. Filing taxes for ESPP income can be a little tricky.
What is an ESPP?
An ESPP is a very lucrative perk offered by some employers. If you have access to one, take a moment now to shout Wheeeee!, dance around jubilantly and feel a wee bit smug. An ESPP allows employees of the company to buy company stock at a discounted rate.
Before we dive into the details, let’s look at a quick example of just how lucrative an ESPP can be.
Example 1. Imagine that your company stock price is $20 a share. You get a 15% discount via the ESPP, and so you get the stock at $17/share. Suppose you invested $2550 in your ESPP over a period of six months ($212.50 per paycheck). With your discount you pick up 150 shares for $2550. You sell them at $20/share for $3000, making a profit of $450. As a percentage, your return is $450/$2550 = 17.64%. Not too shabby, eh? It gets better though.
(The math that follows is a bit simplified. The simplifying assumptions don’t materially affect the numbers) You contributed that $2550 over 6 months, so the first $212.50 contribution was locked up for 6 months, but the last 212.50 yielded a big profit in a matter of days. On average, your money was at work for 3 months to yield 17.64%. Therefore your annualized return = (1 + 17.64%) ^ (12/3) – 1 = a whopping 91.6%. Yes, you read that right. 91.6%.
ESPPs kick ass. I can’t think of anything else that offers higher returns at such a low risk.
ESPP Terminology and Timeline
There is no one standard ESPP plan, but most of them have certain common attributes. I’m going to use my company’s ESPP plan to explain how a typical plan works.
We can sign up for the ESPP, or decide to stop participating, once every 6 months during a period called open enrollment. If you sign up, you will be enrolled in the ESPP starting at the next offering date or grant date.
During open enrollment you decide how much of your salary you want to contribute to the plan. We are allowed to contribute anywhere from 1% to 10% (in increments of 1%) of our gross salary to the ESPP.
The grant date is significant because it determines the amount and kind of taxation you will be subject to. More on that later. It is also significant if your plan supports a look-back provision. We’ll talk more about look-back in a minute, when the shares are actually purchased.
For 6 months starting at the grant date, from every paycheck your chosen amount is deducted and held on your behalf by the company in a non-interest-bearing account. Though the amount of the contribution is based on your gross salary, the deductions are in after-tax dollars.
On the purchase date the company buys shares on your behalf using your accumulated contribution amount from the last 6 months. At what price are the shares purchased? At my company we get a 15% discount on our shares, and our plan supports look-back, so our purchase price is calculated as:
Purchase price = 0.85 * min(FMV on purchase date, FMV on grant date), where FMV stands for Fair Market Value.
Look-back means that the stock price on the grant date is taken into account when determining the purchase price of your shares. In our case, since our offering period lasts for two years, this means that if the stock price rises during those two years, we get to lock in the low price on the grant date for two whole years.
Example 2. If the stock price was $18 on the grant date in November 2015, and then rose to $20 on the purchase date in May 2016, I would purchase the stock at $15.30/share.
We then go back into accumulation mode for the next six months (provided we choose to stay enrolled), and then make another purchase.
Example 3. If the stock price dropped to $19 by November 2016, I would still purchase the stock at $15.30/share, because I purchase at the minimum of the FMV on the purchase date and the FMV on the grant date.
Our offering period is 24 months long, so we have 4 accumulation phases, and 4 purchase dates. The last purchase date coincides with the end of the offering. If we choose to stay enrolled in the plan, we will now get a new grant date and enter a new 24 month offering period.
We are allowed to sell any or all of the purchased stock immediately, effectively allowing us to lock in the 15% (or more, if the stock price has risen above the stock price on the grant day, refer to example 2 above).
Variations in ESPPs
I have used my ESPP to explain how ESPPs work. Grant dates, offering periods, purchase dates, discounts and look-backs are all common ESPP terminology and not specific to my company. So, what are the ways in which ESPPs might vary from what I’ve described above?
- The offering period may not be 24 months. I’ve seen plans that have 12 month offering periods.
- The maximum amount you are allowed to contribute varies from plan to plan.
- Look-back may not be included in the plan. ESPPs without look-back are still excellent investments because you still get the discount on the FMV on the purchase date.
- The amount of the discount may vary. 15% is common, but I’ve seen plans that offer 5% and 10% too.
- There may be a lock-in period. Some plans will not allow you to sell the stock immediately after the purchase date. This is the one provision that would make me wary of an ESPP. If the stock takes a nosedive while the lock-in is in effect, it could wipe out the discount. Think long and hard about investing in an ESPP with a lock-in provision.
Next Time….Taxation of ESPPs
So you enrolled in your ESPP, made bank, and are rolling around in your newfound wealth in the most unseemly manner, being all kinds of smug. But what about taxes? While ESPPs are a thing of beauty, ESPP taxation is decidedly less so. Part 2 of the ESPP Bible will cover the issues around taxation in gory detail.
Until then, if you do have an ESPP, sally forth and enroll forthwith.