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A Detailed Overview of Employee Ownership Plan Alternatives

Employee Stock Purchase Plans

Millions of employees have become owners in their companies through employee stock purchase plans (ESPPs). Many of these plans are organized under Section 423 of the tax code and thus are often called "423" plans. Other ESPPs are "non-qualified" plans, meaning they do not have to meet the special rules of Section 423 and do not get any of the special tax treatment. Most of these plans, however, are very similar in structure.

Under Section 423, companies must allow all employees to participate, but can exclude those with less than two years' tenure, part-time employees, and highly compensated employees. All employees must have the same rights and privileges under the plan, although companies can allow purchase limits to vary with relative compensation (most do not do this, however). Plans can limit how much employees can buy, and the law limits it to $25,000 per year.

423 plans, like all ESPPs, operate by allowing employees to have deductions taken out of their pay on an after-tax basis. These deductions accumulate over an "offering period." At a specified time or times employees can choose to use these accumulated deductions to purchase shares or they can get the money back. Plans can offer discounts of up to 15% on the price of the stock. Most plans allow this discount to be taken based on either the price at the beginning or end of the offering period (the so-called "look-back feature"). The offering period can last up to five years if the price employees pay for their stock is based on the share price at the end of the period or 27 months if it can be determined at an earlier point.

Plan design can vary in a number of ways. For instance, a company might allow employees a 15% discount on the price at the end of the offering period, but no discount if they buy shares based on the price at the beginning of the period. Some companies offer employees interim opportunities to buy shares during the offering period. Others provide smaller discounts. Offering periods also vary in length. NCEO studies, however, show that the large majority of plans have a look-back feature and provide 15% discounts off the share price at the beginning or end of the offering period. Most of the plans have a 12-month offering period, with six months the next most common.

In a typical plan, then, our friend Joe might start participating in an ESPP plan when the shares are worth $40. He puts aside $20 per week for 52 pay periods, accumulating $1,040. The offering period ends on the 52nd week and Joe decides to buy shares. The current price is $45. Joe will obviously choose to buy shares at 15% off the price at the beginning of the offering period, meaning he can purchase shares at $34. For his $34, he gets shares now worth $45. If the share price had dropped to $38 at the end of the offering period, Joe could buy shares instead at 15% off $38.

The tax treatment of a 423 plan is similar to that of an incentive stock option. If Joe holds the shares for two years after grant and one year after exercise, he pays capital gains taxes when he actually sells the stock on all of the gain he has made except the 15% discount ($6 per share in our example). If he sells the shares after meeting the holding rules at a price less than $40, he would pay ordinary income tax just on the difference between the purchase and sale price. The company gets no tax deduction, even on the 15% discount.

If Joe does not meet these rules because he sells earlier, then he pays ordinary income tax on the entire difference between the purchase price ($34) and the exercise price ($45), plus long-term or short-term capital gains taxes on any increase in value over $45. The company gets a tax deduction for the spread between the purchase price and the exercise price ($11 per share in this case).
Non-qualified ESPPs usually work much the same way, but there are no rules for how they must be structured and no special tax benefits. The employee would pay tax on the discount as ordinary income at the time the stock is purchased and would pay capital gains on any subsequent gain. In our example, Chip would pay tax on $11 per share at the time the shares were purchased. The company would receive a corresponding deduction.

ESPPs are found almost exclusively in public companies because the offering of stock to employees requires compliance with costly and complex securities laws. Closely held companies can, and sometimes do, have these plans, however. Offerings of stock only to employees can qualify for an exemption from securities registration requirements at the federal level, although they will have to comply with anti-fraud disclosure rules and, possibly, state securities laws as well. If they do offer stock in a stock purchase plan, it is highly advisable they obtain at least an annual appraisal.

ESPPs are very popular in public companies as they offer a benefit to employees and additional capital to companies. Any dilution resulting from the issuance of new shares to satisfy the purchase requests, or from the company repurchasing outstanding shares and reselling them at a discount, is usually so small that shareholders do not object. Rates of participation vary widely, with the median levels around 30% to 40% of eligible employees. Because most employees do not commit large amounts to these plans, and many do not participate at all, ESPPs should generally be seen as an adjunct to other employee ownership plans, not a means in themselves to create an ownership culture.

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