What Is an ESPP? Definition and How It Works in the U.S.

A 2023 Deloitte survey found that companies offering ESPP (Employee Stock Purchase Plan) often see stronger TSR, EBITDA, EPS, and revenue growth over time compared to those that do not.

What is an Employee Stock Purchase Plan (ESPP)?

An Employee Stock Purchase Plan (ESPP) is an equity incentive plan that allows employees to purchase shares of their company at a discounted price through payroll deductions.

If you enrol in an ESPP, you choose a portion of your pay cheque to be deducted regularly. These contributions accumulate over a set period, and are then used to purchase company stock at a discounted price, often with a lookback provision.

Note: A lookback provision allows employees to purchase company stock at the lower of two prices: the stock price at the beginning of the offering period or the stock price at the end of the purchase period.

There are two types of ESPPs:

• Qualified ESPPs: You’re not taxed at purchase; instead, taxes apply when you sell.
• Non-Qualified ESPPs: You owe ordinary income tax at purchase on the discount received. Any further gains or losses when you sell are subject to capital gains tax.

How do (Employee Stock Purchase Plans) ESPPs work?

Here's a breakdown of how an ESPP works:

1. Enrolment and payroll deductions

Employees enrol in the ESPP and select a percentage of their salary to be deducted from each pay cheque. These contributions are held in an account until the stock purchase date.

2. Offering and purchase periods

• Offering period: A set timeframe (typically 12 to 24 months) during which employees participate in the plan.
• Purchase period: A shorter interval (e.g., every 3 or 6 months) within the offering period when accumulated funds are used to purchase stock.

3. Discounted stock purchase

On the purchase date, the company uses the accumulated deductions to buy stock at a discounted price (often up to 15% off). If the lookback provision applies, the stock is purchased at the lower of the price at the start of the offering period or the purchase date.

How are Employee Stock Purchase Plans (ESPPs) taxed in the U.S.?

The tax treatment of an ESPP depends on whether it is qualified or non-qualified.

1. Qualified ESPP taxation

With a qualified ESPP (under IRS Section 423), you are not taxed when you purchase the stock. Instead, taxes apply when you sell the shares. 

The tax treatment depends on whether the sale is a qualifying or disqualifying disposition:

a. Qualifying disposition (held at least 2 years from the offering date and 1 year from the purchase date):

• The discount (difference between the purchase price and the stock’s fair market value at the start of the offering period) is taxed as ordinary income.
• Any additional gain is taxed as long-term capital gains, which typically has lower tax rates.

b. Disqualifying disposition (sold before meeting the holding period requirements):

• The discount received at purchase (difference between the stock’s fair market value on purchase date and what you paid) is taxed as ordinary income.
• Any additional gain is taxed as capital gains (short-term or long-term, depending on how long you held the shares).

2. Non-qualified ESPP taxation

With a non-qualified ESPP, there are no special tax benefits. You owe ordinary income tax at the time of purchase on the discount received (the difference between the stock’s market price and what you paid). When you sell the shares, any additional gains or losses are taxed as capital gains or losses.

ESPP vs stock options

Both ESPPs and stock options allow employees to buy company stock, but they work differently.

With an ESPP, employees buy shares through payroll deductions at a discounted price. 

Stock options, on the other hand, give employees the right to buy shares at a fixed exercise price in the future, but they are not required to do so. Employees must wait until their options vest before exercising them, and the value depends on the stock price increasing beyond the exercise price.

ESPP vs RSUs

Unlike in an ESPP, employees do not need to contribute their salary to receive RSUs. These shares are granted by the company at no cost; however, employees must wait until they vest to take ownership.