Employee Stock Purchase Plan (ESPP) 101

Companies have a number of ways to grant shares and share options to employees. If companies are able to offer employees the chance to purchase shares through salary contributions, employees can minimise their tax burden and save some administrative headaches too. That's why employee stock purchase plans (ESPPs) can be a competitive advantage for companies looking to set up best-in-class equity plans.

Let's explore employee stock purchase plans and why they can work for high-growth businesses.

What is an employee stock purchase plan?

An employee stock purchase plan is a type of stock plan that allows participating employees to purchase company stock – usually at a discount – through payroll deductions.

ESPPs are most commonly used in the United States, and are predominantly operated by larger companies as opposed to smaller startups. For companies running equity plans internationally, ESPPs bear some similarities to certain UK plans like SAYEs and SIPs. We'll explore these parallels in more detail later on.

For now, let's get started by running through the key processes and milestones of an employee stock purchase plan.

How does an ESPP work?

Like any share scheme, employee stock purchase plans have their own lexicon of need-to-know definitions and dates to be mindful of. Let's run through the key terms.

Enrolment period and offering period

The enrolment period is the timeframe when people can volunteer to sign up to the ESPP. The offering period is the timeframe within which payroll deductions take place and people's contributions accumulate. (These terms can be interchangeable, so if you're an employee signing up to an ESPP be sure to read your contract carefully.) Then, within the offering period, there may be one or multiple purchase periods.

Offering date, grant date and purchase date

The date the offering period starts is known as the offering date: this date is also the grant date for the first shares acquired by team members. The purchase date is the date when employees exercise their right to purchase ESPP shares with their salary contributions.

Purchase price

Employees are often able to purchase stock at a discounted price compared with fair market value (usually between a 5% and a 15% discount). The price is calculated based on fair market value at the lowest price out of the first day of the offering period or the last day of the offering or relevant purchase period.

Team members are usually limited to a maximum of $25,000 in contributions towards ESPP shares per year. (Employees can also benefit from income tax relief on the portion of their salaries set aside for ESPP contributions.) Head to the section on ESPPs and tax to learn more about what the ESPP purchase price means for employees.

Selling your ESPP shares

Employees can normally choose to cash out their ESPP shares straight way once they hit the purchase date and become owners of company stock. However, stock sold straight away may be taxed as income rather than as capital gains. If employees hold ESPP shares for more than a year, shares may be classed as capital gains, carrying a lower overall tax burden.

Who is eligible?

The clue's in the name: employee stock purchase plans are designed exclusively for employees. Normally, plans will not allow people or entities holding over 5% of company stock to participate in the ESPP.

Under Section 423 of the US tax code, companies operating qualifying ESPPs ordinarily must include all employees with at least two years of service in the plan. This makes an ESPP broadly similar to all-employee share plans in Europe, such as the UK's share incentive plan (SIP) which mandates that all employees participate in the plan.

Additionally, ESPPs are usually reserved for employees who have been with the company for a certain length of time – often one year.

Other types of employee stock purchase plans

ESPPs are mainly used in the US, but there are some rough equivalents in operation elsewhere. Let's compare ESPPs against a couple of other popular plans used in the UK.

ESPP vs SAYEs and SIPs

The UK tax code doesn't provide for an exact replica of an employee stock purchase plan. However, a couple of plans used by UK companies bear similarities and could serve as a useful starting point for US companies branching into the UK.

Save As You Earn (SAYE) schemes and Share Incentive Plans (SIPs), like ESPPs, are all-employee stock plans. With SAYE, employees save capital from their pay cheques over a defined period of time, such as three or five years. At the end of the savings period, employees can convert their savings into shares.

There are a number of different ways employees can be granted shares through SIPs. In companies using partnership shares, shares are purchased out of employees' pre-tax salaries, just like an ESPP.

Both SAYE and SIPs are government-approved plans, meaning participating employees benefit from favourable tax treatment. US companies with ESPPs looking to establish a similar plan in the UK may wish to consider a SAYE or SIP as an equivalent stock plan.

ESPP tax treatment

It's important to understand the tax implications of your employee stock purchase plan. Under US tax law, ESPPs are governed by Section 423. ESPPs that qualify under Section 423 have certain tax advantages compared to unqualified ESPPs.

Qualifying ESPPs

ESPPs that are 'qualified' are plans where participating employees hold their company stock for at least two years after the grant date, and at least one year after exercising their right to purchase company shares.

For qualifying ESPPs, capital gains tax will be due on the difference between the share price at exercise, and the price of the company's stock when the shares are sold.

Non-qualifying ESPPs

Stock held in non-qualifying ESPPs may not come with the same preferential tax treatment as qualifying ESPPs.

Manage employee stock purchase plans with ease

For US companies that operate ESPPs, and which are thinking about setting up similar plans in the UK, SAYEs and SIPs could be interesting alternatives that don't require a significant equity admin overhaul.

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