Employee Stock Purchase Plan (ESPP) vs. Dividends: Maximizing Employee Benefits

Working for a company that offers an Employee Stock Purchase Plan (ESPP) can be a valuable perk that can help you reach your financial goals. It’s a benefit not all companies offer, so count yourself fortunate if your company offers one! Unfortunately, many employees don’t take full advantage of their ESPP because they don’t completely understand how to use it to their advantage.

Understanding Employee Stock Purchase Plans (ESPPs)

If your company offers an Employee Stock Purchase Plan (ESPP), you might be leaving free money on the table or taking on more risk than you realize. ESPPs can be one of the most powerful return enhancers available to employees, but only when used intentionally and as part of a broader plan.

An ESPP allows you to purchase company stock, often at a discounted price, such as between 5-15% off the fair market value. For example, if the fair market value on the applicable date is $10 per share, and your plan offers a 15% discount, you can purchase those shares for $8.50 per share. That’s like an automatic "profit" of $1.50 per share at the time of purchase if your plan allows you to sell immediately.

Here's how ESPPs work:

• ESPPs allow you to buy your company’s stock through automatic payroll deductions.
• First, you decide the percentage of your paycheck you want to contribute toward buying company stock.
• At the end of the offering period, the money you’ve set aside is used to purchase shares of company stock.

You make your contributions into the plan via payroll deductions and on set dates, the company purchases shares on your behalf (generally at a discount!) with the funds accumulated and delivers them to you.

Key Advantages of ESPPs

A key advantage here is the discount, often up to 15% off the market price. Some ESPPs also have additional features that can make them more valuable. One such feature, a "lookback," compares the fair market value of the stock at the beginning of the offering period (the ‘offering date’) and the fair market value of the stock on the purchase date, then uses the lower value to calculate your purchase price.

Consider this example. Suppose your company’s stock is priced at $50 at the start of the offering period and rises to $60 by the purchase date. Thanks to a 15% discount, with the lookback feature, you’re able to buy shares at just $42.50 (that’s 15% off the lower $50 price). Right away, you have an unrealized gain of $17.50 per share.

Participation and Flexibility

It’s generally just as easy as participating in a 401(k) plan. You choose the allowable percentage of your paycheck you wish to contribute, and your company will deduct those contributions from your paycheck on an after-tax basis. Your employer will hold those contributions until the purchase date and make the purchase on your behalf. Your enrollment will typically roll over from one purchase period to the next unless you change it.

Participation is voluntary, so companies commonly allow you to withdraw, even in the middle of an offering period. Most plans also allow you to withdraw during the purchase period. Any contributions are then refunded, and you can choose to enroll again during the next enrollment window if you choose.

One important note on choosing your contribution level: Like your 401(k) contribution percentage, the percentage you choose to contribute will be based on your gross (before-tax) pay amount.

Tax Implications of ESPPs

Understanding ESPP tax rules is essential for supporting the financial well-being of participants. You may owe taxes either in the year when shares are purchased and the year when the shares are sold, or only when they are sold. The type of taxes you owe depends on the type of plan offered by your employer, and for tax-qualified ESPPs, on the timing of purchase and when you sell your ESPP shares.

The tax treatment on shares acquired via an ESPP purchase can be complex, just as with taxes on equity compensation in general. Be sure to discuss the potential tax implications of participation with a tax professional if you are considering enrolling in your company’s ESPP.

When participants buy stock through an ESPP, the income is not taxable at the time of purchase. Instead, taxes are triggered when the stock is sold. Ordinary income includes any earnings that are taxed at regular income tax rates. This typically includes wages, salaries, tips, bonuses, and similar compensation. A capital gain is the profit realized from the sale of an asset that has increased in value.

Qualifying vs. Disqualifying Disposition

The way your ESPP gains are taxed depends on how long you hold the shares after purchasing them. A qualifying disposition happens when a participant sells shares at least two years after the grant date and at least one year after the purchase date. If you meet both conditions, a qualifying disposition, the discount portion is treated as ordinary income but not wage income, and the rest is taxed as long-term capital gain. A disqualifying disposition occurs when the required holding periods are not met. If you sell too soon, a disqualifying disposition, the entire discount is treated as ordinary wage income and added to your W-2, leading to higher taxes.

In these cases, participants must pay ordinary income tax on the difference between the stock's purchase price and the market price at the time of purchase. After this point, any additional gain may be subject to capital gains tax rates.

Using ESPP Shares to Reach Financial Goals

Purchasing shares via an ESPP can be an important tool in your financial toolbox to help you achieve your personal goals. If the stock price appreciates over time, and you continue to hold your shares, they could become a valuable part of your nest egg as retirement approaches. Or you can use them to reach shorter-term goals, such as buying a home or paying for college.

How ESPP shares can help you reach your goals is up to you - start by defining your short, medium and long-term goals and line up where this workplace benefit can best help. Like with many investments, there are risks to investing through ESPPs if you hold onto them as shares may not appreciate in value over time and may be less valuable than they were when purchased.

And remember: an ESPP generally allows you to purchase stock at a discounted rate that’s not available to investors who do not work for the company.

Dividends in Employee Ownership Companies

If your employees are owners, should you pay dividends on their shares? For many employee ownership companies, the answer is yes. Dividends can focus people's attention on ownership and, in ESOPs, can provide unique tax benefits.

Dividends used to repay ESOP loans in a C corporation are tax-deductible and normally do not count towards limits on how much stock can be allocated to employee accounts. Dividends passed through on ESOP shares can also be paid directly to employees, with the company deducting their value. Dividends voluntarily reinvested by employees in company stock in the ESOP are also tax-deductible. If combined with a 401(k) plan, they also can be effectively pre-tax to the employee.

Companies considering paying dividends need to consider several issues in making a decision. Should the company use preferred or common stock? If dividends are used to repay a loan, what rules need to be followed?

Preferred vs. Common Stock

Most privately held companies have just one class of common stock; public companies often have multiple classes. If a company has just one class, paying dividends on the ESOP shares can require paying dividends on other shares. Owners of these shares may not want dividends paid to them because both they and the company are taxed on the dividend amount.

To avoid paying dividends to other shareholders, a separate class of dividend paying preferred stock is often created. If the plan is an ESOP, this generally is convertible into voting common stock. Preferred stock is a way to pay owners more of their money now, in the form of dividends, and less later, in the form of increased share value.

The higher dividends on preferred stock mean ESOP companies can take full advantage of ESOP rules that allow dividends used to repay an ESOP loan to be deducted. Because preferred stock pays out more now and less later, it varies less in value than common stock. This makes it less risky for employees, but it also means employees have less at stake in helping the company to grow long term.

Preferred stock may also be more difficult to communicate.

Dividends and ESOP Loans

Dividends on both allocated and unallocated shares can be used to repay a loan. Dividends paid on allocated shares must release shares to employee accounts at least equal in value to those dividends. Dividends paid on unallocated shares can be distributed to employee accounts based on the allocation formula for other contributions or on the prior account balance.

Reasonable Dividends

Dividends must be "reasonable." The IRS has not defined what reasonable means, however. In the one private letter ruling on this issue, a 70% dividend was ruled unreasonable.

Accounting Treatment

Accounting treatment for dividends paid on ESOP loans is complex. Previous rules indicated dividends used to repay a loan would be charged to retained earnings. New rules will require them to be charged to compensation expense, with the charge measured by the value of the shares released.

Taxation of Dividends

Dividends passed through to employees are taxable and do not qualify for the partial tax exclusion treatment available to non-ESOP dividends. They are not subject to the 10% early distribution tax, however. FICA, FUTA, and withholding are not required.

Dividends used to repay a loan end up being allocated as shares and are treated in the same way for tax and distribution purposes.

Decision Making

Plan documents should indicate who decides when and how dividends will be paid. Participants can be given a choice individually, or the company can make the decision.

Impact on Employee Motivation

Companies that pay dividends often swear by their impact on employee motivation. The money gives employees an immediate payback from their stock and provides companies with a periodic way to draw employee attention to ownership issues. In some companies, they may add a few thousand dollars a year in compensation to people who have accumulated a lot of stock.

On the other hand, they provide the greatest reward to those people with the longest participation in the ownership plan. However, as a short-term reward for good work, they may be ineffective because a new worker making a valuable contribution would get a small fraction of what a more senior employee gets.

Integrating ESPPs and Dividends into Financial Planning

Before prioritizing ESPP participation, it’s important to have a solid financial foundation. This includes establishing an emergency fund, contributing sufficiently to retirement accounts such as your 401(k) or IRA, and maintaining healthy cash flow while regularly saving in a taxable brokerage account.

The process is straightforward; make regular contributions from each paycheck, purchase shares at a discount, hold the shares long enough to benefit from favorable tax treatment then when the time is right, sell and reinvest the proceeds to diversify your investments.

While ESPPs offer a discount, they’re still company stock, and because contributions reduce your take-home pay, there’s a real liquidity tradeoff. If your company performs poorly or you need cash before meeting the holding periods, you may face higher taxes or underwhelming returns. The goal isn’t to load up on company stock.

Key Considerations

Many employees don’t take full advantage of their employee stock purchase plan because they don’t fully understand it.

Here are some key considerations to keep in mind:

• Enrollment and Contribution: To enroll in your ESPP and choose your contribution amount, go to Fidelity NetBenefits®. The contributions from your paycheck accumulate over an "offering period."
• Purchase Price: At the end of this period, shares of company stock are purchased on your behalf. The price you pay could be lower than the market price, depending on the features offered by your company. Some companies offer a discount of up to 15% off the market price. Some offer a "lookback"-your purchase price is based on the market price at the start or end of the offering period, whichever is lower. Some companies offer both a discount and a lookback.
• Withdrawal and Adjustments: If you withdraw from your ESPP during the offering period, your unused contributions that have been collected from your paycheck will be returned to you. Any shares already purchased for you will remain in your Fidelity brokerage account. If you wish to participate in future offerings, you might have to enroll again. If your financial situation or goals change, you can adjust how much you contribute to your ESPP.
• Share Management: Your shares are purchased at the end of the offering period and deposited into your brokerage account generally within a few days of the purchase. You can hold on to your shares, sell them, or do a combination of both, depending on your financial goals and your company's holding requirements.

How much you'll pay in taxes depends on the type of ESPP you have. We'll stay in touch through the full life cycle of your plan and let you know when there's action to take.

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