Participating in your employee stock purchase plan (ESPP) can be a great way to supplement cash flow, fund short-term goals, and invest for the future at an advantage.
That said, ESPPs are hardly a "set it and forget it" investment option. Before you decide to contribute, it is important to have a tax-friendly liquidation strategy for your company shares that aligns with your unique financial goals in order to make the most of the opportunity. Here's why.
Company shares acquired through an employee purchase plan are like a tool; helpful in what it can help you do when used appropriately, but otherwise unexciting or even harmful unchecked.
A liquidation strategy (plan to sell) that factors in tax implications is the crucial piece of the puzzle that could make or break your ability to reach the goals you intend your ESPP to fund.
There are a variety of scenarios where it may be better to hold or sell your ESPP shares. For simplicity within this article, we're going to assume you've already contributed and are now debating when and how much to sell, but if we've caught you while you're deliberating participating for the first time, this is still valuable insight to direct at what level you'd like to contribute.
Let's dive in.
Tax Consequences and The Lookback Period
Immediate cash needs aside, the question of whether to sell your ESPP shares usually comes down to their tax treatment or diversification needs.
Most employee stock purchase plans have lookback periods that allow you to purchase shares at a discount based on the current stock price or the share price at the beginning of the offering period—whichever is lower.
This gives you an opportunity to score shares at an even bigger discount, but it also complicates the tax consequences of a sale because it impacts what portion of asset growth may be considered a capital gain.
If your plan does not have a lookback period or you purchased shares and didn’t exercise the lookback benefit, this makes the tax consequences much more straightforward:
The discount from the share price on your purchase date and your purchase price (the employer discount) will be taxed as ordinary income when you sell, and the change in price from this purchase date price will be short-term or long-term capital gain or loss (similar to the treatment of your typical asset purchase).
If the plan has a lookback period, you don’t have an immediate need for the cash, and your portfolio isn’t overly concentrated in your employer’s stock, taking advantage of the lookback provision and hanging onto your shares until you are eligible for a qualifying disposition may make sense.
To clarify this, let’s look at some scenarios. In these, the offering period is 12 months, there are 2 purchase periods at each 6-month interval, and the base employer discount is 15%.
Scenario 1: Plan Doesn’t Offer a Lookback
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On the offering date / grant date, the fair market value (FMV) of your employer share is $100. Over the purchase period, the stock price increased to $150/share on the purchase date.
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With no Lookback, you would get to purchase at a discounted price of 15% from the $150/share, so $127.50.
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If you sell at the $150 price, this discount is taxed as ordinary income, with any gain or loss from the $150 price, being short-term or long-term capital gain or loss.
Scenario 2: The Lookback is Unused
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On the offering date, the FMV of your employer share is $100. Over the purchase period, the stock price dropped to $90/share on the purchase date. Since the current price is lower than the offering date price, even if your employer offers the lookback, you won’t use it!
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You would purchase at a 15% discount from the $90/share, so $76.50. If you sell at the $90 price, this discount is taxed as ordinary income, with any gain or loss from the $90 price, being short-term or long-term capital gain or loss.
Scenario 3: The Lookback is Used, Disqualifying Disposition and Qualifying Disposition
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On the offering date, the FMV of your employer share is $100. Over the purchase period, the stock price increased to $150/share on the purchase date.
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With the Lookback, you would get to purchase at a 15% discount from the $100/share, so $85. This discount ($15 + $50) will be taxed in two different manners. If you sell at the $150 current price, the $15 will be ordinary income and the $50 will be decided based on if you did a Disqualifying or Qualifying Disposition.
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If you do not hold the shares for 12 months from purchasing and 24 months from the offering date, you will have a disqualifying disposition. With a sale price of $150, the $50 discount from the Lookback will be taxed at your ordinary income rate.
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If you do hold the shares long enough to reach a qualifying disposition, with a sale price of $150, the $50 discount from the Lookback will be taxed at your Long-Term Capital Gains Rate (potentially a beneficial tax savings depending on your personal tax situation).
What Are Your Goals?
Taxes and diversification needs aside, the most important thing to consider in your decision is your personal finance goals.
Let's start easy. If you have shares acquired through an ESPP and you have an immediate need for the cash a sale would generate, it is likely going to be recommended to sell ESPP shares immediately and redeploy the cash as needed—regardless of the tax consequences outlined above.
In these situations it is important to understand that selling immediately may not be the optimal choice from a tax standpoint, but can still make sense for your overall financial plan.
Aside from solving your cash needs, one benefit of unloading shares right away is you can lock in the discount you received on the purchase date and avoid the risk of a market downturn, which can wipe out the what would otherwise be benefit of the discount.
On the flip side, if you have other ways of funding your short-term cash needs, holding onto your shares to fund longer-term goals, such as saving for your child’s education or boosting your retirement savings, may be worth considering because holding allows for the potential of greater market growth and more favorable tax treatment as a long-term capital gain and possibility of a qualifying disposition.
Tax Loss Harvesting & Wash Sales
Great tax strategy at times involves making the most of a bad situation, including what is known as tax loss harvesting, where you sell an asset and claim a loss to balance out positive gains elsewhere in your portfolio.
Now, before you go selling your ESPP at a loss to solve this problem, understand that ESPP share purchases can result in what is known as a wash sale. This occurs if you purchase a “substantially similar” investment in the 30 days leading up to or after you sell a security at a loss.
If you trigger a wash sale, you won’t be able to claim the losses on your taxes, potentially wiping away the tax benefit. This can sneak up on participants because employees aren’t actively hitting the button to buy shares within the program. Before selling for this purpose, be sure you understand if additional units are being purchased via your program.
Portfolio Diversification
ESPP and other equity compensation such as RSUs and stock options can quickly become a significant percentage of your total assets if you don’t evaluate your holdings regularly.
This potential over exposure to individual stocks in your portfolio is important when evaluating whether to sell your ESPP shares. At Plancorp, we recommend having no more than 5% to 10% of your overall liquid net worth tied to a single stock. Those regularly participating in ESPP alongside other equity compensation can easily surpass this guidance.
If you already have a significant portion of your portfolio tied up in employer stock, that is a sign that you might want to begin selling your ESPP shares immediately upon purchase.
If you do not and you are going to hold onto them, it is crucial to set a target portfolio allocation for the shares and stick to it, no matter how tempting it is to increase the target allocation when your company stock is performing well.
If you're struggling with this decision, consider whether would you use that amount of cash to purchase employer shares if it weren't for the discount. If not, then you should probably be selling and using the cash or diversifying to align with your overall portfolio allocation.
Next Steps
The key to taking full advantage of your company’s ESPP program is creating a liquidation strategy that aligns with your overall financial plan. It's a balancing act of weighing your goals, the tax implications, and recommended diversification principles within your portfolio.
A Registered Investment Advisor, like Plancorp, can help you develop both a comprehensive wealth management plan and a liquidation strategy for your ESPP shares that aligns with your financial goals and risk tolerance.
Our wealth managers and financial advisors can help you decide whether it’s worth contributing to your employer’s plan and when to stop contributing (if ever), optimize your cash flow with the sale of shares, and evaluate the tax impact of liquidation.
Check out our ESPP calculator to review the tax consequences of selling various shares and schedule a call to see if we can help create a strategy that aligns with your financial goals!
