Owning your employer's stock at a discount

In short

A friend of mine once told me his company let him buy its stock at a discount, and he felt like he had found a hole in the fence of the whole market. If your employer runs a plan like that, you can buy shares through payroll, often for less than the market price. The discount is real money, but it comes with taxes, timing rules, and a concentration risk that deserves a clear look. Ask your benefits office for the plan document before you sign up. Read how the price is set, when the shares arrive, and when you can sell. Work out what share of your savings would end up tied to one company. That last step takes ten minutes. It matters more than the discount itself.

The whole of it

What it is

I once watched a neighbor line up at a church supper for a second helping, and he did it with the quiet pride of a man who knew the cook. An employee stock purchase plan works a little like that. Your employer lets workers buy company shares at a price below what the public pays. The plan is often called an ESPP.

Some plans are called qualified, and they follow Section 423 of the Internal Revenue Code. Those plans have a set of rules. The discount cannot be larger than a stated percent, which the law sets at the current figure, which the official source publishes each year. Employees also cannot buy more than a yearly dollar cap, which is the current figure, which the official source publishes each year. Other plans do not follow those rules, and they are called nonqualified. They can be more flexible, but the tax treatment differs. Your plan document says which kind you have.

Here is the plain truth about the discount. It works like a raise that comes in the form of stock. Nobody hands you a bonus check. The company simply lets you buy something for less than it is worth that day. That is a kindness, and it is also a decision about where your money will sit.

How it works

If you are thinking about joining, picture the plan as a series of windows. Each window is called an offering period. During it, money comes out of your paycheck, after tax, and waits in an account. You pick the percent. Plans usually cap it, and the cap is in the document.

When the window closes, the plan uses the saved money to buy shares for you. That day is the purchase date. The price you pay is set by a formula. Many plans take the lower of two prices, the price at the start of the window or the price at the end, and then knock off the discount. A plan like that is said to have a look back feature. It can make the deal much better when the stock climbed during the window. Not every plan has it, so check yours.

After the shares land in your account, the plan decides when you can sell. Some plans let you sell right away. Others make you hold for a while. The tax bill depends on how long you keep the shares, and that is worth knowing before you act.

For a qualified plan, the Internal Revenue Service describes two outcomes. A qualifying disposition happens when you sell more than two years after the offering began and more than one year after you bought. A disqualifying disposition is any sale sooner than that. In a qualifying sale, part of your gain is taxed as ordinary income and the rest as a long term capital gain. In a disqualifying sale, the discount is generally taxed as ordinary income, and any further gain or loss is a capital gain or loss. Your employer reports some of this on Form 3922 and on your Form W-2. The rules have details, so read the IRS guidance for your plan type.

The numbers, and where to find yours

Plenty of folks sign up without ever finding the numbers that drive the whole thing. They are not hidden. They are just spread across a few pages.

Your plan document, sometimes called the plan summary or prospectus, holds most of them. Look for the discount percent, the offering period length, the purchase dates, the contribution cap you can choose, and whether a look back feature applies. The law sets a ceiling on the discount and on the yearly purchase amount, and the current figures are the current figure, which the official source publishes each year and the current figure, which the official source publishes each year. Your own plan may set lower limits than the law allows.

For the tax side, the IRS publishes Publication 525, which covers taxable and nontaxable income, and Publication 550, which covers investment income and expenses. Both explain how stock plan sales are reported. Form 3922 arrives from your employer after a purchase, and it lists the dates and prices you will need later. Keep it with your tax papers.

A worked example

Let me tell you about a woman named Marisol, a dental office manager who earns $52,000 a year. Her employer, a public company, runs a plan with a 15 percent discount and a look back feature. Marisol decides to put in 6 percent of her pay.

Six percent of $52,000 is $3,120 for the year. If her offering period is six months, that is $1,560 saved up by the first purchase date.

Say the stock cost $40 on the first day of the window and $50 on the purchase date. With a look back, the plan uses the lower price, which is $40. Then it takes 15 percent off. Fifteen percent of $40 is $6. So she pays $34 a share.

Her $1,560 buys 45 shares, because $1,560 divided by $34 is about 45.88, and the plan counts whole shares here for simplicity. The shares are worth $50 each on that day, so 45 shares are worth $2,250. She paid $34 times 45, which is $1,530. The gap is $720 in value she received for $1,530 of cost. The few leftover dollars stay in her account for the next window.

Now the tax. Suppose Marisol sells at once, a disqualifying disposition. The discount counts as ordinary income. The plan treats her gain up to the market price on the purchase date as that income, which is $2,250 minus $1,530, or $720. If she is in a 22 percent bracket, the federal tax on that is $720 times 0.22, which is $158.40. She keeps about $561.60 of that gain, before any state tax. She also kept her original money.

Marisol had a choice, though, and it is the part that keeps me up some nights on her behalf. She could hold on. If the stock fell to $30 while she waited, her 45 shares would be worth $1,350, which is less than the $1,530 she paid. A discount does not protect anyone from a falling price. It only gives a head start.

Where it goes wrong

I have seen good people get tangled here, and not from foolishness. Most of the trouble comes from a few places.

The biggest one is putting too many eggs in one basket. Your paycheck already depends on this company. If you also hold a pile of its stock, a bad year at the company can hit your job and your savings in the same week. Think about how much of your total savings would sit in one name, and whether you would sleep well if it dropped by half.

The next trouble is the tax surprise. The money comes out of your paycheck after tax, and then a tax bill can show up at sale time on the discount. Folks sometimes sell, spend the cash, and then learn they owe more. Set some aside.

Another slip is reporting. The cost basis, which is what the IRS counts as your cost, is often not the number on your brokerage statement. In a plan with a discount, your basis may need to be adjusted so you are not taxed twice on the same gain. Form 3922 and the IRS publications help with that. A tax preparer can too.

A smaller one is leaving the plan. If you quit or are let go, the plan document says what happens to the money waiting in your account. Some plans return it. Others buy shares at the next date. Know the answer before you need it.

And one last thing. A discount can tempt you to sign up for more than you can spare. Do not stretch your grocery money to chase a deal. The plan lets you pick a percent for a reason.

Questions to answer before you leave this page

Do you know what discount your plan gives and whether it has a look back feature? Have you found the dates for each offering period and purchase, and the rule for when you may sell? How much of your paycheck can you set aside without pinching your bills or your emergency savings? If the shares fell by half the day after you bought them, would that change your plans or your sleep? What share of your total savings would end up in this single company, and are you comfortable with that number? Have you looked at Form 3922 and the IRS publications that explain how your sale would be taxed, or asked a tax preparer to walk through it? And finally, what would happen to your plan money if you left your job next month?