A few thousand large U.S. corporations offer employee stock purchase plans (ESPPs), in which workers can buy their company’s stock through a payroll deduction, usually at a significant discount. But according to the National Center for Employee Ownership (NCEO), millions of employees are “leaving money on the table” by not participating, a puzzling phenomenon. CPAs can help their clients understand that the plans can be a valuable source of savings for retirement and other purposes.

This article outlines three ways to participate in ESPPs, each with a different length of time to hold the stock, based on relative risk tolerance and financing ability.

The NCEO estimates that far more than 30 million employees are eligible to participate in qualified ESPPs, but only approximately 10 million employees do so. According to a 2006 NCEO survey, more than one-third of companies responding had participation rates of 20 percent or less, and at another nearly one-quarter of companies, the rates were 40 percent or less. In 2004, the most recent year for which a breakdown is available by type of employee, only 33 percent of eligible salaried employees participated. For hourly employees, the rate was even lower — only about 22 percent. The NCEO attributes low participation to plans not having the most favorable characteristics allowable, along with employee demographics, lack of faith in the company’s prospects and lack of knowledge.

Most ESPPs contain a “look-back” provision; the discount is based on the lower of the stock’s prices at either the beginning of the offering period (looking back) or the purchase date. If the stock’s price increases during this time, the discount can effectively be more than 15 percent.

A Quick Flip — Least Risk

Most corporations allow ESPP participants to immediately sell their shares (called “flipping”) to realize a quick gain equal to the discount minus any taxes and brokerage commission on the sale. Example 2 assumes:

• The ESPP has no look-back provision.
  
  
  
• The discount is 15 percent off the market price on the purchase (exercise) date.
  
  
  
• No brokerage commission is paid for selling the stock.
  
  
  
• The employee’s marginal tax rate on ordinary income is 28 percent.

It’s generally better to flip than not participate, since the discount almost always exceeds the taxes and transaction costs, and risk is low. Employees who prefer to let their shares appreciate in value can do so but should take advantage of the long-term capital gains tax rate.

Holding for More Than a Year — Some Risk

Some corporations do not allow flipping. They require employees to hold stock for a specified time. Those employees and others can still benefit from selling shares after a year, since appreciation in the stock’s value can qualify as a long-term capital gain, with a maximum tax rate of 15 percent. Example 3 incorporates the same assumptions as Example 2, plus:

• The stock does not pay dividends.
  
  
  
• The stock appreciates seven percent per year.

Even if the stock is disposed of after it is held for more than a year, appreciation during the offering period doesn’t always qualify for long-term capital gain treatment. A disqualifying disposition occurs when the shares are held less than two years after the beginning of the offering period. In many cases, however, a disqualifying disposition is not something to avoid because the code treats the stock’s appreciation in price after its purchase as long-term capital gain if held more than one year. However, if the ESPP has a look-back provision and the stock price increased significantly during the offering period, the employee would prefer a qualifying disposition. In this case, the individual is generally better off meeting both holding period requirements so the sale becomes a qualifying disposition, because the code treats the stock’s appreciation in price during the offering period as long-term capital gain.

To illustrate, return to the facts in Example 1 — the price per share is $50 at the beginning of the offering period and $70 at the purchase date. The employee pays only $42.50 per share due to the look-back provision. Further, assume a six-month offering period (which is the most common offering period), no broker’s sales commission, and no change in the stock price after its purchase. Given these facts, if the sale date is one year plus one day after the stock’s purchase, it is a disqualifying disposition, so $27.50 ($70 – $42.50) is ordinary income. If sold 11/2 years and one day after its purchase, it is a qualifying disposition (the sale date is more than two years after the beginning of the offering period), so $7.50 ($50 – $42.50) is ordinary income and $20 — the appreciation during the offering period — is long-term capital gain. This illustration shows a qualifying disposition can receive more favorable tax treatment, but the stock must be held longer, so there is additional risk of a stock price decrease.

After-tax proceeds from sales can finance future purchases. However, if the stock price declines significantly, some additional financing can become necessary.

Holding for Retirement — More Risk

In “The Best Use of Spare Cash”, a co-author of this article, Gregory Geisler, ranked options for using any pay or windfall not spent. Participating in an ESPP could compare favorably to at least some of those options, including investing in an employer-sponsored retirement plan without an employer-provided match. To determine how favorably, we compared the after-tax future value (ATFV) of buying stock through an ESPP at a 15 percent discount to buying the same corporation’s stock at full price through a retirement account. Assuming the top capital gains tax rate remains constant at 15 percent, we found that the ESPP outperforms the retirement account by a consistent amount over any period. If the long-term capital gain rate increases to 20 percent as currently scheduled in 2011, however, the ESPP’s advantage will decline and reverse over time, with the retirement account coming out on top.

For employees whose tax rate is higher now, a contribution to a traditional 401(k) or deductible IRA will result in a higher ATFV than will a contribution to a Roth. (A higher tax rate now often occurs during an employee’s peak compensation years, because taxable income in retirement becomes relatively lower.)

How does the traditional 401(k) retirement account compare in this scenario to buying stock at a 15 percent discount through an ESPP? Assuming that the individual long-term capital gain rate will increase to 20 percent, the ESPP generally has a higher ATFV for only a few years, and the traditional 401(k) has a higher ATFV beyond that point — around the time the capital gain rate increases. To summarize, if an employee expects to have a lower tax rate on ordinary income in retirement than now, CPAs should recommend he or she first put spare cash in a 401(k) with no employer match, before holding stock bought at a 15 percent discount through an ESPP.

What if employees expect to have a higher income in retirement and thus a higher tax rate, as can happen when they have just begun their career or temporarily work part time? In that case, the ATFV of an employee’s contribution to a Roth account will be higher than to a traditional 401(k). Assuming that the individual long-term capital gain rate will increase to 20 percent, the comparison between a Roth retirement account and buying stock at a 15 percent discount through an ESPP. A CPA should advise the individual to first use spare cash to contribute to a Roth retirement account if the stock will be held for a very long time, or to buy stock at a discount through an ESPP if the holding period will not be so long. To summarize, if an individual’s tax rate on ordinary income is expected to be higher in retirement years than it is currently, the individual should maximize both the allowable contributions to the Roth retirement accounts and investment through the ESPP before contributing to a traditional 401(k) with no employer match.

Picking Up the Money

With risks properly considered, employees who have an ESPP available to them can be better equipped by your advice to take advantage of their corporation’s plan. Whether they incorporate an ESPP into their long-range savings strategy or supplement their short-term earnings by quickly selling shares purchased through the ESPP, they’ll appreciate your guidance in how to approach that money on the table and pick it up.

Timothy A. Farmer,CPA, Ph.D., and Gregory G. Geisler,CPA, Ph.D., are associate professors of accounting, University of Missouri–St. Louis. They are contributing writers of the Journal of Accountancy. Their views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.