A Perk for the Rank and File, Too

Stock options aren't the only misunderstood and underutilized employee benefit. Equally underappreciated are employee stock purchase plans (ESPPs), which are available at more than 4,000 companies, including Cisco Systems (CSCO ), Southwest Airlines (LUV ), and Starbucks (SBUX ). These plans allow employees to buy shares of their company stock usually at a discount of 10% to 15%. Used correctly, they can be the closest thing on Wall Street to a sure thing.

Why is that? Because in most ESPPs, the discounted price you pay for the stock is based on the low point of two prices over a specific time period. So, say you are in an ESPP for the hypothetical XYZ company. XYZ designs the plan so participants purchase shares at regular intervals, commonly six months. If at the start of a six-month period, XYZ was $10 a share, and by the end it was $12, the plan will allow you to buy at a 15% discount to the lower price, in this case $10. So at the end of the period you would get the shares for $8.50, and if you sell them for $12 then, you are ensured a 41.2% return. Since you always get the low price, you would still make money even if XYZ fell from $12 to $10, but here you would buy at $8.50 and sell at $10--a 17.7% gain.

Given how lucrative ESPPs can be, it's amazing more people don't take advantage of them. According to a survey of 80 companies by the National Center for Employee Ownership (NCEO), only 55% of companies' employees participate in their plans. "Often, employers don't give them enough information and education to understand their plans," says Jarrett Lilien, chief brokerage officer of E*Trade Group, which administers ESPPs.

Not all ESPPs are created equal. According to the NCEO, 11% of companies do not let employees sell the shares immediately, having "blackout periods" during which they must hold the stock before they can sell. For senior executives, the blackout period may be longer.

Just as with option plans, the tax treatment depends on whether you have a qualified or nonqualified ESPP. Nonqualified plans, which account for about 25% of all plans, are taxed like nonqualified stock options. You pay ordinary income taxes on the entire gain you have on the date you receive the stock--not just the taxes on the gain from buying at a discount--and if you hold the stock for a year after that, you pay long-term capital-gains taxes on any additional gains.

With qualified plans, if you sell immediately, any gain you have is taxed as ordinary income. But if you hold for two years after your "grant date"--the beginning of that six-month buying period in the XYZ case--and one year after you actually buy the stock, different rules come into play. Part of your gain--that which came from the discount--will be taxed as income. The rest is taxed at the long-term capital-gains rate, which peaks at 20%.

As with options, the risk you face of losing money from holding the stock usually outweighs the beneficial tax treatment. So unless you're facing a blackout period, you should sell your shares the moment you receive them.

By Lewis Braham

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