ESPP Disqualifying Disposition: Designing the Ideal Equity Plan

ESPP Disqualifying Disposition: Designing the Ideal Equity Plan

June 19, 2023

ESPP Disqualifying Disposition: Designing the Ideal Equity Plan

Recent research from the National Association of Stock Plan Professionals reveals a startling statistic: Over 40% of employees who participate in Employee Stock Purchase Plans (ESPPs) opt for what's called a 'Disqualifying Disposition,' selling their shares immediately or before meeting the required holding periods. If you're like most people, you might think this strategy goes against conventional financial wisdom.

In reality, understanding the intricacies of ESPP disqualifying dispositions could be a game-changer for startup founders and company owners. Far from being a financial faux pas, a disqualifying disposition can sometimes be a strategic move, offering benefits that might align closely with your company's goals and employee incentives. So, grab your notepad and keep reading to discover why this often misunderstood aspect of employee equity could be an essential tool in your compensation strategy.

What is an ESPP?

An Employee Stock Purchase Plan (ESPP) is a company-run program that allows employees to purchase company shares at a discounted rate. The main aim of an ESPP is to incentivize employees to contribute to the company’s success. Employees can contribute to the ESPP through payroll deductions, which are then used to purchase company shares, usually at a discounted price.

Qualified vs. Non-Qualified ESPP

The legal framework that governs your ESPP is pivotal. Qualified plans are designed to conform to Section 423 of the Internal Revenue Code, offering specific tax advantages that come with compliance with IRS guidelines. Non-qualified plans, on the other hand, aren't bound by Section 423, giving you greater flexibility in designing the plan but without the added layer of tax benefits.

To better understand their distinction, here’s where else they differ:

1. Decision-Making Authority

In a qualified plan, the decision-making power often rests with the shareholders. Any significant changes to the plan, such as altering the discount rate or the offering period, must generally receive shareholder approval. This can make it more cumbersome to adapt the plan to changing business conditions. Non-qualified plans often give the company's board or designated committee greater latitude to make adjustments without shareholder intervention.

2. Eligibility Criteria

Qualified ESPPs have stringent eligibility criteria and cannot discriminate in favor of highly compensated employees or officers. This ensures a level playing field but may prevent you from using the ESPP as a targeted incentive for key talent. Non-qualified plans can be more selective, allowing you to tailor eligibility to suit your company's specific compensation strategies.

3. Employee Participation Limits

For qualified plans, the IRS imposes a $25,000 annual limit on the market value of stock that any employee can purchase. This restriction might be a limiting factor if you want to offer a more generous equity incentive to high-performing employees. Non-qualified plans have no such annual limit, offering greater scope for motivating your top talent through substantial equity ownership.

4. Length of Offering Periods

Qualified ESPPs often have offering periods that range from 3 to 27 months. Within these offering periods, purchase periods are defined, and they can be as short as one day or extend to the entire length of the offering period. Non-qualified plans have the freedom to set offering and purchase periods that better align with the company's financial calendar or strategic goals.

5. The Fine Print on Loans

Some non-qualified plans allow employees to purchase shares through company-facilitated loans. This is not an option in qualified ESPPs. Providing a loan feature could enhance participation rates among employees who might not have immediate access to sufficient cash to invest in the plan.

Indeed, the choice between qualified and non-qualified ESPPs hinges on a multitude of factors such as tax implications, decision-making authority, eligibility criteria, and flexibility in plan design. Make sure you thoroughly assess the needs of both your company and your employees before taking the plunge.

What Does Disqualifying Disposition Mean?

Disqualifying disposition is a sale or transfer of stock that does not meet the specific holding period requirements. In a qualified ESPP, you need to hold the stock for at least two years from the offering date and one year from the purchase date. If you sell or transfer the stock before meeting these holding periods, it's termed a disqualifying disposition. In this case, the tax benefits are forfeited.

Two Types of ESPP Disqualifying Dispositions

Understanding disqualifying dispositions is crucial for strategic decision-making around ESPPs. Not all disqualifying dispositions are the same. The timing and circumstances under which your employee sells or transfers their shares determine the financial and tax consequences. Essentially, there are two types of ESPP disqualifying dispositions, and each comes with its own set of benefits and drawbacks.

1. Immediate Sale

One of the primary reasons you might opt for an immediate sale is the need for immediate liquidity. This approach allows you to convert your shares into cash as soon as they are purchased, fulfilling any urgent financial needs. In an unstable market, selling immediately might save you from the risk of your shares losing value.

Moreover, this strategy is straightforward and easy to understand, making it less prone to errors or misunderstandings. However, be wary of the tax implications. The gains will generally be taxed as ordinary income, not as capital gains, which usually means a higher tax rate.

2. Sale Before Meeting the Holding Periods

You may find that your company’s stock has appreciated significantly in a short time. Selling before the holding period expires but not immediately after the purchase might allow you to maximize your gains.

If you find that your investment portfolio is heavily tilted toward your company's stock, selling some shares before the holding period expires offers an opportunity to rebalance.

Similarly, you may be planning a significant financial move like buying a house, and you need more than just immediate liquidity. Selling before the holding period can provide the funds you need without waiting too long. While you do lose the special tax treatment, you might still benefit from a lower tax rate on any appreciation if you’ve held the stock for over a year.

Understanding these two types of ESPP disqualifying dispositions gives you the flexibility to adapt your equity compensation strategy to a variety of situations. Whether it’s maximizing liquidity, taking advantage of market conditions, or aligning your ESPP with broader financial goals, knowing when and how to employ each type can be invaluable.

Situational Examples Illustrating Disqualifying Disposition in ESPP

Unpacking the theory behind disqualifying dispositions is one thing, but real-world applications bring the concept to life. Here are five common scenarios where you or your employees might consider a disqualifying disposition. Each situation offers valuable insights into the strategic use of this approach within your equity compensation plans.

Situation 1: Urgent Financial Needs

Imagine an employee named Sarah, who unexpectedly faces a hefty medical bill. She decided to make an immediate sale of her ESPP shares to cover the costs. While she misses out on the tax benefits of a qualified disposition, she gains immediate liquidity and successfully navigates her financial crisis.

Situation 2: Market Uncertainty

Tim is an employee in a tech startup, and news breaks that a key competitor is about to release a groundbreaking product. Anticipating a potential drop in his company's stock value, Tim opts for a disqualifying disposition to minimize loss. While he sacrifices tax advantages, he protects his investment from significant devaluation.

Situation 3: Financial Portfolio Rebalancing

Emily, a senior developer at a well-established software company, realizes that over 50% of her investment portfolio is comprised of her company's stock. Concerned about the lack of diversification, she decided to sell some ESPP shares before the holding period expired. While this is a disqualifying disposition, it enables her to rebalance her portfolio, thereby reducing risk.

Situation 4: Upcoming Large Expenses

Daniel is planning to buy a house in the next six months. He chooses to sell his ESPP shares before the qualifying holding period to secure a down payment. While he may pay more in taxes for his gains, the disqualifying disposition enables him to reach his financial milestone without delay.

Situation 5: Retirement Planning

Karen, who is close to retirement, wants to convert her ESPP shares into less volatile assets like bonds. Despite the tax penalties, she opts for a disqualifying disposition to shift her investment strategy in line with her reduced risk tolerance as she nears retirement.

How RSUs Differ From ESPP Disqualifying Disposition

Restricted Stock Units (RSUs) are another form of equity compensation. Unlike ESPPs, RSUs are awarded, not purchased. Here's why some consider RSUs to be more advantageous:

✔ Taxation: RSUs are generally simpler to handle come tax time, without the complex scenarios tied to qualified or disqualifying dispositions.

✔ Less Risk: Since you're not purchasing RSUs, there's no financial risk if the company stock declines.

✔ No Cash Outflow: You don’t need to spend any money to acquire RSUs, making them more accessible for everyone in the company, including those who might not have extra cash to participate in an ESPP.

✔ Guaranteed Equity: With RSUs, you have a guaranteed amount of equity that will vest over time, offering a more predictable form of compensation.

ESPPs are a valuable tool for employee compensation, but they come with their set of complexities like disqualifying dispositions. As you design your company's equity plan, weigh the pros and cons of ESPPs against other forms like RSUs to choose what best aligns with your company's and employees' goals.

For more tailored info about RSUs and how they can help in company-worker alignment, book a demo with Upstock today.

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