 Hello, and welcome to the session in which we will discuss employee stock purchase plans or known as ESPP. What is ESPP? That's the first thing we need to know. Basically, it's when the company grant you the right as an employee to buy the shares of stocks. Is that really right? Because you can buy any shares of stocks at any time you would like to, whether you are an employee or not. Well, guess what? They will give you a discount, so they will sell it to you lower than the ongoing price. Now, one Christmas, literally, I work at Walmart, third shift, and every time you will go to the restroom, there was a sign and they all have the stock price of Walmart, wherever that stock price happens to be that day, and they will say, next depends on you, to remind their employees that they own shares in the company, and because they own the shares, if they work harder, the stock price would go higher and they are better off. So a company like Walmart offers their employee this employee stock purchase plan, and I told you that I work at Merrill Lynch at some point and I used to handle employee stock options and I also we had employee stock purchase plan. So how does it work? Let's dive into it. Let's assume you work for Walmart and Walmart will tell you if you would like to enroll, once you qualify to enroll, there's a period where you can enroll called the offering period or think of the offering period as the grand day. There's an offering period and if you enroll during the offering period, at some point, it's usually the end of the quarter. Usually it's the end of the quarter. You can exercise to buy the shares at a certain price, to buy the shares. So what you do, let's assume for the sake of simplicity, you are making a $2,000 a week and you will tell them I would like to deduct, let's say, $20, well, $200, 10% of my paycheck to buy those stocks. So what happened is this, every week you work for Walmart, Walmart will put away from your paycheck, $200. Then here comes the exercise date. Now on the exercise date, they will buy the shares of Walmart. They will buy, let's assume you end up with having, let's assume you enrolled for five weeks, you had $1,000 in total in your escrow account, which is an account that's yours, but Walmart is holding it. Now on this date, they will have, they would say, for example, they will have the policy. The policy is basically usually it's 10% or 15%. I don't remember Walmart. So whatever the ongoing price is, they will buy the stock at 15% of the market price. Either they would use the fair market value of that date, they could use the fair market value of the offering price. Simply put, they would allow you to buy the shares at a discount. That's basically what it is. So as an employee, you can buy the shares at a discount. Well, someone else, so let's assume the stock price is $64.15. Let's assume someone else wants to buy the stock, they will pay $64.15, if it's $64.25. If you want to buy it, you'll pay 85%, you'll pay $54.63. So you'll buy the stock at a discount. That's basically what it is, and that money is deducted from your payroll. In a nutshell, that's what employee stock purchase plan is. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Now, it's listed under stock options, and the reason is because it works from a tax perspective. It works like an incentive, it's a qualified stock option plan. Specifically, it worked like the incentive stock options that we talked about in the prior session. So we did cover the non-qualified stock options, we did cover the incentive stock options. In this session, we will focus on the taxation of this ESPP. So the first thing is ESPP has to be qualified to be considered an ESPP to qualify. Well, what are the qualifications? Just like an incentive stock option plan, you have to have certain criteria to be considered an incentive stock option plan, to be considered the qualified stock options. Well, the qualification is the employee must be in writing and approved by the shareholders. So the shareholders say, yes, we want to grant, we want to have this plan for our employees. The employee are required to exercise their option within a period of 27 months from the date on which the options were granted or offered. So after that grant, you have 27 months to exercise, usually it's within 3 to 6 months. All full-time employees can participate except highly compensated employees and those with less than 2 years of employment should be included in the plan. So when I worked at Christmas at Walmart, I could not participate because you have to be there for 2 years. And if you are highly compensated, one of those top individuals at Walmart, also you cannot participate because this is for kind of for lower level management. Each employee receiving stock should not own more than 5% of the company voting power, including its corporation, parent and subsidiary. Simply put, you cannot own more than 5%. Forget about Walmart. You know, it's very hard to own 5% of Walmart, even for large, huge investment banks. But the point is, you cannot be, you cannot own 5%. You cannot be a large, in quote, a large shareholder. Also, the exercise should be at least equal to 85% of the fair market value of the company at the grand date or at the exercise date, whichever is lesser. So simply put, they'll give you the discount and discount is basically the maximum discount is 15%. It could be 10, it could be 5. Sometimes they don't give you any discount. Okay, you just, you can buy it, you know, you basically will deduct money from your paycheck and you'll buy the company stocks. If you want to do that, if you want to do that, that's fine. There's no really any incentive, but you're hoping that the stock price will go up and each employee is allowed to acquire the maximum of 25,000 per year. Now you can buy more stocks, but it cannot be considered as an ESPP, employee stock purchase plan. Also similar to incentive stock option, once the stock is exercised, it must be held by the employee for at least one year after the exercise date and two years from the grand date or two years from the offering date, just like the ISO, the employee stock option plan. We have an offering date or a grand date. So let's assume the offering date is September 1st, 20x2. Now let's assume the exercise is was September 1st, 20x3. So you exercise it a year later. Now you bought it and you held the stock until 9, 1, 20x4. So you held it one year from the exercise date. Okay, now you can sell it here. Now it's considered capital gain and you have to hold it two years from the grand date or the offering date. That's what we're saying exactly like incentive stock options. Also the employee should remain employee for the corporation from the grand date up until three months before the exercise date and this period is extended and if the option was granted due to a permanent and total disability. Now what are the taxation of ESPP? So what are the tax consequences? Now remember, here all what you're doing is you're buying stocks. Similar to the incentive stock option, it's not granted as compensation. You are taking your own money from your salary and asking the company to use it to buy stocks. Therefore the employees are not taxed when the option is granted of course or the option when exercised. When there's tax consequences, when you actually sell, as a result of the option lapse and exercise, the employee are not allowed to recognize any loss because they did not recognize any income to be taxed in the first place. So it's not taxable, it's not deductible. If the exercise price is less than the stock fair value on the grand date, the employee recognize an ordinary income when the price is sold. So if you bought it less than the fair market value of the exercise price is less, usually it is that portion is ordinary income. The difference between the exercise price and the fair market value of the stock when sold or the difference between the exercise price and the fair value of the stock when granted depending on which date we are looking at. Now the remaining is classified capital gain and we'll work an example, don't worry about this. So simply put the discounted part, the discounted part, the amount that's below the fair value because you bought it below the fair value, that's considered ordinary income. Basically they gave you a discount. Now if you made any profit after you bought the stock, you have the basis, any profit above the fair value it's treated as capital gain. So the remaining is capital gain. Now what are the tax consequences for the employer for the company? There's no tax consequences. Why not? Because all what the company is doing is issuing stocks. You're not going to get a deduction for that. Simply put they're issuing stocks to their employees. The employee said we're going to invest in the company, take part of our salary and buy the stock. The best way to illustrate this is to look at an example. March 15, John received an employee stock purchase plan as follows. So we have an ESPP in effect, the number of shares to be purchased 200, they can buy it at 90 dollars. The fair market value of the stock at the option is at the option grand date is 100. Simply put they're giving them a 10% discount. On April 3rd, year two when John, when the fair market value was 120, John exercised the option. They bought the option and they waited until May 10th, year three and that's when they sold it. They did really good. I mean this John did really good. Simply put they end up, all in all they buy something for 90 and they sold it for 180. That's what they did because that's what the exercise price. Should John report any income on the grand date? The grand date is when they told you you can buy the stock for 90 dollars. The answer is no, there's nothing. You don't recognize any income, nothing happened. All what they're saying is you can buy the stock for 90 dollars if you're interested, sign up for the plan and by the end of the quarter whatever money we deduct from your paycheck will buy the stock. There's no tax consequences. Determine the adjusted basis of the stock held by John on April 3rd. So April 3rd, when the fair market value of the stock is 120, well guess what? You bought them, you paid 90 dollars. Actually John paid 90 dollars. They have money deducted from their paycheck and they bought the stock at 90 dollars. So they have $18,000 deducted from their paycheck and that's their basis. That's exactly their basis. What is the amount and type of income that John would report when they sold the stock? Now when they sold the stock they have 200 shares. They sold it at 180. This was the proceeds. Now as of May 10th, John already met the requirement for the holding period. So this is a nice. So therefore he should recognize a gain of 18,000. How did we get to that? Well the proceeds are 36,000. The basis are 18,000. But now what we have to do, we have a gain of 18,000. How is that gain is treated? Remember the amount that's below the exercise price. Remember we bought it for 90. On the grand date it was 100. So there's a $10 discount. We bought it at $10 discount times 200 shares. Of this amount, 2,000 it's going to be considered ordinary income. And what's not ordinary income, it's going to be considered capital gain. And this is what John likes. Like likes the capital gain. But that $2,000 because of that $10 discount will be treated as ordinary income. What is the employer's tax consequences? In other words, do they have any deduction? If so, how much? And the answer is no. ESPP are not provided as a compensation. And as a result, the employer don't receive any tax deduction. All what happened is you took your money, which you earned, you went back and you told the company, I want to buy the stock. Well, in this situation, the company sold you the stock at a 10%, not technically 10%, but a $10 discount. I'm not sure if that's considered 10% or not at a $10 discount. Let me just put the $10 discount. Okay. Yes, exactly. If you take 100 times 10%, that's $10. They gave it to you at a $10 discount. That's all what happened. What should you do now? Go to Farhat Lectures and look at additional resources to help you understand whether you are an accounting student, CPA candidate or an enrolled agent. Good luck, study hard, invest in your accounting career. It's worth it and stay safe.