What is an employee stock purchase plan (ESPP) & how it works?

When it comes to attracting and retaining top talent, competitive compensation is just the start. Today’s employees want to feel invested in their company’s growth—literally. 

An employee stock purchase plan (ESPP) offers just that. ESPPs allow employees to buy company stock at a discount, giving them a direct investment in the business. For employers, stock purchase plans are a simple way to offer staff a meaningful stake in the company. For employees, they're an opportunity to build wealth while supporting the business they help shape. 

In this guide, we’ll explain what ESPPs are, how they work, the benefits for employees and employers, and how they affect tax reporting.

What is an ESPP?

An ESPP allows employees to buy company stock at a discounted price—up to 15% off the market price, the maximum allowed under IRS Code Section 423. It’s one of several tools in the equity compensation playbook, alongside virtual stock options, restricted stock units (RSUs), and stock grants—all designed to align company success with employees’ long-term financial goals. 

When employees enroll in the program, they select a contribution amount through payroll deductions from each paycheck. Payroll sets aside payments over a defined offering period—typically three to six months—and uses the accumulated funds to periodically purchase company stock on the employee’s behalf at the eligible discounted stock price. Once employees receive their ESPP shares, they can hold, sell, or manage them as they see fit. 

How do employee stock purchase plans work?

Before jumping into the mechanics, let’s define the two ESPP types employers can offer under IRS Section 423: qualified and nonqualified plans. 

• Qualified ESPPs: These stock purchase plans meet specific IRS requirements under Section 423 of the tax code. Employees can purchase company stock at a discount—up to 15%—without owing taxes at the time of purchase. Many programs include a minimum holding period to help purchasers qualify for favorable capital gains tax treatment when they sell the stock.
• Nonqualified ESPPs: These plans are more flexible and allow employers to design stock purchase programs without the same IRS restrictions, but they typically don’t offer the same tax advantages.

Whether the ESPP is qualified or nonqualified, the structure and purchasing process generally follow the same steps:

1. Enroll in the plan: Employees opt in during a designated enrollment period and select a contribution rate between 1% and 15% of their paycheck. For qualified ESPPs, the IRS limits purchases to $25,000 worth of stock per calendar year (based on the stock’s value when the company grants the option). IRS rules also prohibit participation by employees who own 5% or more of the company’s stock.
2. Make payroll deductions: Payroll withholds the selected amount from each paycheck during a set offering period. These payroll deductions accumulate over time and go toward periodic or one-time stock purchases. 
3. Buy company stock: At the end of the offering period, the company uses the employee’s total contributions to purchase shares. Employers may offer a lookback provision, which applies the discount to the stock’s price at the beginning or end of the offering period, whichever is lower. This gives employees the advantage of both a discount and the lowest stock price available during that window. 
4. Manage ESPP shares: Once the company purchases the stock, employees can choose to hold or sell it. Qualified plans may require a minimum holding period—typically one year after purchase and two years after the grant date—to preserve favorable tax treatment.

How does the IRS tax ESPPs?

The tax implications of an ESPP depend on whether the company plan is qualified under Section 423 of the IRS tax code or nonqualified. This classification determines when employees pay taxes, how much they pay, and whether those taxes fall under ordinary income or capital gains. 

Here’s how the two types of ESPPs compare:

Qualified ESPPs

Qualified plans offer the most favorable tax treatment but only if employees meet certain IRS conditions, including the required holding period. If employees meet those conditions, here’s how the IRS treats the purchase and sale of ESPP shares:

• No taxes at purchase: Employees don’t owe taxes on ESPP shares until they sell them. 
• Taxes owed at sale: If employees meet the holding period requirement, the IRS taxes the discount as ordinary income, and any additional gain qualifies for capital gains treatment, which is usually at a lower income tax rate.
• Disqualifying disposition: If employees sell before meeting the holding period requirement, the IRS taxes the entire gain as ordinary income. 

Nonqualified ESPPs

Nonqualified plans don’t meet Section 423 requirements, so they don’t receive the same tax advantages. The IRS treats them more like a bonus or regular income. As a result, the tax treatment works differently at each stage:

• Taxable at purchase: The IRS taxes the difference between the purchase price and the stock’s fair market value as ordinary income. 
• Taxes owed at sale: Employees pay capital gains tax on any change in value after purchase, since the IRS already taxed the discount portion as ordinary income.

Benefits of employee stock purchase plans

An ESPP strengthens the connection between compensation and company performance. When thoughtfully designed, ESPPs benefit both sides of the paycheck: Employees work toward long-term financial goals, and employers build a more invested, loyal team. 

Here’s a closer look at how ESPPs support both employees and employers: 

For employees

ESPPs are more than an attractive job perk. They create a structured path for employees to save, invest, and participate in the company’s success. 

• Built-in savings habit: Because contributions come directly from payroll deductions, employees steadily invest in their personal financial goals without extra effort. It’s an easy way to grow passive income while building financial discipline. 
• A stake in success: ESPPs give employees skin in the game. With each share, they’re not just earning a salary — they’re contributing to something they partially own. That alignment can bring greater meaning to daily work.
• Discounted stock purchase: Buying shares at a discounted purchase price offers an instant financial win. It’s a rare opportunity to build long-term equity at below-market rates, adding value from the first payroll deduction. 
• Flexibility and control: Once employees receive ESPP stock, they can decide how to exercise stock options—hold, sell, or integrate them into a broader investment strategy. Many companies pair ESPPs with financial wellness benefits, like access to a financial advisor, to help employees make informed choices that align with long-term financial goals. 

For employers

A well-structured ESPP is a big boost to a company’s compensation strategy, helping attract competitive global talent and retain them through long-term, equity-based incentives. 

• Retention with real value: When employees hold a tangible stake in the business, they’re more likely to take a future-focused view, both of their careers and their investments. ESPPs help foster that kind of commitment.
• Increased engagement: Ownership can drive motivation. Employees who participate in ESPPs often view their performance, the company’s success, and their personal financial growth as closely connected. 
• Potential tax advantages: Depending on the ESPP’s structure and local tax regulations, companies may qualify for corporate tax deductions. For global organizations, Oyster helps companies design ESPP programs that deliver lasting value for both employees and employers.

Empower your team with Oyster

An ESPP gives employees a real piece of the pie when it comes to company growth. It’s a powerful way to foster a positive workplace culture and support your team’s long-term financial well-being. 

With Oyster, you can offer competitive, stock-based benefits across borders with ease. Our Total Rewards platform helps you create and manage equity programs that attract top talent, build loyalty, and scale your business. 

Book a demo to learn more.

FAQs

Who’s eligible for ESPPs?

Companies can define their own eligibility requirements, but most ESPPs are available to full-time employees after a set waiting period. For qualified Section 423 plans, the IRS requires companies to offer the plan to all eligible employees on equal terms.

Can employees sell their ESPP shares immediately after purchase?

In many cases, yes, but it depends on the plan. Some ESPPs allow employees to sell shares immediately after purchase, giving employees quick access to cash. Others include a holding period clause. Selling too soon may trigger a disqualifying disposition, causing employees to miss out on long-term gains and certain tax advantages. 

What are the risks of participating in an ESPP?

Like any investment, ESPP stock carries market risk. Stock prices fluctuate, and there’s no guaranteed return, even with a discounted price. Employees should consider how ESPPs fit into their broader financial goals and consult a financial advisor to build a diversified investment portfolio.