Employee stock purchase plans

http://www.thefreelibrary.com/Employee+stock+purchase+plans.-a0118956252

INTRODUCTION


There has been great interest recently in the use of
stock-based
compensation in American companies. Although there is an older
literature on employee stock ownership plans (ESOPs) and an emerging one
on stock options (see Murphy (1999) for a recent review), very little
research has been done on employee stock purchase plans (ESPPs). An ESPP See Employee Stock Purchase Plan.  is a
tax-subsidized saving vehicle that allows a worker to use after-tax
income to purchase company stock, often at a discount. For employees in
most plans, the primary tax advantage comes from the fact that if the
shares are held long enough, the discount on the stock gets taxed as
capital gains rather than as ordinary income. Because many of the tax
advantages are contingent upon Adj. 1. contingent upon -
determined by conditions or circumstances that follow; "arms sales
contingent on the approval of congress"
contingent on, dependant on,
dependant upon, dependent on, dependent upon, depending on, contingent  the
plan being offered broadly within a
firm, ESPPs potentially represent a much broader vehicle for company
stock ownership than stock option plans typically targeted to top
executives and key employees. Indeed, the National Center for Employee
Ownership (NCEO NCEO National Center for Employee Ownership
NCEO
National Center on Educational Outcomes , 2001a) estimates that
over 15 million American workers
are eligible for ESPPs.

We make three contributions in this paper. First, we describe the
institutional features and parameters associated with ESPP plan design)
Second, we describe the corporate and personal income tax treatment of
ESPPs, and analyze the circumstances CIRCUMSTANCES, evidence. The particulars which
accompany a fact.
     2. The facts proved are either possible or
impossible, ordinary and probable, or extraordinary and improbable,
recent or ancient; they may have happened near us, or afar off; they are
public or  under which employers and employees
will jointly prefer compensation through an ESPP relative to cash from a
purely tax perspective. Finally, we examine empirically patterns of ESPP
participation and contributions using administrative data from 1997-2001
for a large health
services health
services Managed care The benefits covered under a health
contract  company.


There are two principal findings. First, compensation through a
tax-qualified ESPP, the dominant type offered, appears to be less
advantageous from a pure tax perspective than through a non-qualified
ESPP or cash, unless corporate tax rates are substantially below the top
statutory rate and there is substantial share price appreciation. Given
that tax-qualified ESPPs are the dominant type of plan, this suggests
that non-tax considerations play a significant role in the decision to
provide these plans. Second, for most plans, ESPP participation is
essentially a risk-free way to increase gross compensation for the
employee, yet participation is only about 40 percent at the company we
analyze. This suggests that a substantial fraction of employees are
either liquidity constrained con·strain  
tr.v.
con·strained, con·strain·ing, con·strains
1.
To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at
force.

2. , do not fully understand these plans,
or
face non-trivial transactions costs.


This paper is organized as follows. The first section lays out
the
basic institutional features of and facts about ESPPs. The second
section discusses the personal and corporate income tax treatment of
ESPPs, respectively. In the third section we then analyze the joint
impact of personal and corporate taxes on the employer provision of
ESPPs. The fourth section provides an empirical analysis of ESPP
participation and contributions at a single large firm and considers a
number of potential explanations for the substantial non-participation
that is observed. There is a brief conclusion.


ESPPs: FEATURES AND FACTS


An ESPP is an employer-sponsored plan that allows employees to
purchase company stock with after-tax income. In a typical ESPP plan,
employee contributions to the plan are accumulated ac·cu·mu·late  
v.
ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates

v.tr.
To
gather or pile up; amass. See Synonyms at gather.

v.intr.
To
mount up; increase.  by payroll deduction deduction, in logic,
form of inference such that the conclusion must be true if the premises
are true. For example, if we know that all men have two legs and that
John is a man, it is then logical to deduce that John has two legs.  over
a six-month offering period. At the end of the offering period,
contributions are used to purchase shares of the employer's stock
at a 15 percent discount off of the market price of the stock at either
the beginning or the end of the offering period, whichever is lower.


Although this is the description of a "typical" ESPP
plan, there are many ESPP plan design parameters that vary across firms.
For example, although the vast majority of plans accumulate Accumulate

Broker/analyst recommendation
that could mean slightly different things depending on the
broker/analyst. In general, it means to increase the number of shares of
a particular security over the near term, but not to liquidate other
parts of the portfolio to buy a security  employee
contributions smoothly over time through payroll deduction, some plans
allow employees to purchase shares with cash outright. (2) The period
over which this accumulation is done, the offering period, is specified
in the company's plan description. Although almost half of
companies with ESPPs have a biannual bi·an·nu·al  
adj.
1.
Happening twice each year; semiannual.

2. Occurring
every two years; biennial.

---

bi·an
 (six-month) offering period, this
period can be as short a three months or as long as 27 months (the
maximum legal time limit for most plans). (3) In all plans, employees
are permitted to purchase shares at the end of the offering period. In
addition, plans with sufficiently long offering periods may specify
intermediate purchase dates. For example, the offering period may be one
year, composed of two biannual purchase periods. (4)


A key plan parameter (1) Any value passed to a program by the
user or by another program in order to customize the program for a
particular purpose. A parameter may be anything; for example, a file
name, a coordinate, a range of values, a money amount or a code of some
kind.  is the purchase price of the company stock.
Although some plans use the fair market value on the purchase date as
the purchase price, over three-quarters have what is known as a
"look-back" feature, in which the purchase price is the
minimum of the fair market value at the beginning and end of the
offering period? In addition, the employer may offer the shares at a
discount legally limited to be no more than 15 percent applied to the
minimum price from the look-back. Naturally, a plan with a discount and
a look-back feature can result In a significant gain at sale when stock
prices rise during the offering period. The NCEO (2001b) found that 86
percent of ESPP plans offered employees the full 15 percent legal
maximum discount on the purchase price of the stock, six percent offered
a 10 percent discount, and only eight percent offered no discount. (6)


More complicated ESPPs have a "reset" provision, in which
if the stock price falls by the end of the purchase period, the plan
automatically withdraws the employees' accumulated payroll
deductions for that period, and rolls them into the next offering
period. This ensures the lowest purchase price to the employee. Some
ESPPs also allow employees with accumulated payroll deductions to
individually withdraw those funds before the end of the offering period.
Usually when this occurs, the plan stipulates the employee is no longer
eligible to purchase in that period, and, in some plans, may have to sit
out subsequent offering periods before becoming eligible again. (7)


TAX TREATMENT OF ESPPs


The tax treatment of ESPPs depends on whether the plan is a
qualified or nonqualified
plan Nonqualified plan

A
retirement plan that does not meet the IRS requirements for favorable
tax treatment. . NCEO (2001b) reported that 77 percent of
ESPP plans were qualified. A qualified plan, often referred to as a
"423 plan," must comply with the rules spelled out in Section
423 of the Internal
Revenue Code The Internal Revenue Code
is the body of law that codifies all federal tax laws, including
income, estate, gift, excise, alcohol, tobacco, and employment taxes.
These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq.
 (IRC (Internet Relay Chat)
Computer conferencing on the Internet. There are hundreds of IRC
channels on numerous subjects that are hosted on IRC servers around the
world. After joining a channel, your messages are broadcast to everyone
listening to that channel. ). (8) These rules require that
only the employees of the company, parent company or subsidiaries may
participate in the plan, and the right to buy company stock is
non-transferable. However, employees who own five percent or more of
voting power (for all classes of stock of the company, parent, and
subsidiaries) are not eligible for the plan. At its discretion, the plan
may further legally exclude from participation highly-compensated
employees as defined in IRC Section 414, employees with less than two
years of tenure, and employees who work fewer than twenty hours per week
or five months per year? In practice, however, these exclusions do not
appear frequently. For example, NCEO (2001b) reported that 98 percent of
plans allowed employees with less than two years of service to
participate and 68 percent of plans allowed part-time employees to
participate.


Beyond these allowable limits on participation, all employees
must,
in general, have the same rights and privileges under the plan. Section
423 limits ESPP purchases to $25,000 worth of stock (or less) per
calendar year, although this will bind for only a small fraction of
employees. Plans may limit further the extent of employee participation,
such as the number of shares an employee can purchase or the fraction of
employee compensation that can be allocated to the ESPP plan, as long as
this restriction is applied uniformly across employees. Most plans limit
employee contributions to no more than 10 to 15 percent of compensation,
and 71 percent of plans impose limits on share purchases (NCEO, 2001a).
Non-qualified plans do not have to conform to Verb 1.
conform to - satisfy a condition or restriction; "Does this
paper meet the requirements for the degree?"
fit, meet

coordinate
- be co-ordinated; "These activities coordinate well"
..... Click the link for more information. these
rules and typically
are targeted to a select subset A group of commands or functions that do not
include all the capabilities of the original specification. Software or
hardware components designed for the subset will also work with the
original.  of employees, much like non-qualified
stock options (NQSOs).


Personal Income Tax Treatment


For a qualified plan (QESPP), the extent of the personal
income tax
benefit depends on whether the stock is sold in a qualified disposition.
A qualified disposition is one that satisfies what is known as the 1-2
holding rule: the employee must hold onto the stock for (1) at least one
year after the purchase date and (2) two years after the beginning of
the offering period. If this condition is met, the gain at sale is
decomposed de·com·pose  
v.
de·com·posed, de·com·pos·ing, de·com·pos·es

v.tr.
1.
To separate into components or basic elements.

2.
To cause to rot.

v.intr.
1.  into
two parts: taxable ordinary income and taxable capital
gains. Taxable ordinary income is defined as the lesser of (a) the
spread between the fair market value at the time of sale and the
purchase price and (b) the discount at the beginning of the offering
period. The portion that is taxable as ordinary income is subject to
social security (Federal Insurance Contributions Act (FICA FICA
abbr.
Federal
Insurance Contributions Act

Noun 1. FICA - a
tax on employees and employers that is used to fund the Social Security
system
income tax - a personal tax levied on annual income

)) and
unemployment insurance (Federal Unemployment Tax Act (FUTA FUTA Federal Unemployment Tax Act (US) )) taxation as
well. The taxable capital gain (or loss) is simply that part of the gain
at sale not treated as ordinary income. (10)


Mathematically, we express this as follows. Denote de·note  
tr.v. de·not·ed,
de·not·ing, de·notes
1. To mark; indicate: a frown that denoted increasing impatience.

2.
 the fair market
values of a share of company stock on the first and last days of the
offering period as [P.sub.f] and [P.sub.l], respectively. Let 8 denote
the discount off the fair market value, which is legally constrained to
be 0 [less than or equal to] [delta] [less than or equal to] 0.15. With
a look-back feature, the purchase (exercise) price, [P.sub.e] is


[1] [P.sub.e] = (1 - [delta]) min([P.sub.f], [P.sub.l]).


If the share price falls during the period (and there is no
reset
provision), the participant purchases at the discounted last-day share
price, otherwise the participant does no worse than purchasing at the
discounted first-day share price. Let c be the employee's
contribution rate made out of after-tax income, but expressed as a
fraction of gross earnings y. Then at a purchase price [P.sub.e], the
employee will purchase


[2] N = cy/(1 - [delta]) min([P.sub.f], [P.sub.l])


shares.


If the shares are sold just when the 1-2 rule is met, denoted
as
period q, the disposition amount is [P.sub.q]N. The total gain from sale
is ([P.sub.q] - [P.sub.e])N, which can be decomposed on a per share
basis into two parts:


[3] min([delta][P.sub.f], [P.sub.q] - (1 -
[delta])min([P.sub.f],
[P.sub.l]))


and


[4] [P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]) -
min([delta][P.sub.f], [P.sub.q] - (1 - [delta])min([P.sub.f],
[P.sub.l])).


Equation [3] is the portion of the gain at sale that is taxed
as
ordinary income, which is the lesser of (a) the spread between the fair
market value at the time of sale, [P.sub.q], and the purchase price,
[P.sub.e] = (1 - [delta])min([P.sub.f], [P.sub.l]), and (b) the discount
at the beginning of the offering period, [delta][P.sub.f]. Equation [4]
is the portion of the gain at sale taxed at the long-term capital gains
rate.


Participants in a qualified plan may not meet the holding
requirements in the 1-2 rule, and, therefore, trigger a disqualifying
disposition
disqualifying disposition

The sale,
gift, or exchange of stock acquired through an employee stock purchase
plan within two years of enrollment or one year of the purchase date. A
disqualifying disposition results in ordinary income for tax purposes.
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The spread between the fair market value on the purchase
date and the purchase price, [P.sub.l]-[P.sub.e], is treated as cash
compensation and is taxed in the calendar year in which the disposition
occurs. The difference between the sale price and fair market value at
purchase, [P.sub.s]-[P.sub.l], is taxed (offset) as a capital gain
(loss) at the appropriate capital gains rate depending upon how long the
stock was held. The most common disqualifying disposition is to buy
company stock and sell it immediately after purchase, known as a
"same-day sale."


For dispositions from a non-qualified plan (NQESPP), the
spread
between the fair market value on the purchase date and the purchase
price, [P.sub.l] - [P.sub.e], is treated as cash compensation and is
taxed in the calendar year in which the purchase occurs. (11) The
difference between the sale price and the fair market value at purchase,
[P.sub.s] - [P.sub.l], is taxed (offset) as a capital gain (loss) at the
appropriate capital gains rate depending upon how long the stock was
held.


Corporate Tax Treatment


At the corporate level, there is also asymmetric A difference between two opposing modes. It
typically refers to a speed disparity. For example, in asymmetric
operations, it takes longer to compress and encrypt data than to
decompress and decrypt it. Contrast with symmetric. See asymmetric
compression and public key cryptography.  tax treatment of
QESPPs and NQESPPs. In an NQESPP, the spread between the fair market
value on the purchase date and the purchase price, [P.sub.l] -
[P.sub.e], is treated as cash compensation on which the firm must pay
its statutory portion of the payroll
tax Payroll Tax

Tax an employer
withholds and/or pays on behalf of their employees based on the wage or
salary of the employee. In most countries, including the U.S., both
state and federal authorities collect some form of payroll tax. .
The firm deducts the total
compensation cost (cash plus payroll tax) in the tax year when the
purchase occurred when calculating its corporate income tax. For a
disqualifying disposition in a QESPP, the spread between the fair market
value on the purchase date and the purchase price, [P.sub.] - [P.sub.e],
is treated as cash compensation on which the firm must pay payroll tax.
However, the firm deducts the total compensation cost (cash plus payroll
tax) in the tax year when the disqualifying disposition occurred when
calculating its corporate income tax. For a qualifying disposition in a
QESPP, the firm does not get a corporate tax
deduction Tax deduction

An
expense that a taxpayer is allowed to deduct from taxable income.

---

tax deduction

See deduction. , not even
for the
ordinary income the employee ultimately will claim for the personal
income tax.


An Example


Consider a typical QESPP with a 15 percent discount ([delta] =
0.15),look-back and a six-month offering period. Assume the employee is
paid $42,500 annually and (on an after-tax basis) contributes five
percent of gross pay to purchase stock, or cy = $2,125. Let the share
price be $5 on the first day of the offering period ([P.sub.f] = $5) and
$8 on the last day of the offering period ([P.sub.l] = $8). With the
discount and look-back, the employee gets to purchase at a price,
[P.sub.e], of $4.25 ($5.00 x 0.85). The total number of shares purchased
with the $2,125 contributed is, thus, N = 500.


Assume first that the employee holds the shares 18 months for a
qualified disposition. Let the price at disposition, [P.sub.s], be $15,
which implies a disposition of $7,500. The total gain at sale is
$7,500-$2,125 = $5,375. The discount at the start of offering period was
$0.75 per share ($5.00 x 0.15), or $375 ($0.75 x 500). This is less than
the total gain at sale, so $375 is taxed as ordinary income and is
subject to FICA and FUTA taxes; the remainder, $5,000 ($5,375-$375), is
taxed as a long-term capital gain. Furthermore, because the shares were
held for a qualified disposition, the employer gets no corporate tax
deduction.


Now assume that the shares were disposed of immediately after
purchase in a same-day sale. In this case, the disposition is $4,000 ($8
x 500). The total gain at sale is $4,000-$2,125 = $1,875, all of which
is taxed as ordinary income and is subject to FICA and FUTA taxes.
Because the shares were sold in a disqualifying disposition, the
employer gets a corporate tax deduction for the amount, $1,875, taxed as
ordinary income; the employer's statutory FICA and FUTA taxes on
the $1,875 are deductible That which may be taken away or subtracted.
In taxation, an item that may be subtracted from gross income or
adjusted gross income in determining taxable income (e.g., interest
expenses, charitable contributions, certain taxes).  as well.


TAXES AND THE EMPLOYER PROVISION OF ESPPs


The employer has a choice between offering compensation
through
cash or an ESPP. To determine which form is preferred, we consider the
tax consequences to the employer and employee jointly using the global
contracting approach of Scholes et al. (2002). Under this approach, we
compare the net benefit to the employee from two forms of compensation
that have the same present value after-tax cost to the employer. If one
form is tax-preferred by the employee, it will be jointly tax-preferred.
Because a QESPP in which all dispositions are disqualifying dis·qual·i·fy  
tr.v.
dis·qual·i·fied, dis·qual·i·fy·ing, dis·qual·i·fies
1.

a. To render unqualified or unfit.

b. To
declare unqualified or ineligible.

2.  and an
NQESPP are treated effectively the same from the corporate and personal
tax perspectives, a useful point of departure is to compare cash to
NQESPP compensation. Later we consider the tradeoff between an NQESPP
and QESPP explicitly.


Cash vs. NQESPP Compensation


Without
loss of generality Without loss of
generality (abbreviated to WLOG or WOLOG and less
commonly stated as without any loss of generality) is a
frequently used expression in mathematics. , we begin by assuming
that the employer
wants to pay the employee an additional amount of compensation above and
beyond current gross earnings y. (12) Second, we note that once the
employee purchases shares through an NQESPP, there is no preferential pref·er·en·tial  
adj.
1.
Of, relating to, or giving advantage or preference: preferential treatment.

2.  personal
capital gains treatment relative to a private purchase by the
employee outside of an NQESPP using after-tax cash compensation, and
there are no corporate tax implications upon sale. Therefore, the
decision to offer an NQESPP hinges Hinges may refer to:

• Plural form
  of hinge, a mechanical device that connects two solid objects, allowing a
  rotation between them.


• Hinges, a commune of the Pas-de-Calais département,
  in northern France

 solely on the amount and tax
treatment of compensation provided to the employee at the time of
purchase, and how it is jointly valued relative to cash. (13)


Specifically, the additional compensation m to the employee
who
contributes cy to the ESPP is the difference between the fair market
value and the exercise price at the time of purchase, [P.sub.l] -
[P.sub.e], multiplied by the number of shares purchased, which by [1]
and [2] is


[5] m = [[P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l])
-1]cy.


Let [[tau].sub.cg] be the marginal
tax rate Marginal Tax Rate

The
amount of tax paid on an additional dollar of income. As income rises,
so does the tax rate.

Notes:
Many believe this discourages
business investment because you are taking away the incentive to work
harder.  on long-term capital
gains, [[tau].sub.O] be the marginal tax rate on ordinary income,
[[tau].sub.P] be the marginal payroll tax rate, and [[tau].sub.C] the
corporate tax rate. In an NQESPP, m is treated as cash compensation on
which the firm must pay its statutory portion of the payroll tax, which
is deductible, so that the total net compensation cost to the firm on
the last day of the offering period is (1 - [[tau].sub.C])(1 +
[[tau].sub.P])m. In present value, this is equal to (1 -
[[tau].sub.C])(1 + [[tau].sub.P])m[[1 + (1 -
[[tau].sub.C])[r.sub.C]].sup.-(l-f)] on the first day of the offering
period, where [[tau].sub.C] is the corporate gross rate of return. On a
present value after-tax basis, the employer is indifferent INDIFFERENT. To have no bias nor partiality. 7
Conn. 229. A juror, an arbitrator, and a witness, ought to be
indifferent, and when they are not so, they may be challenged. See 9
Conn. 42.  to paying m
through an NQESPP on the last day and m' in cash compensation on
the first day of the offering period, where m' = m[[1 + (1 -
[[tau].sub.C])[r.sub.C]].sup.-(l-f)], which would cost the firm (1 -
[[tau].sub.C])(1 + [[tau].sub.P])m[[1 + (1 -
[[tau].sub.C])[r.sub.C]].sup.-(l-f)] as well.


After payroll and ordinary income taxes, the employee values
m' in cash on the first day of the offering period as (1 -
[[tau].sub.P] - [[tau].sub.O])m', but values m in deferred
compensation on the last day of the offering period as (1 -
[[tau].sub.P] - [[tau].sub.O])m[[1 + [rho]].sup.-(l-f), where p is the
employee's discount rate. Technically, this discount rate is the
sum of the pure rate of time preference from period f to l and the
opportunity cost to the employee of foregoing the use of the
contribution cy during the offering period. As long as this discount
rate exceeds the net corporate rate of return, [rho] > (1 -
[[tau].sub.C])[r.sub.C], the employee will prefer the compensation paid
in cash.


NQESPP vs. QESPP


Recall that the employer does not get a corporate tax
deduction for
compensation of m paid through a qualifying disposition in a QESPP, but
is able to deduct de·duct  
v. de·duct·ed,
de·duct·ing, de·ducts

v.tr.
1.
To take away (a quantity) from another; subtract.

2.
To derive by deduction; deduce.

v.intr.  m
at purchase in a NQESPP. This means that the
employer is indifferent between paying compensation of m through a QESPP
to m/[(1 + [[tau].sub.P])(1 - [[tau].sub.C])] through an NQESPR For
compensation of m in a QESPP, if the shares are sold just when the 1-2
rule is met, then from [2]-[4] the present after-tax value to the
employee at q is


[6] [min([delta][P.sub.f], [P.sub.q] - (1 -
[delta])min([P.sub.f],
[P.sub.l]))/(1 - [delta])min([P.sub.f], [P.sub.l])](1 - [[tau].sub.O] -
[[tau].sub.P]) +[[P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]) -
min([delta][P.sub.f], [P.sub.q] - (1 -
[delta])min([P.sub.f][P.sub.l]))/(1 - [delta])min([P.sub.f], [P.sub.l])
cy](1 - [[tau].sub.cg]).


The first term in square brackets brackets: see
punctuation.  is the portion of the gain at
sale that is taxed as ordinary income, and the second term in square
brackets is the portion of the gain at sale taxed at the long-term
capital gains rate. In contrast, for compensation of m/[(1 +
[[tau].sub.P])(1 - [[tau].sub.C])] in an NQESPP, if the shares are sold
at q, the after-tax value at q to the employee is


[7] [([P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l])
-1)(m/(1 +
[[tau].sub.P])(1 + [[tau].sub.C])) [[1 + (1 +
[[tau].sub.C])[r.sub.C]].sup.(q-l)](1 - [[tau].sub.O] - [[tau].sub.P])
+[([P.sub.q] - [P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l]))(m/(1 +
[[tau].sub.P])(1 + [[tau].sub.C])) [[1 + (1 +
[[tau].sub.C])[r.sub.C]].sup.(q-l)](1 + [[tau].sub.cg]).


The first term in square brackets in [7] is the portion of the
gain
at sale that is taxed as ordinary income (expressed in period q
dollars), and the second term in square brackets is the portion of the
gain at sale taxed at the long-term capital gains rate. Therefore,
whether the compensation is paid through a QESPP versus an NQESPP
depends upon under what values of Ks" vo' [[tau].sub.P], and
[[tau].sub.C][6] dominates [7], given [r.sub.C] and a share price path.


There are two clear predictions from [6] and [7]. First, a
QESPP
should become relatively more desirable as the corporate tax rate falls,
because compensation paid through a QESPP is not corporate tax
deductible but is through an NQESPP. Second, a QESPP should become
relatively more desirable as the spread between the ordinary and
long-term gains rates widens, and the employee is able to convert a
larger portion of ESPP compensation from ordinary to capital gains
income.


Figure 1 shows how the tax advantage of compensation through a
QESPP versus an NQESPP (defined as the quotient quotient - The number obtained by
dividing one number (the "numerator") by another (the "denominator"). If
both numbers are rational then the result will also be rational.  of
[6] to [7]) changes
with the corporate tax rate, [[tau].sub.c] assuming both a 15 percent
discount and a look-back, annual share price appreciation of 10 percent,
a profit rate of ten percent, and q - l equal to 18 months (the minimum
required holding time for a qualified distribution with a six-month
offering period). A tax advantage of greater than one means that the
QESPP is preferred to the NQESPP.


As noted above, the tax advantage declines as the corporate
tax
rate rises, holding other tax rates fixed. Specifically, the solid line
gives the tax advantage for an employee with marginal tax rates of 28,
7.65, and 20 percent on ordinary income, payroll, and long-term capital
gains, respectively. At the statutory corporate tax rate of 35 percent
the tax advantage is 0.89, which implies that the personal tax benefit
from the compensation paid through a QESPP is 89 percent of that if paid
through an NQESPP. This employee prefers the QESPP only when the
corporate tax rate falls below 22 percent. The single-clashed line gives
the tax advantage for a high-income employee in the top income tax
bracket Noun 1. income
tax bracket - a category of taxpayers based on the amount of their
income
income bracket, tax bracket

bracket - a category
falling within certain defined limits  and above the OASDI
taxable earnings cap, with marginal tax
rates of 39.6, 1.45, and 20 percent on ordinary income, payroll, and
long-term capital gains, respectively. (14) At the statutory corporate
tax rate of 35 percent, the tax advantage is 0.88 in this case. This
employee prefers the QESPP only when the corporate tax rate is 20
percent or less. Finally, the double-dashed line gives the tax advantage
for a low-income employee with marginal tax rates of 15, 7.65, and 10
percent on ordinary income, payroll, and long-term capital gains,
respectively. At the statutory corporate tax rate of 35 percent, the tax
advantage is 0.88 in this case. This employee prefers the QESPP only
when the corporate tax rate is 21 percent or less.


Figure 2 illustrates how the tax advantage changes as the
marginal
tax rate on long-term capital gains changes, using the same parameter
values as in Figure 1, except the corporate tax rate is fixed at 35
percent. The tax advantage declines as the capital gains rate rises,
holding other tax rates fixed. However, the QESPP is never preferred to
the NQESPP by any of the employees under this parameterization.


Empirical Implications


This analysis of the influence of taxes on the incentives for
employers to provide ESPPs highlights two important issues for empirical
analysis. First, QESPPs are offered far more frequently than NQESPPs (77
percent of plans vs. 23 percent as reported by NCEO (2001b)), even
though the latter seem to have a greater tax advantage. In contrast, the
vast majority of stock option plans, 95 percent, are non-qualified (Hall
and Liebman, 2000). Yet for the three prototypical employees illustrated
in Figure 1, QESPPs are jointly tax-preferred to NQESPPs only when the
corporate tax rate is substantially below the top statutory rate of 35
percent (in the 20-22 percent range, depending upon the employee).
Indeed, the assumption of large capital gains associated with 10 percent
annual share price appreciation helps to drive the relative
attractiveness of QESPPs in the figure. If annual share price
appreciation is instead assumed to be 1 percent, then QESPPs dominate
NQESPPs only when the corporate tax rate is in the 14-18 percent range
(depending on the employee).


This naturally raises the question of why firms even offer
QESPPs.
One potential explanation is some firms do have both a low marginal
corporate tax rate (due to low corporate taxable income) and
sufficiently high share price appreciation to make offering a QESPP
desirable from a tax perspective. In this regard, NCEO (2001b) reports
that the top three industries in 2000 with ESPPs were software,
e-commerce, and semiconductor and electronic component manufacturing.


Another explanation is that the non-tax benefits of
broad-based
employee ownership through qualified plans often cited in the plan
administration literature, such as increased loyalty and retention, are
sufficiently
large In mathematics, the phrase sufficiently
large is used in contexts such as:

is true for
sufficiently large

 to offset any tax disadvantage
relative to a
non-qualified plan. We note, however, that there is nothing in principle
that prevents the employer from offering an NQESPP that is broad-based
and uniform across employees and, thus, mimics a QESPP in design. In
practice, there appear to be design differences in the two types of
plans. For example, NCEO (2001a) reported that, even though there is
nothing that prohibits the employer from doing so, most NQESPPs did not
offer a discount on the purchase of company stock, which is common in
QESPPs.


The accounting treatment of ESPPs may explain this.
Specifically,
QESPPs have been deemed as noncompensatory plans for accounting
purposes, such that there is no expense recognition at grant, exercise,
or sale. However, NQESPPs that provide a discount and are not
broad-based may recognize an expense for the amount of the discount
(similar to NQSOs granted in the money prior to 2000). This potential
non-tax cost of NQESPPs may explain both why NQESPPs typically have not
offered discounts and why QESPPs have been the dominant type of plan.


Second, given that the employer has chosen to offer an ESPP,
employee participation would be predicted to be 100 percent if all
employees were fully informed, financially rational, with access to
perfect capital markets and no transactions costs, because contributing
to an ESPP and disposing of shares in a same-day sale is essentially a
risk-free way to increase gross compensation. To see this, note that the
factor in square brackets in [5] is the gross return to the employee on
the contribution if the shares are disposed of in a same-day sale. With
a 15 percent discount ([delta] = 0.15), which is typical, this return is
17.6 percent even with zero or negative share appreciation during the
offering period. For a six-month offering period, this implies an
annualized annualized

Of or
relating to a variable that has been mathematically converted to a
yearly rate. Inflation and interest rates are generally annualized since
it is on this basis that these two variables are ordinarily stated and
compared.  rate of return of over 38 percent, far above the
annual
interest rate charged on credit
card debt Credit card debt is
an example of unsecured consumer debt, accessed through ISO 7810 plastic
credit cards.

Debt results when a client of a credit card
company purchases an item or service through the card system. .
Moreover, this is the
lower-bound on the potential return to ESPP participation--with a
look-back and any positive share appreciation, the actual return can be
even greater. Only employees not fully informed or who were unable to
borrow would not find participation attractive.


EMPIRICAL ANALYSIS WITH COMPANY DATA


Unfortunately, we do not have data on a large random sample of
companies to examine empirically the impact of taxes on the employer
provision of ESPPs, and leave that analysis for future research.
Instead, in the remainder of the paper, we examine patterns of ESPP
participation and contributions using administrative data from 1997-2001
for a large health services company that employs approximately 30,000
people. We use the perfect capital markets, perfectly informed, no
transactions cost model as a point of departure for the analysis of
employee participation conditional on the firm having decided to offer
the plan. Not surprisingly (at least to some readers), we do not find
the universal participation in the ESPP plan that this paradigm would
suggest. Because of this, we first lay out what employee characteristics
are correlated cor·re·late  
v.
cor·re·lat·ed, cor·re·lat·ing, cor·re·lates

v.tr.
1.
To put or bring into causal, complementary, parallel, or
reciprocal relation.

2.
..... Click
the link for more information. with participation, and
then we outline a number of
alternative factors that might explain the substantial
non-participation.


Company Data Description


The company data come from eight cross-sectional snapshots of
all
active employees: June and December, 1997; June and December, 1998; June
and December, 1999; June, 2000; and December, 2001. The data contain
basic administrative items, such as hire date, birth date,
race/ethnicity, gender, and gross pay. The data also include variables
that capture several important aspects of employee stock purchase plan
participation, although we do not have all of this information available
for some of the early cross sections. The ESPP data include
participation status, the contribution rate, number of shares held, and,
for later cross-sections, the number of shares bought and sold. We also
have data on 401(k) participation, such as current participation status
and an individual's current contribution rate and investment
allocation. In addition, we have data on stock options, which are
granted to less than 15 percent of the company's employees, at a
single point-in-time.


There are four non-wage/savings programs sponsored by this
company.
The first is the 401(k) plan. This plan is discussed in greater detail
in Madrian and Shea (2001). Company stock is not an investment option
within the 401(k) plan, and employer matching contributions are not made
in the form of company stock.


The second savings plan sponsored by the company is the QESPP.
The
features of this company's employee stock purchase plan are fairly
standard. The plan has two annual offering periods that begin on January
I and July I of each calendar year and are six months in duration.
Employees can contribute to the plan an integer integer: see number;
number theory  percentage of gross
earnings up to a maximum of 10 percent through payroll deduction. The
plan has both a look-back feature and a discount--the stock purchase
price is 15 percent off of the lesser of the fair market price at the
beginning and the end of the offering period. All full-time employees
are eligible for the plan, as are part-time employees working 20 or more
hours per week and temporary employees with assignments lasting more
than five months. Beginning in 1999, all employees were immediately
eligible to participate upon hire (although they could not actually
enroll until the next offering period); before 1999, there was a 60-day
service requirement.


The third company--sponsored savings plan is an employee stock
ownership plan (ESOP ESOP

See: Employee Stock Ownership Plan

---

ESOP

See Employee Stock Ownership Plan (ESOP).
). This plan is not associated with the 401(k) plan
and is not voluntary. At year-end, the company allocates a total number
of shares, determined annually on the basis of corporate profitability,
to the ESOP. These shares are then distributed across employees on the
basis of employee compensation (that is, higher paid employees receive
proportionately pro·por·tion·ate  
adj.
Being
in due proportion; proportional.

tr.v. pro·por·tion·at·ed,
pro·por·tion·at·ing, pro·por·tion·ates
To make
proportionate.  more shares). Overall, however, the ESOP is
small--the
mean value of the ESOP accounts is just over $300--and, in fact, the
ESOP was discontinued dis·con·tin·ue  
v.
dis·con·tin·ued, dis·con·tin·u·ing, dis·con·tin·ues

v.tr.
1.
To stop doing or providing (something); end or abandon:  toward the end of our sample
period.


Finally, the company grants stock options to approximately
4,000 of
its 30,000 employees. These tend to be the more highly compensated
managerial employees within the firm. Unfortunately, we do not have very
extensive information on the stock options granted to employees over
time, or on when they are exercised. We do, however, have a snapshot (1) A saved copy of memory including the
contents of all memory bytes, hardware registers and status indicators.
It is periodically taken in order to restore the system in the event of
failure.

(2) A saved copy of a file before it is updated.
 of
the stock options held by employees at a single point in time.


The sample used for our analysis is all employees who are ESPP
eligible, 401(k) eligible, and who have been with the company for at
least 1 yean yean  
v. yeaned,
yean·ing, yeans

v.intr.
To bear
young. Used of sheep and goats.

v.tr.
To give
birth to; bear. Used of sheep and goats.  We impose the tenure
restriction because the service
requirements for both ESPP and 401(k) eligibility changed during the
period covered by our data. Employees with more than one year of tenure,
however, were continuously eligible to participate in both plans over
the entire time period. Conditional on having one year of tenure, almost
99 percent of employees are eligible for both the ESPP and 401(k) plan.
Overall, our sample includes 163,695 person-year observations on 44,943
employees. Table 1 gives summary statistics on the employees in our
sample.


One feature of the compensation structure that changed quite
significantly over our sample period is the switch to automatic
enrollment in the 401(k) plan. Prior to 1998, employees were only
enrolled in the 401(k) if they made an affirmative AFFIRMATIVE. Averring a fact to be true; that
which is opposed to negative. (q.v.)
     2. It is a general rule of
evidence that the affirmative of the issue must be proved. Bull. N. P.
298 ; Peake, Ev. 2.
     3.  election. Beginning
April 1,1998, however, all newly hired employees were automatically
enrolled in the plan and required to contribute 3 percent of pay unless
they actively opted out of participation (a so-called negative
election). Madrian and Shea (2001) examined in greater detail the impact
of automatic enrollment on 401(k) participation, contribution rates, and
investment allocation. While ESPP participation at this company always
has been through an affirmative election, the dramatic increase in
401(k) participation from automatic enrollment documented in Madrian and
Shea (2001) could have affected ESPP participation if employees viewed
the 401(k) and the ESPP as substitute saving vehicles. (15) We discuss
this below.


Participation and Contributions: Basic Facts


Table 2 gives summary statistics on ESPP participation and
contribution rates for each cross-section. Column (1) shows the sample
size of each cross--section. Column (2) illustrates that across all
employees, the participation rate, defined as the share of eligible
employees having committed to purchase shares in that
cross-section's offering period (not as having a positive ESPP
share balance) fluctuated between 35 and 38 percent and then rose to
almost 44 percent in December, 2001. During this same period, the stock
price appreciated significantly. The time path of share prices is shown
in Figure 3, along with the S&P 500 for comparison. Column (4) of
Table 2 shows that the average contribution rate (conditional on
participating) was basically time-invariant, hovering hov·er  
intr.v.
hov·ered, hov·er·ing, hov·ers
1. To
remain floating, suspended, or fluttering in the air: gulls hovering over the waves.

2.
 around 4.6 percent
of pay. Only 7.7 percent of employees (or 20 percent of participants)
contributed 10 percent of pay, the plan limit.


Columns (1)-(3) of Table 3 show ESPP participation and
contribution
rates by various demographic and job characteristics measured in the
administrative data: gender, age, race, job tenure and gross pay. The
first set of rows in Table 3 shows that ESPP participation is much
higher for men than women (47.6 percent vs. 34.8 percent), so that being
female is associated with a reduction in participation of 12.8
percentage points. Participation rates are substantially higher for
whites than for blacks, Hispanics, or individuals of another or unknown
race. In particular, blacks have a participation rate that is 16.5
percentage points lower than that of whites. Finally, the other rows of
the table indicate that participation increases monotonically with age,
tenure, and income.


We include the tabulations on 401(k) behavior for employees
hired
prior to automatic enrollment, shown in columns (4)-(6), as an important
comparison. In principle, under the perfect capital markets, perfect
information, no transactions costs model, 401(k) participation also
should be 100 percent and all employees should contribute to the plan
limit, because the employees can receive the employer match, cash out,
pay the early withdrawal penalty tax, and still come out ahead. This is
clearly not the case, as 401(k) participation, though higher than ESPP
participation, is also well below 100 percent. As with the ESPP, 401(k)
participation is much higher for men and whites and increases with age,
tenure, and income. The same observable characteristics that drive ESPP
participation also appear to drive 401(k) participation. (16)


Because many of the factors associated with ESPP participation
are
highly correlated with each other (for example, high-income employees
are more likely to also be older, white, male, and high tenured ten·ured  
adj.
Having
tenure: tenured civil servants; tenured
faculty.

Adj. 1. tenured
.....
Click the link for more information. employees),
we next turn to estimating multivariate models to isolate isolate /iso·late/ (i´sah-lat)
1. to separate from others.

2.
a group of individuals prevented by geographic, genetic, ecologic,
social, or artificial barriers from interbreeding with others of their
kind.  the independent impact of these demographic
characteristics on ESPP
participation and contributions. The primary dependent variable,
[D.sub.c], is a dummy Sham; make-believe; pretended; imitation.
Person who serves in place of another, or who serves until the proper
person is named or available to take his place (e.g., dummy
corporate directors; dummy owners of real estate).  that
takes on a value of one if the employee
commits at the beginning of the offering period to contribute to the
ESPP and purchase company stock at the end of the offering period, and
zero otherwise. Let i index individuals, s states, and t offering
periods. Then the baseline specification is


[8] [D.sup.c.sub.ist] = [alpha]'[X.sub.ist] +
[beta][D.sup.auto.sub.it] + [[gamma].sub.s] + [[theta Theta

A measure of the rate of decline
in the value of an option due to the passage of time. Theta can also be
referred to as the time decay on the value of an option. If everything
is held constant, then the option will lose value as time moves closer
to the maturity of the option. ].sub.t] +
[u.sub.ist]'


in which X is a vector of variables explaining the
participation
decision and includes a constant along with dummy variables for the
categories of demographic and job characteristics shown in Table 3. The
excluded categories are male, age 50 and over, white, job tenure of one
to two years, and gross pay less than $20,000. We do not observe marital
status marital status,
n
the legal standing of a person in regard to his or her marriage state.  in
these data. However, we have the employee's health
insurance election: employee-only coverage, employee plus one dependent
(a spouse or child), employee plus two dependents (spouse and/or
children), or coverage waived. Because individuals who elected
employee-only coverage are predominantly pre·dom·i·nant  
adj.
1.
Having greatest ascendancy, importance, influence, authority, or
force. See Synonyms at dominant.

2.  single, we
included a dummy for
this health election category in the X vector as a rough control for
marital status. We also included a dummy
variable This article is not about
"dummy variables" as that term is usually understood in mathematics. See
free variables and bound variables.

In regression analysis, a dummy
variable  [D.sup.auto] equal to
one if the employee was subject to automatic 401(k) enrollment and zero
otherwise and a full set of state and offering period fixed effects,
[gamma] and [theta], respectively. (17)


Column (1) of Table 4 shows the parameter estimates from the linear
probability
model The linear probability
specification of a binary regression model assumes that, for binary
outcome
and regressor vector  of ESPP participation. Robust standard
errors that
account for the fact that there are multiple observations on individuals
are reported in parentheses. Women have a statistically significant 0.91
percentage point lower probability of participating in the ESPP. This
is, however, substantially smaller in magnitude than the male-female
difference of 12.8 percentage points in the unconditional HEIR, UNCONDITIONAL. A term used in the civil
law, adopted by the Civil Code of Louisiana. Unconditional heirs are
those who inherit without any reservation, or without making an
inventory, whether their accep