Employee stock purchase plans offer workers the opportunity to buy company stock through a payroll deduction plan, often at a discount.

Employee stock purchase plans are a popular way for companies to reward employees with stock on a tax-favored basis. In many ways, ESPPs are like incentive stock options, but with some big differences. Although there is no actual "option" involved, companies consider ESPPs a very similar form of compensation. The option is whether to participate or not.

Here are some of the major features of ESPPs and how they differ from or are like incentive stock options (ISOs):

Let's expand on these concepts and add some more.

All basic employee stock purchase plans contain the same features, although companies may add their own twists and enhancements. As long as the company stays within the IRS requirements, there is some latitude in implementing the plan.

As an employee, you have the option to participate or not. If you want to participate, the company will have a sign-up period. During this period, you can designate up to 10 percent of your salary to the plan.

The company will withhold that amount from each paycheck. You will still pay withholding taxes on the amount just the same as if you received the cash.

ESPPs are not qualified retirement plans. Some of these plans, such as 401(k) plans, withhold money before you pay any taxes on it.

Next comes the offering period, which is usually six months, but can be any length the company chooses. Most do not have offering periods beyond one year.

During the offering period, the money deducted from your check is accumulating in an account. At the end of the offering period, the money buys company stock, often at a discount. The purchase arrangement is one of the key benefits of an ESPP. Some companies offer a discount of up to 15 percent.

However, the way the plan decides the stock's price is the really special aspect of the plan. The plan looks at the stock's price at the beginning of the offering period and at the end of the offering period. Whichever number is lower is the price you pay for the stock. Any discount applies to this price.

For example, say your ESPP's offering period is six months and pays a 15 percent discount. The stock's price at the beginning of the offering period is $30 per share and $35 per share at the end.

The plan would use the $30 per share price as its starting point. The 15 percent discount reduces the price to $25.50 per share. You have just bought stock worth $35 per share for $25.50 per share. That's a 38 percent return (actually the return is higher because you are paying in over the course of the offering period, rather than one payment). It doesn't get much better than that.

If things don't go well and you want out of an ESPP, you can usually get your money back if you withdraw before the end of the offering period. Check the details of your plan for the particulars.

I just stated that it couldn't get any better. Well, that's not exactly true. It does get better because you do not have any tax liability when you acquire the stock. You don't even report it on your tax return—no income tax and no alternative minimum tax.

When you sell the stock, you will have to report some income and some long-term capital gain. These reporting requirements are nothing compared to incentive stock options and alternative minimum tax problems.

Employee stock purchase plans and ISOs do share one common component, and that is the holding period you must meet to gain the tax advantages.

One of two dates determines the holding period: (1) two years after the beginning of the offering period or (2) one year after you bought that stock.

The end of the special holding period is determined by whichever one of these dates is the latest. In most cases, that is going to be the first choice: two years after the beginning of the offering period.

It doesn't matter how long the offering period was; the clock starts at the beginning of the period. If you satisfy the holding period, you may report some of your profit as income and some as long-term gain.

The amount of tax you pay as income is arrived at by coming up with two numbers. The first number is your profit. The second number is the difference between what you paid for the stock and the price of the stock at the beginning of the offering period.

When you have these two numbers, the smallest one is the amount you report as income. Let's continue our example.

The stock at the beginning of the offering is $30 per share. You buy it for $25.50 per share. After the holding period, you sell the stock for $40 per share. How much income do you report?

The difference between $30 per share and $25.50 per share or $4.50 per share is what you report as income. You will also have to report $10 per share as a long-term capital gain. The basis for calculating long-term capital gain is the price you paid plus the income you reported (in this case, $25.50 + $4.50 = $30).

If you remember our discussion of incentive stock options from Lesson 5, "Incentive Stock Options," all of your profit from an ISO is a long-term capital gain.

If you sell at a loss, you do not have to report any income. That may seem obvious, but if you don't satisfy the holding period requirement, you may end up reporting income anyway. Selling or otherwise disposing of the stock before the holding triggers a new calculation on the amount on income you report. You have to report income on the difference between what you paid for the stock and the price of the stock at the end of the offering period.

For example, the stock is selling for $30 per share at the beginning of the offering period and $40 at the end of the period. You receive a 15 percent discount off the lesser of these two numbers, which in this case is $30, making the price you pay $25.50 per share.

Early disposition means you report income on the difference between what you paid and the price of the stock at the end of the offering.

If you sold the stock at a loss, you would still have to report $14.50 per share as income. You can see the penalty for not meeting the holding requirement can be severe.

Remember, in order to calculate the income, you must report differently depending on whether you satisfy the holding period. If you satisfy the holding period, you use the price at the beginning of the offering and if you do not satisfy the holding period, use the price at the end of the offering period.

If you use your imagination, you can see that there are times when the stock is lower at the end of the offering period than at the beginning of the period and that it is better to sell before the holding period is complete.

Employee stock purchase plans are a good investment, assuming the company's stock is worth something and has prospects for being worth more.

There are several attractive features about ESPPs:

ESPPs can be great investment tools, but don't become too heavily invested in any one stock, including your company's stock. If you reach that point, consider selling off some of your company stock and diversifying your portfolio. My book Macmillan Teach Yourself Investing in 24 Hours can show you how.