Employee stock purchase plans of this type (sometimes called "tax-qualified" ESPPs) meet the requirements in Section 423 of the Internal Revenue Code. When you become eligible and enroll in the plan, you can elect to have a specified percentage of your compensation withheld from your paychecks on an after-tax basis. The company uses these accumulated funds to purchase shares of company stock for you.

The purchase price is typically equal to (a minimum of) 85% of the stock's fair market value. When the plan has a lookback feature, this discounted price is based on the market price either on the first day of the offering period or on the purchase date (whichever is lower). No tax applies until you sell the shares.

You can't purchase in any calendar year more than $25,000 in shares under the plan (valued at the undiscounted stock price on first day of the offering period). Unused amounts can be carried forward if the offering period spans more than one year.

Alert: You want to understand the features of your company's ESPP design. The three key considerations are:

  1. the size of the discount
  2. whether there is a lookback
  3. the length of the offering period and the purchase period
These are the factors that can make a Section 423 ESPP a good deal.