Section 423 ESPP Eligibility: Exclusions, 5% and $25,000 Limits

To qualify under Section 423 of the Internal Revenue Code, an Employee Stock Purchase Plan must be offered to substantially all employees of each participating corporation on the same terms, with only four narrow categories the employer may choose to exclude. Every participant has to receive the same rights and privileges, no one who would own 5% or more of the company’s stock can be granted an option, and no employee can accrue the right to buy more than $25,000 of stock (measured at grant-date value) in any calendar year. These are the Section 423 ESPP eligibility requirements that determine who gets in and on what terms.

Broad Participation and Equal Rights

Section 423(b)(4) requires that options be available to all employees of any corporation whose workers are granted options under the plan.¹ A company cannot hand-pick individuals. It either includes a group or excludes it using one of the statute’s permitted categories.

Section 423(b)(5) reinforces this with an equal-treatment rule: every participant must have the same rights and privileges. The purchase price formula, the contribution mechanics, and the offering terms have to be identical across the workforce. The one permitted variation is that the number of shares an employee can buy may scale with total compensation or base pay, so long as the relationship is uniform. A plan can let everyone contribute up to 10% of salary, for instance. The dollar amounts differ by pay level, but the percentage and the rules are the same for everyone.¹

The Four Permitted Exclusions

Section 423(b)(4) gives employers a short menu of groups they may leave out. These are the only permitted exclusions, and a plan that excludes anyone outside these categories cannot qualify under Section 423.²

Employees who have worked for the company less than two years.
Employees whose customary employment is 20 hours or less per week.
Employees whose customary employment is five months or less in any calendar year.
Highly compensated employees, as defined under Section 414(q).

Each exclusion is optional. An employer may apply all four, some combination, or none. Many companies use only the short-tenure exclusion, and often set the waiting period below the two-year maximum at something like six months or a year.¹

Highly Compensated Employee Threshold

The Section 414(q) definition looks at prior-year pay. For 2026, the threshold is $160,000, so an employee who earned more than $160,000 in 2025 qualifies as highly compensated for the 2026 plan year.³ The figure is adjusted periodically for inflation. Some employers use this exclusion to focus ESPP benefits on the broader workforce, but many prefer to keep their higher earners enrolled, so it is not common.

Union Employees Are Not On the List

Employees covered by a collective bargaining agreement are notably absent from the permitted exclusions. Treasury regulations make clear that a plan excluding any group not specifically listed in Section 423(b)(4) cannot qualify.² If union workers at a participating subsidiary are otherwise eligible, the plan has to include them or risk disqualification. Whether a union employee actually participates often depends on what the bargaining agreement covers, but the employer cannot unilaterally carve them out.

The 5% Ownership Ceiling

Section 423(b)(3) blocks any option grant that would leave an employee owning 5% or more of the total combined voting power or value of all classes of stock in the employer, its parent, or any subsidiary immediately after the grant.¹ Unlike the exclusions above, this is not optional. The company must enforce it.

Ownership is measured using the attribution rules of Section 424(d), which reach further than most employees expect. Stock owned by your spouse, siblings (including half-siblings), parents, grandparents, children, and grandchildren counts as yours for this test. Stock held through a corporation, partnership, estate, or trust is attributed proportionately to the shareholders, partners, or beneficiaries.⁴ Stock the employee could buy under any outstanding option also counts as currently owned, meaning the very option being granted can push someone across the line.

At a large public company, this rule rarely affects rank-and-file workers. It matters most at smaller or closely held corporations, where founders, early employees, or their relatives may hold meaningful stakes.

The $25,000 Annual Purchase Cap

Section 423(b)(8) limits how much stock any one employee can acquire through all qualified ESPPs of the same employer group in a single calendar year. The ceiling is $25,000 in fair market value, measured at the time the option is granted rather than when the purchase occurs.⁵ That timing matters: if the stock climbs between grant and purchase, you may pay well under $25,000 out of pocket while the grant-date value still hits the cap.

The right to buy accrues at the rate specified in the option for each calendar year the option remains outstanding. Unused capacity does not roll forward. The regulations are explicit that unused purchase rights under one option cannot be carried over to any other option, and failing to exercise an earlier option does not raise the limit for a later one.⁶ Each calendar year stands on its own.

Because the cap uses grant-date value while the purchase price is often the lower of grant-date or purchase-date price, a company cannot simply cap employee contributions at 85% of $25,000 and consider itself safe. If the price drops between grant and purchase, the same contribution buys more shares than expected and can push an employee over the limit. Plan administrators watch this actively, and many plans include automatic refund mechanisms for excess contributions.

Which Employers and Workers Count

Only employees in a common-law employment relationship qualify for a Section 423 plan. Independent contractors, consultants, and non-employee board members are ineligible no matter how much work they do for the company. The employee must work for the corporation granting the option, its parent, or a designated subsidiary.

Sections 424(e) and 424(f) define parent and subsidiary corporations using a 50% voting-power threshold. A parent must own at least 50% of the voting stock in each corporation down an unbroken chain ending at the employer. A subsidiary must sit in an unbroken chain starting with the employer where each link holds at least 50% of the next corporation’s voting stock.⁴ A company that owns only 40% of another entity cannot include that entity’s employees in its qualified ESPP.

A parent can choose which qualifying subsidiaries participate. Once a subsidiary is added, though, the broad-participation and equal-rights rules apply to all of its eligible employees. You cannot bring in a subsidiary and then pick and choose within its workforce.

Foreign Subsidiaries

Employees of foreign subsidiaries create a particular problem. Because participants must receive the same rights and privileges, including a foreign subsidiary means giving its employees the same terms as domestic participants, and local securities laws, tax rules, and labor regulations can make identical treatment impractical or even illegal. Many multinational employers respond by running a separate, non-qualified “mirror” plan for international staff that echoes the ESPP’s economic terms without being subject to Section 423, preserving the qualified status of the U.S. plan.

Discount and Offering Period Limits That Shape the Terms

Two other Section 423 rules shape what the “same rights and privileges” must look like across participants. The purchase price cannot fall below 85% of the stock’s fair market value. Section 423(b)(6) sets that floor: the option price must be at least 85% of fair market value either when the option is granted or when it is exercised, whichever produces the lower price for the employee.¹ Most plans pair this 15% maximum discount with a “lookback” that bases the price on the lower of the stock’s value at the start or end of the offering period.

The statute also caps offering length. If the plan uses a lookback, or any pricing method where the final price is not purely the fair market value on the purchase date, the option must expire within 27 months of the grant date. Plans that set the purchase price at no less than 85% of the fair market value at exercise get up to five years.¹ Six-month offerings are the norm in practice because shorter cycles are simpler to administer.

Taken together, these rules describe a plan that has to look the same for a warehouse worker as for a senior engineer, subject only to a compensation-based sizing rule, a short list of optional exclusions, and two hard ceilings on ownership and annual purchases. A single deviation, such as excluding a group that is not on the statutory list, can disqualify the entire plan.

1
Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans
2
eCFR. 26 CFR 1.423-2 – Employee Stock Purchase Plan Defined
3
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
4
Office of the Law Revision Counsel. 26 USC 424 – Definitions and Special Rules
5
Federal Register. Employee Stock Purchase Plans Under Internal Revenue Code Section 423
6
Internal Revenue Service. Internal Revenue Bulletin: 2009-49