Employee Stock Option Plan (ESOP)

How does an Employee Stock Ownership Plan Work?

The beneficiary employees, price of shares, and the number of shares will be decided by the employer. Once the employees have been granted the ESOPs, a grant date will be provided.

After the ESOPs have been offered, the stocks will be in a vesting period, where they will be in a trust fund for a certain duration. Employees will have ownership of the stock only if they remain in the company for the vesting period.

Post the vesting period, employees can purchase the shares at a price that has been allotted. This price will be below the market value. The ESOP must be bought back by the company if the employee retires or leaves the organisation within the vesting period.

Cost and Distribution of ESOPs

The cost of ESOPs may include administrative costs, accounting fees, and legal fees. Depending on the plan’s complexity and size, the cost of maintaining and creating an ESOP will vary. The distribution of ESOP in India can occur in different methods.

If employees decide to acquire shares, they can choose whether to hold on to the shares or sell them immediately. In case employees choose to sell shares, the proceeds will be transferred to them after taxes have been deducted from the gain.

What are the Tax Implications of ESOPs?

The different tax implications of ESOPs are mentioned below:

1. Options provided by the company are not taxable.

1. Vested options are not taxable.

1. When an employee exercises the option of buying shares, the difference between the market value of the shares and the exercise value of the share will be taxable according to the tax bracket the employee falls under.

1. When an employee sells the shares, it is considered capital gains. If the employee sells the shares within one year 15% tax is levied against the capital gains. If the employee sells the shares after one year, they are considered long term assets and are not taxable.

1. If an employee has ESOPs in a company based abroad, when the shares are sold it will be considered short-term capital gains and will be added to the income of the employee. The employee will be taxed according to the tax bracket he/she falls into after that.

1. If capital gains are long term, 10% tax will be levied without the benefit of indexation or 20% tax will be levied with the benefit of indexation.

ESOP Example

An example of how much tax must be paid on the gains are mentioned in the table below:

The tax implications have been relaxed in case of start-ups. No perquisite needs to be paid the year the ESOP has been exercised. The TDS will be deferred to the dates mentioned below (whichever is earlier):

1. The date the employee leaves the company.

1. The date the ESOP is sold by the employee.

1. Once the employee completes five years from the grant date of the ESOP.

Why are ESOPs given?

There is a multitude of reasons for which an employer would give an ESOP to an employee.

1. The trend of giving ESOPs is more prevalent in start-ups, which cannot afford to provide large compensation packages to their employees.
2. By providing an employee with an ESOP, the employer gets the employee vested in the interests of the company and provides the employee with a sense of ownership, thereby, motivating the employee to perform a task with an actual vested interest in the company.
3. Some companies provide ESOPs to employees which can be exercised on a future date, to provide an incentive for a long-term commitment by the employee to the company.

What benefits does the company enjoy by providing ESOPs?

1. Acquiring the shares of a departing owner: The owners of private companies can use the ESOP to sell their shares. Companies are allowed to make tax-deductible contributions to the ESOP to buy out the shares or the company can use the ESOP to borrow money to buy the shares.
2. Borrowing money at lower after-tax cost: Cash borrowed under ESOP is used to buy company shares and shares of existing owners. Contributions to the ESOP are tax deductible as they are made to repay the loan amount. Both principal and interest are tax deductible.
3. Creates an employee benefit: A company can issue treasury shares or new shares to an ESOP and deduct the value from the taxable income. Companies sometimes contribute cash to the ESOP to buy shares from existing public or private owners. In public companies, ESOPs are often used in conjunction with the employee savings plan. Rather than matching the employee's savings through cash, the employers can match the employee's savings through stocks from an ESOP, and usually, the employers will match the savings at a higher level through stocks.

What are the Tax Implications of ESOPs?

1. Options provided by the company are not taxable.
2. Vested options are not taxable.
3. When an employee exercises the option of buying shares, the difference between the market value of the shares and the exercise value of the share will be taxable according to the tax bracket the employee falls under.
4. When an employee sells the shares it is considered capital gains. If the employee sells the shares within one year 15% tax is levied against the capital gains. If the employee sells the shares after one year they are considered long term assets and are not taxable.
5. If an employee has ESOPs in a company based abroad, when the shares are sold it will be considered short-term capital gains and will be added to the income of the employee. The employee will be taxed according to the tax bracket he/she falls into after that.
6. If capital gains are long term, 10% tax will be levied without the benefit of indexation or 20% tax will be levied with the benefit of indexation.

What are the Disadvantages of ESOPs?

1. Options can become an obligation for the company. ESOPs do not have an option premium and the only compensation a company can hope for is indirectly through increased liquidity and sometimes through a tax advantage. The risk for the exercise remains the same as it is for normal stocks. This can make options riskier than normal stocks.
2. Only when the exercise on the options is executed does it generate liquidity for the company and the amount of liquidity is uncertain till the date of the exercise. The liquidity benefits with ESOPs is highly uncertain.
3. There are still various unclear guidelines for the valuation and accounting procedure for ESOPs in a company.

Benefits of ESOPs

The main benefits of ESOPs for employers and employees are mentioned below:

Employers

1. Talent can be attracted as ESOPs is an additional compensation.

1. Employee productivity will increase.

1. Employee retention as they have to remain in the company for the vesting period.

Employees

1. Shares can be purchased at a discounted price.

1. If the company makes a profit, a part of it will be provided to shareholders.

1. In the company they work for, employees will enjoy ownership.

Treatment of Tax at the Time when ESOPs are Sold

Capital gains tax will be levied when the employee decides to sell shares. The tax will be levied on the difference between selling price and Fair Market Value (FMV) at the time the share has been exercised. Shares will be taxed at 15% if sold within 12 months and 15% if sold after 12 months.