Employee Stock Ownership Plan

An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs give the sponsoring company—the selling shareholder—and participants various tax benefits, making them qualified plans, and are often used by employers as a corporate finance strategy to align the interests of their employees with those of their shareholders.

Employee Stock Ownership Plan

What is ESOP Meaning

ESOP full form stands for Employee Stock Ownership Plan. Under this plan, employers offer their employees the stock of the company at a low or no additional cost that they can encash after a specified period at a specific price.

ESOP taxation in India is done as a prerequisite and is subject to tax at the time of exercise or transfer of shares to the employee.

Some popular ESOP example in India includes those offered by L&T, ICICI Bank, Infosys and many other companies when they were starting up.

How Does an Employee Stock Ownership Plan (ESOP) Work?

Employers decide the number of shares to be offered under ESOPs, their price, and the beneficiary employees. ESOPs are then granted to employees, and a grant date is provided. 

Once ESOPs are offered, they remain in a trust fund for a specific period, called the vesting period. Employees should stay with the organization for the vesting period to avail the ownership of stock by exercising the ESOP. 

Once the vesting period expires, employees get the right to exercise their ESOPs. The date on which the vesting period expires is called the vesting date.

Employees can exercise their ESOPs and buy the company shares at allotted prices, which are lower than the market value. Employees can also sell the shares that they have bought through ESOPs and make a gain on their holdings.

If the employee leaves the organization or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.

ESOP Initial Costs and Distributions

In India, the initial costs of an Employee Stock Ownership Plan (ESOP) can include legal fees, accounting fees, and administrative costs.

The cost of creating and maintaining an ESOP varies based on the size and complexity of the plan.

Furthermore, ESOP distributions in India might take place in various methods.

When an employee exercises their stock option to acquire shares, they have the choice to sell the shares right away or store them for prospective appreciation.

If the employee decides to sell the shares, the proceeds will be sent to them, less any taxes owing on the gain. If the employee decides to keep the shares, they will have a stake in the firm and may receive dividends or capital gains if the stock price rises.

Benefits of ESOPs for Employees

  • Stock Ownership

Employees can enjoy ownership in the company that they work for as ESOPs give them the right to own a part of the company’s share capital.

  • Dividend Income

A part of the profit earned by the company is distributed among the shareholders in the form of dividends. Employees can, therefore, earn additional dividend income and also get the direct benefit from the efforts that they put toward the company’s profitability.

  • Buy Shares at a Discounted Rate

At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the shares allotted to them. This, therefore, allows them to invest in the company at a preferential rate.

Benefits of ESOPs for Employers

ESOPs are favourable for employers too. Here’s how:

  • Employee Retention 

Since employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain employees.

  • Better Productivity

Since employees themselves stand to gain from the profits earned by the company, ESOPs can boost employee productivity and make the company more profitable.

  • A Tool for Attracting Talent

ESOPs are additional compensation plans that help employers attract and retain talented employees. In fact, for start-ups, ESOPs help lure in good talent in the initial days when high pay packages are not feasible.

Tax Implication of ESOPs

There are dual tax implications of ESOPs. 

  1. When the employee exercises his/her rights and buys the shares of the company
  2. When the employee sells the shares after buying them

Let’s understand these instances in detail:

  • Tax Treatment at the Time of Buying the Shares

Employees can buy the shares after the vesting date at a rate lower than the Fair Market Value (FMV) of the share as of that date. As such, the difference between the FMV and the exercise price of the share is treated as a prerequisite in the hands of the employee and taxed at his income tax slab rate.

ESOP Example

Exercise date

January 1, 2022

FMV

Rs. 150/share

Exercise price 

Rs. 85/share

Taxable value of perquisite 

150 − 85 = Rs. 65/share

Number of shares exercised 

1,000

Total taxable perquisite 

1,000*65 = Rs. 65,000

Tax payable (assuming a tax slab of 30%)

30% of 65,000 = Rs. 19,500

In the case of start-ups, however, the government has relaxed the tax implications on ESOPs.

Start-up employees would not have to pay the tax on the perquisite in the year when they exercise the ESOP. For them, TDS on ESOPs would be deferred to the following dates, whichever is earlier:

  • Completion of five years from the ESOP grant date
  • Date when the employee sells the ESOP
  • Date of leaving the company
  • Tax Treatment at the Time of Selling the Shares

If the employee sells the shares, the difference between the selling price of the share and the FMV on the date when the share was exercised, would be subject to capital gains tax. 

If the gains are earned from selling the shares after 12 months of buying them, 10% tax would be applicable on gains exceeding Rs. 1 lakh. If, however, the shares are sold within 12 months, the gains would be taxed @15%. 

In the above example, if the employee sells the shares, here’s how the tax would be calculated:

Exercise date

January 1, 2022

FMV as of January 1, 2022

Rs. 150/share

Case 1: Shares sold on October 1, 2022

FMV on October 1, 2022

Rs. 165/share

Difference between the FMVs

165 − 150 = Rs. 10/share

Number of shares 

1,000

The total amount of short-term capital gain

1,000*10 = Rs. 10,000

Short-term capital gains tax payable

15% of 10,000 = Rs. 1500

Case 2: Shares sold on February 2, 2023

FMV on February 2, 2023

Rs. 180/share

Difference between the exercise FMV and sale FMV

180 − 150= Rs. 30/share

Number of shares

1,000

The total amount of long-term capital gain

1000*30 = Rs. 30,000

Long-term capital gains tax payable

Nil as the gain is below Rs. 1 lakh

Taxation of foreign ESOPs in India is also similar, and you would be taxed in India on the perquisites earned from a foreign company. 

FAQs

How are ESOP Shares Allocated?

In India, the company’s board of directors or pay committee allocates ESOP shares based on variables such as an employee’s position, seniority, or performance.

Employees may be required to meet specific requirements before exercising their options to acquire the shares, and the shares are kept in trust. Typically, the exercise price is fixed at a discount to the market price at the time of grant.

How to Calculate ESOP?

Calculating an Employee Stock Ownership Plan (ESOP) entails determining the FMV of the company’s stock, allocating the number of shares to the ESOP, determining the vesting period, determining the exercise price of the options, and calculating the tax implications for both the employer and the employee.