ESOP: Meaning, Benefits, Taxation and How It Works

Employee compensation is much more than their monthly salaries and annual bonuses today. Several companies are now providing additional benefits that help employees create long-term wealth, and one such popular benefit is the Employee Stock Ownership Plan (ESOP).

The purpose of ESOPs is to allow the employees to own the shares, usually at a discounted price, in the company they work for. ESOPs are widely used by both start-ups and big companies to attract and retain talent. Employees can make better financial decisions by understanding what ESOP is along with its benefits and working structure, resulting in better gains.

What is ESOP?

The full form of ESOP is Employee Stock Ownership Plan, meaning a compensation scheme, wherein the employees of the company are given ownership in the form of shares.

The employees get the option to buy company shares at a predetermined price after a certain period, under an ESOP. Most companies provide the employees with the benefit of selling them shares at a price lower than the market value.

ESOPs are generally offered by the companies to reward employees and improve retention. Several popular examples of ESOP in India are plans offered by Infosys, TCS, ICICI Bank, amongst several other companies.

Table of Contents

1. What is ESOP?
2. How Does an Employee Stock Ownership Plan (ESOP) Work?
3. Initial Costs and Distribution of ESOPs
4. Benefits of ESOPs for Employees
5. Benefits of ESOPs for Employers
6. Taxation of ESOPs in India
7. ESOPs in Unlisted Companies
8. Things Employees Should Know Before Accepting ESOPs

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

The way an Employee Stock Ownership Plan (ESOP) works, it follows a structured process. The company determines:

• The number of shares to be offered
• Eligible employees
• The exercise price
• Vesting conditions

To know how an Employee Stock Ownership Plan (ESOP) works, below is the process, such as:

Grant of ESOPs

When the company grants stock options to its employees on a specific date, it is known as grant date.

Vesting Period

The employees are not allowed to own or sell the company shares immediately. They must complete a waiting period called the vesting period. The vesting period encourages employees to stay with the organization for a longer duration.

Vesting Date

Once the vesting period expires, the employee becomes eligible to exercise the ESOPs and the date on which it happens is called the vesting date.

Exercising the ESOP

The employees gain the benefit of buying the company shares at a predetermined price, which is lower than the current market value.

Selling the Shares

After purchasing the shares, employees may either hold them for future growth or sell them and book profits. If the employee resigns or retires before the vesting period is completed, the advantages of ESOP may lapse depending on company policy.

Initial Costs and Distribution of ESOPs

Implementing an ESOP involves several administrative and legal expenses. Some common ESOP-related costs include:

• Legal documentation charges
• Accounting fees
• Valuation expenses
• Compliance and administrative costs

The actual cost depends on the size of the company and the complexity of the ESOP structure.

When employees exercise their stock options, it depends on them whether they want to either sell the shares immediately or retain them for long-term appreciation.

If the employees choose to sell the shares, they receive the proceeds after applicable taxes. If they continue holding them, they may benefit from:

• Dividend income
• Capital appreciation
• Increased ownership value

Benefits of ESOPs for Employees

Several financial and professional factors determine the advantages of ESOPs for employees such as:

Stock Ownership Opportunity

The employees get the benefit of becoming a partial owner of the company through ESOP, creating a stronger sense of involvement and responsibility.

Wealth Creation

When a company performs well, resulting in a rise in the share prices, the employees can earn significant profits by selling their shares at a higher value.

Dividend Income

For the employees holding the company shares can also receive dividend income when the company distributes the profits to shareholders.

Purchase Shares at Lower Prices

One of the biggest ESOP benefits is the ability to buy shares at discounted rates compared to the prevailing market price.

Long-Term Financial Growth

Holding ESOP shares for a long period of time may help employees build wealth over time through capital appreciation.

Benefits of ESOPs for Employers

ESOPs are not only beneficial for employees but also valuable for employers. The benefits of ESOPs for employers include:

Employee Retention

The employees are allowed to exercise their options only after their vestige period ends, encouraging them to stay with the company for a longer period.

Better Productivity

When the employees own company shares, they often feel more connected to business performance and are dedicated to improve productivity and commitment.

Attracting Skilled Talent

ESOP also helps in attracting talented professionals in start-up companies when offering high salaries may not be feasible.

Aligning Employee and Company Goals

ESOPs align employee interests with company growth because both benefit when the company performs well.

Taxation of ESOPs in India

ESOP taxation in India generally takes place at two stages, that is when employees exercise the ESOPs and buy shares, and when employees sell the shares. Let’s understand both situations as following:

1. Tax on Exercising ESOPs

When employees exercise their stock options, they usually buy shares at a price lower than the Fair Market Value (FMV). The difference between the FMV and exercise price is treated as a perquisite and taxed according to the employee’s income tax slab.

Example of ESOP Tax Calculation

For instance:

• FMV of share = Rs. 310
• Exercise price = Rs. 230
• Difference = Rs. 80 per share
• Shares exercised = 1,000

Taxable perquisite value:
1,000 × 80 = Rs. 80,000. The tax payable is Rs. 24,000, if the employee falls under the 30% tax slab.

ESOP Tax Relief for Start-Up Employees

The government has provided relief to eligible start-up employees regarding ESOP taxation, which reduces the immediate tax burden on employees.

Tax payment on ESOP perquisites can be deferred until the earliest of the following events:

• Completion of five years from grant date
• Sale of shares
• Leaving the company

2. Tax on Selling ESOP Shares

When employees sell ESOP shares, capital gains tax becomes applicable. The taxable gain is calculated as:

Selling Price – FMV on Exercise Date

• Short-Term Capital Gains (STCG): The gains are taxed at 15% if the shares are sold within a year.
• Long-Term Capital Gains (LTCG): Whereas, the gains exceeding Rs. 1 lakh are taxed at 10% if the shares are sold after one year.

ESOPs in Unlisted Companies

Selling shares of unlisted companies can be difficult because there may not be enough buyers. In such cases:

• Fair Market Value is determined by registered valuers or merchant bankers
• Capital gains taxation differs from listed shares

For unlisted shares:

• Gains within 24 months are treated as short-term capital gains
• Gains after 24 months qualify as long-term capital gains and are taxed accordingly

After the company becomes publicly listed, its employees get better liquidity and easier opportunities to sell their holdings.

Things Employees Should Know Before Accepting ESOPs

ESOPs can become highly rewarding if the company performs well in the future. However, employees should understand the associated risks and taxation before making decisions. Before accepting an Employee Stock Ownership Plan, employees should carefully evaluate:

• Vesting period
• Company growth potential
• Tax implications
• Liquidity options
• Exit conditions

Conclusion

Employee Stock Ownership Plans have become an important part of modern compensation structures. The employees of a company can participate in the company’s growth with the help of ESOPs, whereas equally, there are benefits of ESOPs for employers or organizations to retain talented employees.

When managed wisely, ESOPs help in creating long-term financial opportunities for employees of both start-up and big companies. By understanding the meaning of ESOP, how it works, vesting periods, advantages of ESOP, and taxation, the employees can benefit the most from this scheme.