Everything you need to know about ESOP

A Comprehensive Guide

ESOPs explained: vesting, taxation, benefits & more.

Learn how Employee Stock Ownership Plans work in India.

Employee Stock Ownership Plan, better known as ESOP, is a strategic employee benefit that grants employees the opportunity to purchase company stock. In essence, it transforms employees into shareholders. Unlike a standard paycheck, ESOPs provide a pathway for employees to build wealth by becoming a recipient of the company's success. Employees can encash these shares after a predetermined vesting period at a specific price. We have created a quick and easy guide for you to understand how ESOPs work. Let us get right into it.

How Do ESOPs Work?

Employee Stock Ownership Plan (ESOP) involves a structured process designed to transition employees into shareholders. It begins with the employer's decision on share allocation and pricing, followed by a series of stages that govern the employee's ability to acquire these shares.

• Grant Date: The initial date when ESOPs are formally awarded to employees, setting the timeline in motion.

• Vesting Period: A predetermined duration during which employees must remain employed to qualify for exercising their ESOPs, fostering long-term commitment.

• Vesting Date: The culmination of the vesting period, granting employees the right to purchase shares at the agreed-upon price.

• Exercising ESOPs: The process where employees purchase shares at the exercise price, often lower than the market value.

• Selling Shares: Employees have the option to sell acquired shares for profit, capitalizing on market appreciation.

• Leaving Before Vesting: If an employee leaves before the shares have vested, they typically forfeit the right to exercise those ESOPs. For vested shares held by employees leaving the company, the company may choose, as per the terms of the ESOP scheme, to return these shares to the ESOP pool for future allocations.
• Initial Costs: Companies incur setup costs, including legal, accounting, and administrative fees, which vary based on plan complexity.

How Do ESOPs Benefit The Company?

ESOPs create a mutually beneficial structure, where the employees owning shares is opportune for employees and employers.

1. For Employees:

• Stock Ownership: Enables employees to become shareholders, participating in the company's growth and capital gains.
• Dividend Income: Provides a share of the company's profits, directly rewarding employee contributions.

• Discounted Share Purchase: Offers the opportunity to buy company shares at a preferential price, enhancing investment returns.

1. For Employers:

• Employee Retention: Encourages long-term employment through the vesting period, reducing staff turnover.

• Increased Productivity: Motivates employees to enhance performance, as their efforts directly impact company profitability.

• Talent Attraction: Serves as a competitive benefit, attracting skilled professionals, especially in startup environments with limited initial funding.

Taxation of ESOPs in India

ESOPs are subject to taxation at two distinct stages: when the shares are purchased and when they are subsequently sold. It's essential to be aware of these tax obligations to effectively manage your financial planning.

1. Tax Treatment at the Time of Buying the Shares:

• The difference between the Fair Market Value (FMV) and the exercise price is taxed as a perquisite, based on the employee's income tax slab.
• For startup employees, tax on the perquisite is deferred until the earlier of: five years from the grant date, sale of the shares, or leaving the company.
• Example: If FMV is ?150, the exercise price is ?85, and ?1,000 shares are exercised, the taxable perquisite is ?65,000.

1. Tax Treatment at the Time of Selling the Shares:

• Capital gains tax applies to the difference between the selling price and the FMV at the time of exercise.
• Short-term capital gains (shares sold within 12 months) are taxed at 20% for employees of listed companies. For employees of unlisted companies, such gains are taxed according to the income tax rates.
• Long-term capital gains (shares sold after 12 months) are taxed at 12.5% on gains exceeding ?1.25 lakh.
• Example: If shares are sold within 12 months, and the gain is 10,000, then the tax is 2000 for employees of listed companies. If sold after 12 months and the tax is 1250, and below 1.25 lakh, then there is no tax.

• Taxation of foreign ESOPs is similar to domestic ESOPs.

Bottom line

Employee Stock Ownership Plans offer an avenue for employees and employers to become party to a company's success. Now that you know how ESOPs work, it must be clear how beneficial they are for employees and employers alike. Remember, pay heed to the vesting period, as it is the key to utilizing your ESOPs in the best way possible.

Need any help with company structure? Book a FREE 15-minute consultation for your company and get in touch with our brilliant team of legal and taxation experts. Get to www.jjfintax.com to know more.

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