What is ESOP?
An ESOP or an employee stock ownership plan is a tool used by companies to retain their key or valuable employees. Employees working at a certain grade in the company are rewarded with company shares.
Here are some features of an ESOP:
- Based on grade, payscale, service terms, and other factors
- Eligible employees are allocated a specific percentage of shares at a price lower than the market value.
- The shares are kept in a trust
- When the employee leaves the company or retires, the company buys back the shares from the employee at the market price
- These shares are allocated to another eligible new or existing employee
- Employees become owners with this plan
- Improves employee productivity since they feel motivated as company owners
In the next section, we explain how an ESOP works, its benefits, and so on.
Understanding how ESOPs Work:
This is a step-by-step guide to how ESOPs function:
- Creation of Trust: The first step to creating an ESOP is creating a trust with either share of the company or funds for buying the shares. Companies get tax deductions on contributions to the trust.
- Allocation of Shares: After the trust is created, the shares are allocated to employees according to the number of years worked, compensation, or both factors. An employee needs to complete a year to be eligible for an ESOP.
- Vesting Period: The shares stay in the trust for a certain duration, called the vesting period. The employee can claim the shares only when the vesting period is over.
- Price on Vesting: The employee can buy the share at the agreed price below market value after the vesting period. Employees can sell the shares received as ESOP at a profit.
- Retirement Before Vesting: If an employee leaves or retires before vesting, the company needs to buy their shares within 60 days.
How do Employees Benefit From ESOPs?
Here are some ways in which employees can benefit from an ESOP:
Become Shareholders
With an ESOP, an employee becomes an owner of the company with a certain number of shares depending on their grade.
Earn Dividends
Companies distribute a percentage of their profits as dividends to existing shareholders. Employees can earn additional income through dividends apart from their salary and other benefits.
Get Shares at Lower Rates
Employees are allocated shares at a much lower rate than market value, making it both affordable and profitable for them to own shares.
What Do Employers Gain from ESOPs?
Employers also benefit from ESOPs in the following ways:
Retaining Employees
Since employees need to complete the vesting period to be eligible for ESOPs, the company can retain employees longer.
Higher Productivity
When the company does well, the price of its shares goes up. The employees who own shares through ESOPs feel motivated to perform at their optimal level since the value of their ESOPs also goes up.
Attracting the Best Talent
As an employee compensation tool, an ESOP helps attract the company's best talent. Start-ups use this tool since they cannot afford to pay high salaries to employees initially.
Now that ESOP meaning is clear, let's understand how they are taxed.
How is ESOPs Taxed?
Taxes are applicable at the following stages:
- At the time of vesting
- When selling the shares received as ESOP
Taxation of ESOP at the Time of Vesting
Let us understand how ESOPs are taxed when an employee buys the share at the end of the vesting period with an example.
| Date of Vesting | November 1, 2022 |
| Fair Market Value (FMV) | Rs. 670/share |
| Price of ESOP | Rs. 400/share |
| Amount to be taxed | Rs. 670 - Rs. 400 = Rs. 270/share |
| Number of Shares | 1000 |
| Total taxable value | 1000 x 270 = 2,70,000 |
| Tax Payable (at 30% tax slab) | 30% of Rs. 2,70,000 = Rs. 81,000 |
The Government has provided relief to employees of start-ups. The tax would not be payable in the year of vesting. TDS would be deducted at a later date which would be the earlier of the following dates:
- After 5 years are complete from the date of vesting of ESOP.
- The date on which the employee sells the ESOPs
- The date the employee leaves the company.
Taxation of ESOP When the Shares are Sold
The tax will be payable on capital gains when the shares are sold. The capital gains are calculated as the difference between the market value and the ESOP price.
Capital gains taxes are applicable as follows:
- Long-Term Capital Gains: When shares are sold after a year, the capital gains over Rs. 1 lacs are taxed at 10%.
- Short-Term Capital Gains: If shares are sold before a year, the capital gains would be taxed at 15%.
Capital gains of ESOP are explained here using the above example.
Short-Term Capital Gains:
| Exercise Date | November 1, 2022 |
| Fair Market Value on November 1, 2022 | Rs. 670 |
| Shares sold on February 1, 2023 | |
| Fair Market Value on February 1, 2023 | Rs. 900 |
| Capital Gains | Rs. 230 |
| Number of Shares | 1000 |
| Total Short-Term Capital Gain | 1000 x 230 = Rs. 2,30,000 |
| Tax @ 15% | Rs. 34, 500 |
Long-Term Capital Gains
If the employee sells the shares on December 31, 2023, then the long-term capital gains on the sale of ESOP will be calculated as follows:
| Fair Market Value (December 31, 2023) | Rs. 1000/- |
| The difference with the sale value of ESOP | Rs. 1000 - Rs. 670 = Rs. 330 |
| Number of Shares | 1000 |
| Total Long-Term Capital Gain (Rs. ) | 330,000 |
| Net taxable Long-Term Capital Gains (Rs.) | 330,000 - 1,00,000 = Rs. 230,000 |
| Tax Payable on net Long-Term Capital gains | Rs. 230,000 x 10% = Rs. 23,000 |
| Net gain for the employee (Rs) | 330,000 - 23,000 = Rs. 3,07,000 |
Conclusion
An ESOP is an employee benefit plan that is a strong employee motivation tool that benefits both the company and the employee. Companies benefit from higher productivity, and employees become company owners; therefore, it is a win-win deal for both the employers and the employees. However, not all types of ESOPs are the same. Actions and rules vary from one type to the other, which is why it is essential to be aware of the types to make the most out of this benefit.
Frequently Asked Questions (FAQs)
When is an Employee Eligible for an ESOP?
An employee must complete the vesting period to qualify for an ESOP. Employees buy the share from the company when they leave the company or retire after completing the vesting period.
How is the Number of ESOPs Decided?
The factors that are considered for allocating ESOPs to employees include the number of years of service and pay scale. Since these are performance-based employee benefit plans, the top performers are eligible for more ESOPs.
Do Employees Have to Pay Tax on ESOPs?
Yes, employees have to pay taxes on ESOPs. These taxes are applicable at the time of vesting when the employee receives the ESOPs. The difference between the ESOP's fair market value and the ESOP's price is multiplied by the total number of shares received to arrive at the tax payable. The rate is based on the tax slab of the employee.
Employees have to pay a tax for a second time at the time of selling the share. Short-term capital gains taxes are applicable if the share is sold within a year. Long-term capital gains taxes are payable if the shares are sold after a year.
Why Do Companies Offer ESOPs?
Companies offer ESOPs to new employees to attract new talent. They are also offered to high performers to boost productivity. This employee benefit plan helps retain employees since they need to complete the vesting period to receive the ESOP.