ESOPs: How They Work, Benefits, Costs, and Tax Implications
ESOPs, or Employee Stock Ownership Plan, is a program that provides a company’s workforce with an ownership interest in the company. Here’s a detailed breakdown:
What is ESOP?
An ESOP (Employee stock ownership plan) refers to an employee benefit plan which offers employees an ownership interest in the organisation. Employee stock ownership plans are issued as direct stock, profit-sharing plans or bonuses, and the employer has the sole discretion in deciding who could avail of these options. However, employee stock ownership plans are just options that could be purchased at a specified price before the exercise date. There are defined rules and regulations laid out in the Companies Rules that employers need to follow for granting employee stock ownership plans to their employees.
How an Employee Stock Ownership Plan (ESOP) Works
An Employee Stock Ownership Plan (ESOP) is a program that grants employees the right to purchase a specified number of company shares at a defined price after a certain period, known as the option period. Here’s a detailed look at how ESOPs work:
Establishment: The process begins with the company setting up an ESOP trust fund. This fund either purchases the company’s stock or receives shares directly from the company.
Funding: The company funds the ESOP through various methods, such as borrowing money to buy shares, directly contributing shares, or using cash to purchase shares. This funding is essential for acquiring the stock that will be allocated to employees.
Allocation: Once the ESOP trust holds the stock, it allocates shares to individual employee accounts. The allocation is often based on factors like salary levels or seniority within the company.
Vesting: Before employees can exercise their stock options, they must complete a pre-defined vesting period, which typically ranges from three to six years. During this time, employees gradually earn the right to more shares, incentivizing them to stay with the company and contribute to its success.
Exercise of Options: After the vesting period, employees can use their ESOPs to purchase company stock at a price lower than the market value. This provides a significant financial benefit as they can buy shares at a discount.
Selling Shares: Employees have the option to sell the shares they purchased through the ESOP. If the company’s stock has appreciated, employees can profit from the sale of their shares.
Ownership and Payout: When employees retire, leave the company, or in the event of their death, the company typically buys back their stock at fair market value. This buyback provides employees or their beneficiaries with the monetary value of their shares. If an employee departs before completing the vesting period, the company must repurchase the ESOP shares at fair market value within 60 days.
In summary, ESOPs provide a structured way for employees to gain ownership in their company, benefiting both the employees through potential financial gains and the company by fostering a committed and motivated workforce.
Cost of ESOPs and Distributions
Setting up and maintaining an Employee Stock Ownership Plan (ESOP) involves various costs. In India, these costs can include legal fees, accounting fees, and administrative expenses. The total cost depends on the size and complexity of the ESOP.
When it comes to ESOP distributions, there are several options. After an employee exercises their stock option to obtain shares, they can either sell the shares immediately or hold onto them for potential future gains. If they sell the shares, they will receive the proceeds minus any taxes owed on the profit. If they choose to keep the shares, they will own a part of the company and might receive dividends or benefit from an increase in the stock price.
ESOP Taxation
ESOPs have two main tax implications for employees:
At the Time of Purchasing Stock
When employees exercise their options and buy shares after the vesting period, they usually pay less than the market value of the shares. The difference between the market value and the purchase price is considered a benefit and is taxed as part of the employee’s income.At the Time of Selling Stock
When employees sell the shares, they must pay taxes on any gains from the sale.
For new businesses, the Indian government has eased some of the tax burdens associated with ESOPs. Employees at startups do not have to pay taxes on the benefit in the year they exercise the ESOP. Instead, tax deductions at source (TDS) on ESOPs are deferred to the earlier of the following:
- Five years from the date of the ESOP grant,
- The date the employee leaves the company,
- The date the employee sells the shares.
This makes ESOPs a more attractive option for employees in startups, as it allows them to defer taxes and potentially benefit from long-term gains in the company’s stock.
Benefits of ESOPs
Benefits for Employees
- Ownership Stake: Employees get a share in the company, allowing them to benefit from its success.
- Retirement Savings: ESOPs act like a retirement plan, helping employees save and build wealth as the company grows.
- Tax Advantages: Employees don’t pay taxes on ESOP shares until they receive them, usually at retirement.
- Job Stability: ESOP companies are typically more stable and less likely to lay off workers during tough times.
- Improved Benefits: Companies with ESOPs often offer better benefits than those without.
- Increased Engagement: Employees who own part of the company are usually more involved and committed to their work.
Benefits for Employers
- Succession Planning: Business owners can transfer ownership to employees, avoiding the need to sell to an outsider.
- Tax Savings: Contributions to the ESOP are tax-deductible, lowering the company’s tax bill.
- Financing Source: ESOPs can help finance the company, especially useful during buyouts.
- Improved Performance: ESOP companies often see better productivity and profits compared to non-ESOP companies.
- Talent Retention: Offering ESOPs can help attract and keep talented employees who appreciate the chance to own part of the company.
- Flexible Structure: ESOPs can be customized to fit the company’s specific needs and goals.
What will happen to ESOPs when the company is listed?
Selling shares purchased through ESOPs is difficult for unlisted companies since there may be few purchasers and the FMV is established by merchant bankers. Furthermore, capital gains are taxed in accordance with debt funds.
This means that shares sold within 36 months of exercising them generate short-term capital gains, which are taxed at your marginal tax rate. Long-term capital gains, defined as those generated after 36 months, are taxed at 20% with indexation.
An ESOP is a beneficial tool for both companies and employees, fostering a culture of ownership and potentially enhancing financial performance and employee satisfaction. However, it requires careful planning and management to mitigate risks and ensure its success.
However, after the company is listed, employees have additional possibilities to cash out their shareholdings. Furthermore, market changes influence the FMV.
Selling ESOP Shares
When to Sell: Employees can sell their ESOP shares after they leave the company.
Tax Treatment When Selling Shares: When an employee sells ESOP shares, they must pay taxes on the difference between the selling price and the Fair Market Value (FMV) at the time the shares were exercised. This difference is considered capital gains.
- Short-term Capital Gains: If shares are sold within a year of purchase, the gains over Rs. 1 lakh are taxed at 10%. If the shares are sold within 12 months, the gains are taxed at 15%.
- Long-term Capital Gains: If the shares are held for more than a year before selling, the profits are taxed at a lower rate of 10% on any gains over Rs. 1 lakh.
Taxation of Foreign ESOPs: The taxation rules for foreign ESOPs are similar. Employees are taxed in India on the benefits earned from ESOPs granted by foreign companies.
To read about the difference between ESOPs and Sweat Equity Shares click here.