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What is ESOP? Full Form, Meaning, Taxation, Benefits & How Does It Work

Updated on: Jun 12th, 2023


7 min read

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The full form of ESOP is "Employee Stock Ownership Plan". Employee compensation has progressed beyond the basic wage package provided by businesses. Employees are now given much more than just pay stubs; one such benefit is the Employee Stock Ownership Plan (ESOP).

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 does an Employee Stock Ownership Plan (ESOP) work?

An organisation grants ESOPs to its employees for buying a specified number of shares of the company at a defined price after the option period (a certain number of years). Before an employee could exercise his option, he needs to go through the pre-defined vesting period which implies that the employee has to work for the organisation until a part or the entire stock options could be exercised.

Employees can use their ESOPs to purchase business stock at allowed prices that are lower than the market value. Employees can also sell shares purchased through ESOPs and profit from their investments.

If an employee leaves or retires before the vesting term, the corporation must purchase back the ESOP at fair market value within 60 days.

Cost of ESOPs and Distributions

Legal fees, accounting fees, and administrative expenditures may be included in the initial costs of an Employee Stock Ownership Plan (ESOP) in India.

The cost of establishing and sustaining an ESOP varies according to the plan's size and complexity.

Furthermore, ESOP distributions in India may occur in a variety of ways.

When an employee exercises their stock option to obtain shares, they have the option of selling them immediately or storing them for future appreciation.

If the employee decides to sell the shares, the proceeds, less any taxes due on the gain, will be sent to them. If the employee agrees to keep the shares, they will own a piece of the company and may be eligible for dividends or capital gains if the stock price rises.

Why Company offers ESOPs to their employees?

Organisations often use Employee stock ownership plans as a tool for attracting and retaining high-quality employees. Organisations usually distribute the stocks in a phased manner. For instance, a company might grant its employees the stocks at the close of the financial year, thereby offering its employees an incentive for remaining with the organization for receiving that grant. Companies offering ESOPs have long-term objectives.

Not only do companies wish to retain employees for the long term, but also intend to make them the stakeholders of their company. Most of the IT companies have alarming attrition rates, and ESOPs could help them bring down such heavy attrition Start-ups offer stocks for attracting talent. Often such organisations are cash-strapped and are unable to offer handsome salaries. But by offering a stake in their organisation, they make their compensation package competitive.

ESOPs from an employee’s perspective

With ESOPs, an employee gets the benefit of acquiring the shares of the company at the nominal rate, and selling them (after a defined tenure set by his employer) and making a profit. There are several success stories of an employee raking in riches together with founders of the companies. A very notable example is Google when it went public. Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions too.

ESOP Taxation

ESOPs have dual tax effects:

  • When an employee exercises their rights and purchases company stock
  • When the employee sells the stock after purchasing it

Let's take a closer look at these examples:

Tax treatment at the time of buying the shares

Employees can purchase shares after the vesting date at a price less than the share's Fair Market Value (FMV) on that date. As a result, the difference between the FMV and the exercise price of the share is considered a pre-condition in the employee's hands and taxed at his income tax slab rate.

However, in the case of new businesses, the government has softened the tax implications of ESOPs.

Employees at the start-up would not have to pay the tax on the perk in the year in which they exercised the ESOP. TDS on ESOPs would be delayed until the sooner of the following dates:

  • Five years from the date of the ESOP grant
  • When does the employee sell the ESOP?
  • Date of departure from the company

Tax treatment at the time of selling the shares

If the employee sells the shares, the difference between the selling price and the FMV on the date the share was exercised is taxable as capital gains.

If you sell your shares within a year of buying them, you will have to pay a 10% tax on any profits over Rs.1 lakh. If the shares are sold within 12 months, the profits are taxed at 15%.

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

Benefits of ESOPs for the employers

Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee to put in his 100%. Although motivation, employee retention and awarding hard work are the key benefits which ESOP brings to employers, there are several other noteworthy advantages too. With the help of ESOP options, organisations could avoid cash compensations as a reward, thus saving on immediate cash outflow. For organisations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.

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.

However, after the company is listed, employees have additional possibilities to cash out their shareholdings. Furthermore, market changes influence the FMV.

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