Understanding Employee Stock Ownership Plans (ESOPs): Definition, Function, Taxation, and Advantages

An Employee Stock Ownership Plan (ESOP) represents a modern approach to employee remuneration, moving beyond traditional salary packages. Businesses now frequently offer ESOPs as a key benefit, providing employees with a stake in the company's future.

Understanding ESOPs

An ESOP is a benefits program designed to give employees a direct ownership share in their company. These plans can manifest as direct stock allocations, profit-sharing schemes, or bonuses. While employers decide eligibility, ESOPs primarily provide options to buy company shares at a pre-determined price before a specific exercise date. Companies must adhere to established rules and regulations, particularly those outlined in the Companies Rules, when issuing these plans.

Operational Mechanics of ESOPs

Companies provide ESOPs, enabling employees to acquire a set number of company shares at a fixed price following a specified option period, which typically spans several years. Prior to exercising these options, employees must satisfy a predetermined vesting period, meaning they must remain employed with the organization until a portion or all of their stock options become exercisable. Employees can utilize their ESOPs to buy company shares at advantageous prices, often below current market value. Subsequently, they have the opportunity to sell these acquired shares and realize profits from their investment. Should an employee depart or retire before completing the vesting term, the company is generally obligated to repurchase the ESOPs at their fair market value within 60 days.

ESOP Expenses and Payouts

Initial expenses associated with implementing an Employee Stock Ownership Plan in India can encompass legal, accounting, and administrative fees. The overall cost of setting up and maintaining an ESOP fluctuates based on its scale and intricate nature. In India, ESOP distributions can take several forms. Upon exercising a stock option to acquire shares, an employee has the choice to either sell them immediately or retain them, hoping for future value appreciation. If the shares are sold, the employee receives the proceeds after deducting applicable taxes on the profit. Should the employee choose to hold the shares, they gain partial ownership of the company and may become eligible for dividends or capital gains if the stock's value increases.

Employer Motivation for Offering ESOPs

Companies frequently deploy Employee Stock Ownership Plans as a strategic instrument for drawing in and keeping top-tier talent. These organizations typically distribute shares in stages. For example, a company might issue shares at the end of a fiscal year, thereby encouraging employees to stay with the firm to receive their full grant. Businesses implementing ESOPs generally pursue long-term goals, aiming not just to retain staff but also to foster a sense of shared ownership. In sectors like IT, where attrition rates can be high, ESOPs can be instrumental in reducing employee turnover. Furthermore, startups often leverage stock options to attract skilled individuals. Since these nascent businesses may face cash flow constraints preventing competitive salaries, offering equity ownership can significantly enhance their compensation packages.

Employee Benefits from ESOPs

From an employee's viewpoint, ESOPs provide the advantage of purchasing company shares at a favorable rate. After a tenure determined by the employer, employees can then sell these shares for a profit. Numerous accounts exist of employees accumulating substantial wealth alongside company founders through these plans. A prominent illustration is Google's initial public offering, where not only founders Sergey Brin and Larry Page became immensely wealthy, but many stock-holding employees also achieved millionaire status.

Tax Implications of Employee Stock Ownership Plans

ESOPs involve two distinct tax events: when an employee exercises their right to acquire company shares, and subsequently when those purchased shares are sold.

Taxation Upon Share Acquisition

After the vesting date, employees can purchase shares at a price below the Fair Market Value (FMV) on that day. The disparity between the FMV and the exercise price is treated as a perquisite for the employee and is subject to their applicable income tax slab rate. However, for emerging businesses, the government has eased the tax burden on ESOPs. Startup employees are exempt from paying tax on this perquisite in the year they exercise their ESOPs. The Tax Deducted at Source (TDS) on ESOPs is deferred until the earliest of these events:

• Five years following the ESOP grant date.
• The date the employee sells the ESOP.
• The employee's date of leaving the company.

Taxation Upon Share Sale

If an employee sells the shares, the difference between the selling price and the FMV on the exercise date is subject to capital gains tax. Selling shares within a year of purchase incurs a 10% tax on profits exceeding Rs. 1 lakh. If shares are sold within 12 months, profits are taxed at 15%. Similar taxation rules apply to foreign ESOPs in India, meaning perquisites earned from a foreign company are taxable in India.

Employer Advantages of ESOPs

Companies offer stock options primarily to motivate their workforce. Employees are encouraged to perform optimally, as they directly benefit from an increase in the company's share price. While boosting motivation, retaining talent, and recognizing diligent effort are core advantages for employers, ESOPs also present other notable benefits. These plans allow organizations to provide rewards without immediate cash outlays, conserving vital working capital. For businesses initiating large-scale operations or undergoing expansion, ESOPs often serve as a more practical and feasible reward mechanism compared to cash bonuses.

ESOPs Post-Company Listing

For unlisted companies, liquidating shares acquired via ESOPs can be challenging due to a limited pool of buyers and the fair market value (FMV) being determined by merchant bankers. Capital gains are also taxed similarly to debt funds in this scenario. Shares sold within 36 months of exercise result in short-term capital gains, taxed at the individual's marginal income tax rate. Long-term capital gains, applicable to shares held for over 36 months, are taxed at 20% with indexation benefits. Once a company becomes publicly listed, employees gain more avenues to divest their shareholdings, and the FMV is then influenced by dynamic market conditions.