Everything You need to Know About ESOP

employee stock ownership plan — (source: inc42)

Every employee is valuable to an organisation since their hard work can help the company succeed in the industry. ESOP’s full form is Employee Stock Ownership Plan, which offers ownership interests to the employees. It encourages employees to increase their security by purchasing stocks of the company. Therefore, the meaning of ESOP is connected to tax benefits to the selling shareholders and buying participants of the stocks.

Are you an employee who wishes to purchase your organisation’s stocks? We will find out all about ESOP and its benefits with this article!

What Is ESOP?

There have been frequent discussions and concerns regarding employee security in the longer term. When employees support an organisation with their loyalty, they expect security in return. ESOP is a relevant employee benefit plan. If one wonders “what is ESOP?”, it can be explained as a form of employee stock ownership plan. Organisations issue such plans as bonuses, direct stock or profit-sharing plans.

Therefore, the meaning of ESOP concerns employees' abilities and rights to go above the essential employee compensations and the decision to purchase company stock. Employees can choose the appropriate option and buy it at a fixed price before the exercise date. Employees looking to purchase such stock ownership plans need to follow regulations in Companies Rules. Employers have complete discretion in granting such requests from the employees.

Now, one might think, “how does an ESOP work?” Usually, when an organisation and its shareholders mutually deem it necessary, they allow employees to buy a specific number of shares at a fixed price after the option period. A predefined vesting period is applicable before an employee can exercise the option of purchasing shares. It means that employees have to work for the organisation until they can exercise the stock options.

What Are the Benefits of ESOP?

As you already know, ESOP stands for Employee Stock Ownership Plan. It means that one can connect the benefits of ESOP with stocks and taxation. When considering the employer perspective, the following ESOP benefits might motivate an organisation and the employers.

1. Employee Retention

Companies aim to retain employees for a long time, and the motivation of ESOP can help them do so. Business owners unable to offer handsome salaries can avoid an alarming attrition rate by offering ESOP and distributing stocks in a phased manner. Employees usually give 100% in the quality of their performances when they have a stake in the company's wellbeing and its success.

2. Financial Assistance

Organisations avoid additional cash compensations, such as a hike and bonus as a reward, thereby saving cash outflow. ESOP financially encourages staff longevity. Moreover, as employees stay longer for the company, employers save money on hiring, recruiting and training new employees.

3. Tax Advantage

ESOPs are useful for initiating tax deductions in organisations. For instance, stock contribution to ESOP taxation can be tax-deductible, enabling company leadership to gain a cash flow advantage with new stock. Dividends and loan repayments can also be tax-deductible in ESOPs.

4. Share Market

Business owners create ESOP to maintain a stable share market for their business. It allows companies to issue new shares to employees as required for gaining funds or buying through tax-deductible loans and cash payments. Moreover, employee ownership also enables employers to shift company control towards employees, bringing employees and employers on the same line.

Thus, as individuals come to know about the meaning of ESOP, they can easily understand that it is highly advantageous for most growing businesses. On the other hand, one cannot undermine the benefits of ESOP for employees.

5. Increased Security

When employees receive ESOP, they are liable to gain a share of the company. It naturally increases their security for the future, as they can benefit from the company's success. It increases their interest in the workflow and helps them give a more extended period in one company.

6. Delayed Taxation

One of the significant benefits of ESOP for the employees might be tax advantages. Similar to a 401(k), ESOP enables employees not to pay taxes on the value of their ESOP contribution until they retire. In other cases, if they cash out their plan before retirement, they will have to clear the taxes.

7. Retirement Planning

While retiring, employees might worry about the payments for accumulating company stock. However, another advantage of ESOP is in a no-cost retirement plan. It enables employees to be exempted from paying anything while getting shares of company stock.

8. Management Buyouts and Diversification

ESOP financing allows employees to repay their acquisition tax with pre-tax money. It enables employees to use ESOP as an effective financial tool for management buyouts. Moreover, employees over 55 years of age or with ten years of ESOP participation can diversify a portion of their ESOP benefit accounts.

What Happens to ESOPs When the Company Is Listed?

Usually, ESOP concerns the ability of employees to become a part of an organisation’s success story. However, several organisations consider enlisting their names under Initial Public Offerings (IPO). In this journey, they use ESOPs to align the interests of employees with that of stakeholders for long-term growth. Instances are also rare for companies implementing cash-settered stock incentive plans in their initial years, but they choose to implement ESOP before going IPO.

In this regard, the differences between the ESOP scheme for private companies and listed companies can be observed. Primary legislation Companies Act, 2013 is responsible for governing ESOP for listed and unlisted companies. They are subject to following Rule 12 of the Companies. SEBI SBEBSE Regulations, 2021 state that no company can make a new grant involving share transfer to the employees before its IPO listing. However, they can do so with the help of Pre-IPO schemes after getting them ratified by their shareholders.

Employees of unlisted companies have limited liquidity to cash out on their stock options. It is because employers expect employees to show greater efficiency and commitment and thereby reap the benefits of ESOP. Thus, once a company becomes an IPO, employees can exercise their vested ESOPs and encash their shares at market price. Employees need to list it immediately upon exercise in stock exchanges if any share arises out of ESOP after the IPO.

How Does Tax Implication for ESOPs Work?

Now that you understand ESOP meaning, you might be wondering, "what are ESOP shares?” In this regard, one can observe that the amount of ESPOs taxation when selling the shares is determined by the difference between sale value and fair market value.

ESOPs are usually taxed at two instances, as listed below.

At the time of exercise: ESOP is taxed as a perquisite when employees agree to exercise this option. Here, the taxation amount comes from the difference between the FMV and exercise price. The employer can deduct the TDS amount on this perquisite.

At the time of sale by the employee: If the employee ever decides to sell the shares he/she once bought, another tax event occurs here. ESOP is charged as a capital gain here, which is the difference between the sale price and FMV on the exercise date.

Thus, this concept connects with ESOP taxation in India. The following types of shares are common in this regard.

Listed shares

When organisations hold ESOPs for less than 12 months, profit made on the listed share is treated as short term capital gains and taxed at 15%. However, if ESOPs are sold after 12 months, the profit on the listed share is considered long term capital gains.

Unlisted shares

In such cases, when shares are held for 24 months, profits made on them are treated as long term capital gains. They are taxed at about 20% with indexation.

Now, let us check the taxation process in ESOP as discussed in the following.

The 1st level of taxation

In this stage, ESOPs are taxed as perquisites. The value is calculated as follows.

Value on the allotment date = (FMV per share – Exercise price per share) x number of allotted shares

The 2nd level of taxation

Individuals deciding to sell their shares will be liable to paying capital gain tax. The calculation will be as follows.

Capital gains = Sale proceeds – FMV of shares at the time of share allotment

Various Stages of ESOP /Units/ Exercise Price	Rate of Tax/FMV of a Share	Tax to be Paid
Grant/100/100	Nil/120	Nil
Vesting/100/100	Nil/150	Nil
Exercise/100/100	Income tax slab rate/170	Tax = 30% x 100 shares x (₹170 - Rs 100) = ₹2100 and 3% cess
Sale of shares if listed/20/Nil	15% on short term capital gains/250	Tax =15% x 20 shares x (₹250 - Rs170)= ₹240 and 3% cess
Sale of shares if listed/80/Nil	Exemption of long term capital gains/300	Nil, exemption of long term capital gains on listed shares is
Sale of shares if unlisted/20/Nil	Income tax slab rate/250	Tax =30% x 20 shares x (₹250 - ₹170)= ₹480 and 3% cess
Sale of shares if unlisted/20/Nil	20% tax on long term capital gains after cost indexation/300	Tax = 20% x 80 shares x (₹300 - ₹170CII for 2016-17/CII for 2014-15) = 20% x 80 x (300 - 1701125/1024) = ₹1811 and 3% cess

Therefore, you can observe the importance of ESOP regarding employee future and organisation expansion. It has its fair share of benefits for both employers and employees. However, several complicated rules and regulations are applicable for the plan, which organisations should decipher properly before implementing.

Frequently Asked Questions

✓ Is ESOP good for employees?

ESOPs are often considered one of the essential remunerations for the employees. It helps to maintain liquidity and form an employee perspective. With their increasing loyalty, employees create a secured future.

✓ Can I cash out my ESOP?

Employees usually are permitted to cash out their ESOPs. However, it depends on the terms listed in the ESOP plan guidelines.