An employee stock ownership plan (ESOP) grants employees company shares, often based on the duration of their employment. Typically, it is part of a compensation package, where shares will vest over a period of time.
ESOPs are designed so that employees’ motivations are aligned with the company’s growth. From a company’s perspective, ESOPs have certain tax advantages, along with incentivising employees to focus on the company performance.
ESOPs are perhaps one of the most important types of employee compensation. From the standpoint of a startup, it helps to preserve liquidity, and from the perspective of an employee, it is a reward for loyalty.
Definition of ESOP
ESOP is a form of employee benefit plan that encourages employees to buy shares in the firm or become shareholders. The employer offers the employee specific company stocks for no or little cost, which stay invested in the ESOP trust fund until the employee's options vest and they execute them, or they exit the firm.
Consider the case of an employee who has been working at a big software company for five years. They have the right to obtain 20 shares after the first year under the company's employee stock ownership plan, and a total of 100 shares after five years. When the employee retires, the value of their stock will be paid to them in cash.
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Understanding ESOP Taxation
When a specified time period from the date of grant has passed, shares are vested in the employees (vesting), which means that the employee has an unrestricted right to receive the shares. Once such alternatives have been granted to the employee, he has the right to exercise them (exercise).
When an employee exercises his or her stock options, the company allots shares to the employee (allotment). In India, ESOPs are awarded in accordance with the SEBI Guidelines of 1999.
ESOP taxes are determined at two levels:
1. A first levy occurs when an employee's shares are allotted to him after he has exercised his option and the vesting period has ended
The difference between the fair market value of the shares on the exercise date and the amount paid by the employee for the exercise or subscription to the shares is computed and taxed at the time of allotment of shares on the exercise date. Perquisite value is the name given to this taxable worth.
2. When an employee chooses to sell his or her ESOP authorised shares, a second charge is imposed
When an employee sells the shares that were given to him under an ESOP, he must pay tax on any earnings or gains that result from the transaction. Such profit is subject to taxation under the heading of "Capital Gains." Capital gains are further divided into two categories: ‘Short Term Capital Gains' and ‘Long Term Capital Gains,' depending on how long the shares have been held.
It can be said that an ESOP is a way for employees to invest in their employer's business. The plan's objective is to match workers' interests with the interests of the company's shareholders.
Employees are elevated from employees to owners of the firm when they are given a share in it. Employees are motivated to perform better since they are shareholders as well. In the company meetings, the possession of shares determines the voting power. Since senior workers are given more shares than newly hired employees, the latter have less voting power at shareholder meetings.