ESOP (Employee Stock Ownership Plan) vesting and exercise refer to the process by which employees can acquire and sell company stock that has been granted to them as part of their compensation package.
In this article, we will take a look at what to keep in mind when exiting or selling ESOPs. First, it is important to understand how ESOPs work.
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How do ESOPs work?
Vesting refers to the process by which an employee becomes entitled to ownership of the company stock over time. Typically, ESOPs have a vesting schedule, which specifies how long an employee must work for the company before they can take ownership of the stock. The vesting schedule may be based on a number of factors, such as the employee's tenure with the company or their performance.
Once an employee has vested in their ESOP shares, they can exercise their options to purchase the stock. This means they pay the strike price (the price at which the stock was initially granted) to acquire the shares. The employee can then choose to hold onto the stock or sell it.
When an employee exercises their ESOP options, they would be subject to taxes on the difference between the strike price and the fair market value of the stock at the time of exercise. If the employee holds onto the stock and sells it later, they may also be subject to capital gains taxes on any profits they make. Here are things to keep in mind when exiting ESOPs.
1. Exit in tranches: One should always exit in tranches or in portions. So, on one hand, one should be able to reap the benefits of growth, while one should not hold on forever just to make profits.
2. Tax planning (STCG vs LTCG): When selling the shares, one should keep in mind the impact of the short-term capital gains and the long-term capital gains tax. Short-term capital gains is taxed at the normal tax slab. So, when one is in a tax slab of 30%, short-term capital gains will be taxed at 30%.
However, the long-term capital gain is lower at 20% for unlisted shares and 10% for listed shares. So, if you have held your shares for 11 months or 23 months, it makes sense to hold them for another month, so that you can pay lower taxes. Keeping this in mind will help you make tax-efficient decisions.
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3. Cash flow for tax: This one is a very practical move. When your ESOP is vested according to the schedule, and when you exercise your option, then you have to pay taxes and transfer the shares to your demat account. Then one should sell only that much so that their tax costs are covered and they do not have to pay anything from their own pocket. Along with it, they should also keep the above points (LTCG vs STCG) in mind.
4. Stage of the company (Series A, Pre IPO or IPO): As mentioned earlier, you should sell in tranches. If the IPO is near and you sell it post the IPO, then you get the tax benefits of listed shares. Also, When an IPO comes, the prices are good, and it has been seen that after an IPO, prices mostly tend to go down. In the case of IPO-bound companies or for companies who have a plan for an IPO, you should save some shares for selling post the IPO. Even after the IPO, it should be sold in two to three tranches.
5. Consider other avenues of tax saving: When you have long-term capital gains, other avenues of tax savings open up for you. For example, u/s 54F, tax exemption is allowed on long-term capital gains earned from selling a capital asset other than property. So, if you have long-term capital gains out of selling ESOPs, you can reinvest the sales proceeds towards the purchase or construction of a house property.
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The long term capital gain on the sale of the shares will be allowed as an exemption u/s 54F. Here, it is important to note that as per the Union Budget 2023, a maximum of ₹10 crore will be allowed as a deduction u/s 54F.
Keeping the above points in mind will help you make the right decisions when exiting ESOPs.
BM Singh, ESOP Expert & Managing Partner, BMSA Consultancy
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