Employee Stock Option Plan: Meaning, Benefits & Taxation

7 min read • Published 2 February 2023
Written by Krishna Deshmukh
Employee Stock Ownership Plan (ESOP)

In recent years, we have witnessed the increase in the number of startups in different fields. Many of these budding firms are offering various benefit programmes to retain talented employees. Other than salary hikes and incentives, companies can offer Employee Stock Options Plans (ESOPs). These encourage employees to stay longer with the organisation, as they have more to benefit by contributing to the organisation’s growth.

If you are considering a position that offers ESOPs with your salary package, the thought of taxation of the same must have  definitely crossed your mind. 

Read on to learn how ESOPs work, their benefits and details of ESOP taxation

What Are ESOPs?

Employee Stock Option Plans (ESOP) fall under employee benefit plans that companies offer to their employees. With this plan, employees receive ownership rights of their company’s stocks which can be redeemed at a set date in the future. ESOPs allow employees to purchase their company’s shares at a discounted price. 

However, not all employees are eligible for ESOPs. It is the employer’s decision to select the employees who will receive ESOP privileges.  These decisions are made by employers on the fulfilment of certain conditions like reaching a set target or getting a promotion. Upon eligibility, employees get a nominal right to these stock options.

An ESOP benefit remains an option until the employees exercise their rights. However, employees cannot exercise their rights on ESOPs until a minimum predetermined period, known as the vesting period, as mentioned in the employment contract ends. Afterwards, they can purchase the company shares at a price lower than their fair market value. By doing so, employees gain a part of their company’s ownership.

Employees can choose to sell these shares in the market when the time seems favourable and earn profits from it. However, one must note that employees are not obliged to exercise their rights on these stock options.

To exercise rights in these stock options, employees must work under the same employer for the entire vesting period. One must note that promoters and directors of a company are not eligible for ESOPs. 

How Does ESOP Work?

The working of ESOP are mentioned as follows:

  • At first, employers plan on the volume of stock options they wish to share with employees.
  • Following this, they plan and nominate the names of employees who will receive these shares.
  • The employees’ names are announced by the staff and they can purchase these options at a predetermined price or exercise price on the grant date. 
  • However, employees must wait till the vesting period ends to exercise their rights over these stock options. Until then these, stocks remain in the company’s trust.
  • It is to note that, if employees are fired or quit their job during this vesting period, they will lose these stock options. 
  • After the vesting period is over, nominated employees can exercise their ESOPs to purchase the company’s shares at the exercise rate. This amount is likely to be lower than the current price of the shares also known as Fair Market Value or FMV. 
  • After purchasing, employees can hold on to these stocks or sell them immediately to make profits as per their preference.

How Are ESOPs Beneficial for Employees?

The following list highlights some of the essential benefits of ESOPs for employees.

  • ESOPs ignite a sense of ownership among employees

Employees get a part of their company’s ownership by exercising their ESOP rights. This acts as a motivation for them to work hard. In addition, employees gain a sense of belonging, which influences them to work toward  the overall growth of the organisation . 

  • ESOPs act as a retirement benefit for employees

If employees do not exercise their stock options after the vesting period, they can hold them on for long-term benefits. After the vesting schedule ends, employees in a public company can choose to hold these stock options and use them as a part of their individual retirement fund. In this way, they will get the benefits in the future.

  • ESOPs act as an additional income

ESOPs turn to shares after an eligible employee exercises them at a discount price after the vesting schedule. They can choose to sell these shares at Fair Market Value when the market value of these shares is favourable. Employees earn a good profit by selling them at a price higher than their exercise price. 

Moreover, employees can benefit from their company’s dividends if it is a publicly-listed company. These work as additional income along with their regular salaries.

Taxation of Returns on ESOPs

Owing to their merits, ESOPs are becoming popular amongst many Indian companies. Earlier, only big companies provided ESOPs to their senior employees. However, now many start-ups provide ESOP with a standard salary package to their best employees. Here is what you must know about taxation rules on ESOP

ESOP taxation occurs under these two circumstances. 

  1. When an employee exercises stock options

When an employee exercises an ESOP, the difference between its fair market value  and exercise price is called pre-requisite. This pre-requisite amount is taxed when employees exercise their rights over stock options after the vesting period. 

Further, employers will deduct your TDS upon this pre-requisite amount. The same will get reflected on the employee’s Form 16.

For example, let’s say Company XYZ Pvt. Ltd. allocates 10,000 shares to Mr Roy as stock options. The fair market value of these shares on the exercise date is ₹300 per share, and exercise price is ₹10. So, when Mr Roy purchases these shares, its pre-requisite value is ₹(300-10) *10,000= ₹29,00,000. This amount will be taxed as per Mr Roy’s income tax slab. 

  1. When an employee sells ESOPs for capital gains

The profits that employees earn from selling their stocks become their capital gains. The value is determined by calculating the difference between selling price of their shares in the market and their market value on the exercise date.

Things to Consider about ESOP Taxation

To properly understand ESOP taxation, it is necessary to keep the following things in mind:

  • Long and short term capital gains

The tax implication of your gains from ESOP depends on the holding period of your shares. The period between the exercise date and the sale date is called the holding period. 

For listed shares, capital gains by selling shares after holding for one year are taxed at 10% (without indexation). This long-term capital gains tax is applicable on profits above ₹1,00,000 under Section 112A of the IT Act. Short-term capital gains are taxed at a 15% rate according to Section 111A of the IT Act.

Unlisted shares have a minimum holding period of 2 years. According to Section 112A of IT Act, long term capital gains for unlisted shares are subject to 20% taxation with indexation. Meanwhile, short-term capital gains are taxed according to the investor’s income tax slab rates.

  • Disclosures

If employees working in foreign companies are awarded ESOPs, they must provide details of their foreign holdings while filing ITR in India.  This process is referred to as disclosure. This is a mandatory step for resident taxpayers who own ESOP and RSU under overseas firms.

Final Words

Most companies and organisations offer ESOP as an add-on to their standard salary package. This helps attract and retain qualified individuals to fill the key positions of the organisation. 

If you are offered a position that has the benefit of ESOPs in addition to your salary, you should carefully consider the value and potential of the company’s shares. You should also make sure to understand the rules of ESOP taxation before deciding on an ideal salary package.

Frequently Asked Questions

Who is entitled to Employee Stock Option Plans?

Permanent employees of organisations working inside or outside India can gain from an ESOP. Apart from this, an employer can grant ESOP to any employee based on their performance. 

What rights do I get on exercising ESOP?

You will receive a share certificate to exercise your rights on ESOP (purchasing the awarded stock options); however, you may or may not acquire voting rights.

What determines the prices of ESOPs?

To determine the prices of their ESOPs, companies hire third-party valuation firms. These valuation firms gather  information about the company to judiciously calculate the prices of ESOP.

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Krishna Deshmukh

Investment Principal
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk. learn more

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