What are ESOP’s?

ESOP (Employee Stock Ownership Plan) is a part of an employee compensation package that gives employees ownership stake in their employing company. The idea behind offering ESOPs to employees is to align their interest with the owners of the company. When the employees work for the long-term sustainability of the company, both the employee and owner of the company can benefit.

How do ESOPs work?

ESOP’s provide the rights to the employees to buy shares at fixed price, which is lower than the market price, at future specified date. Let’s take an example of an employee working in a tech company. The tech company has offered an ESOP compensation plan to its employees to buy shares at ₹1,000 per share (exercise price) after 3 years from now. This 3-years waiting period to earn the right to buy the shares is called vesting period. The date on which the vesting period expires is known as vesting date.

Also, ESOP only grants an option to an employee to buy the stocks during the fixed period (exercise period). He may also choose not to buy the shares. Also, an employee can sell the allocated stock anytime or after the specified lock-in period is over.

Tax Treatment of ESOPs

ESOP’s are treated as perquisite and taxed at two different events in the hands of the employee. When any employee exercises their option to buy stock, they pay tax on the difference between the ESOP exercise price and fair market value of stock. Again, when the employee sells that stock, he incurs the capital gain tax liability when his selling price is higher than the fair market value on exercise date.

In India, for the purpose of tax treatment, if the holding period of unlisted stocks is less than 2 years, any gain would be treated as short-term capital gains and any gain on unlisted shares which are held for more than 2 years would be treated as long-term capital gain.

Conclusion

ESOP’s have proved to be an effective tool in motivating employees to work for long-term goals of the company. During recessions and business slowdown, ESOPs help companies to attract and retain high-quality talent. They can be particularly useful for cash-strapped companies to attract the right talent and stem staff attrition rates. During the pandemic, many Indian startups like Zomato, Grofers, Oyo offered ESOP’s to their employees to compensate for pay-cuts to retain talent. Besides, ESOP’s provide sponsoring company and beneficiary employees various tax benefits and can create financial freedom for its employees in the long run.