Taxability of ESOP Under Income Tax Act: Exercise, Sale & Tax

ESOPs are getting attention, particularly among young startups. ESOP is a method to get motivated, engage, and incentivize the workforce. It enhances awareness among employees, as they are given the chance to influence decisions regarding the products and services of the company. The blog will explain the taxability of ESOP under income tax act in a simple way.

What is ESOP (Employee Stock Ownership Plan)?

An ESOP is a type of employee benefit plan that authorises employees to buy company stock at a price less than the market value, with the additional benefit of ownership interest. Employees with time can become equity shareholders in the company and benefit from its growth. ESOPs are normally granted to employees as an incentive at the end of the fiscal year.

They can motivate and appreciate employees by providing ownership of the company, which supports reducing employee turnover rates.

Functionality of ESOP

Initially, the company forms an ESOP trust and contributes cash to authorise employees to buy shares of stock from existing owners or the company itself at less than the fair market value. If the company has insufficient cash, then the ESOP can take out a loan to buy new or existing shares while the company contributes money to help pay off the loan.

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Thereafter, the employee obtains a share in the trust based on the number of years worked, compensation, or both. The share stays in the trust for a fixed period known as the vesting period, after which the employee can claim the shares. Later, the employee can buy the shares at the agreed price less than the fair market value, and sell them for a profit.

The company should buy back an employee’s shares within 60 days if they leave or retire before the vesting period.

Major Advantages of ESOP

Here we have mentioned the benefits of ESOP:

Favorable Growth of the Company

Rutgers University conducted the National ESOP Comparison Study, which discovered that companies that had chosen Employee Stock Ownership Plans (ESOPs) exhibited a 2.4% surge in annual sales growth and a 2.3% rise in annual employment growth compared to the non-ESOP companies. The study was based on a sample of more than 1000 companies, and the results were conducted across a range of industries and companies of distinct sizes.

Key Benefits for Employers

An effective way to retain employees is ESOPs, as they are required to wait out the vesting period before they can exercise their ESOPs. Also, furnishing the company’s shares encourages employees to increase productivity and make the company more profitable.

Generate Additional Income

When the company earns a profit, it is distributed among the shareholders in the form of dividends. Therefore, the employees earn additional income in the form of dividends.

Purchase Shares at a Discounted Price

When utilising ESOPs, employees get the opportunity to purchase the shares allotted to them at a very low price.

Taxation Benefits

ESOPs provide various tax advantages to companies and employees. Companies can make tax-deductible contributions to an ESOP trust to purchase company stock, and employees can defer paying taxes on the stock received via the ESOP until they sell it.

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Key Terms of ESOP

• This is when the employer provides the employee with the option to own the company’s shares at a later date.
• Once both parties agree, after completing specific conditions, the vesting date is when the employee is qualified to buy shares.
• It is the duration between the grant date and the vesting date.
• Once the vesting of stock is completed, the employee has the option to buy the shares within the stipulated time. The same period is said to be the exercise period.
• It is the date on which the employee utlises the option.
• The price at which employees use the option is stated as the exercise price. The same price is typically less than the fair market value of the stock.

ESOP Expenses and Distributions

In India, legal fees, accounting fees, and administrative expenses may be considered when setting up an Employee Stock Ownership Plan (ESOP). The cost of implementing and maintaining an ESOP can differ as per the plan’s size and complexity.

In India, ESOPs can be distributed in various ways. When an employee uses their stock options to acquire shares, they can either sell them immediately or hold onto them in the hope that their value will appreciate in the future.

If an employee decides to sell the shares, the proceeds after deducting applicable taxes on the profit are paid out to them. Conversely, if the employee chooses to retain the shares, they become a partial owner of the company and may be entitled to dividends or capital gains if the stock price rises. The structure and outcomes of ESOP distribution offer employees flexibility in managing their stock options.

Why Do Businesses Provide ESOPs to Employees?

ESOPs are frequently used by employers to retain high-quality employees. Companies typically distribute these stocks at the end of the financial year, which incentivizes employees to stay with the company and receive the grant.

Companies aim to retain their employees for the long term while also turning them into stakeholders. This also helps employers craft attractive compensation packages.

Why Do Employees Want to Receive ESOPs?

ESOPs enable employees to receive shares of the company at a lower rate and sell them at a higher rate. This increases their total salary package and allows them to earn huge profits.

Key Points to Know About the Taxability of ESOP Under Income Tax Act

• ESOP granted to an employee is non-taxable. However, when an employee acquires shares by exercising an ESOP, the difference between the ‘fair market value’ of the shares (on the date of exercise) and the ‘exercise price’ paid by the employee is taxable as a ‘perquisite’ (additional benefit) for the employee.
• If an employee sells the ESOP shares, the difference between the sale price and the fair market value of the shares on the date of exercise is considered as capital gains. If the shares are kept for less than 12 months, then the short-term capital gains are taxed at the applicable rate. If the shares are kept for more than 12 months, then the capital gains are long-term and are taxed at a lower rate. Note: Long-term capital gains of less than Rs 1.25 lakhs are exempt from capital gains tax.
• Under the ESOP scheme, employers can claim a tax deduction for the cost of the shares issued to employees. The deduction is available in the year the employee exercises the option and receives the shares.
• An employee receiving ESOPs from a qualifying start-up will not have to pay tax in the year they exercise the options. TDS on ESOPs can be deferred until whichever of the following dates comes first: expiry of 5 years from the year of allotting the ESOPs or the date of sale of ESOPs by the employee.

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FAQ’s Related to ESOPs