What is ESOP Meaning, Benefits & How Do ESOPs Work?

ESOP, also known as an Employee Stock Ownership Plan, is an employee benefit program. Under this scheme, employers offer ownership of the organisation to employees. The employee can hold the company's stocks, which they can encash after a specified period or at a specified rate. 

However, employees must follow certain rules and regulations laid out by the organisation to avail themselves of the employee stock ownership plan benefits. The objective of ESOP is to align the interests of employees with other shareholders so they work harder to contribute to the success of the company.

Also Read: All You Need to Know About Employee Benefit Program

The process of employee stock ownership plans is straightforward. 

• Employers first determine the number of shares offered under the ESOP, their price and the beneficiaries. These ESOPs are then offered to employees, and a grant date is provided.
• Once the ESOP is offered to employees, they remain in a trust period for a specified period, which is also called the vesting period. During that period, the employee should remain with the organisation to exercise the ESOP and acquire stock.
• Once the vesting period is over, employees get the right to exercise their ESOPs. The date at which the vesting period is over or expires is called the vesting date. By exercising the ESOP, employees can buy the shares at an allotted price. 
• This allotted price is generally lower than the market value. Furthermore, employees can also sell the stocks they have bought through EOSPs and gain from their holdings. 

However, if an employee decides to leave the company or gets retired before the vesting period, the organisation is required to buy all the stocks of the EOSP at a fair market value within 60 days.

The initial cost of an employee stock ownership plan generally includes legal, administrative and accounting fees. The cost of maintaining an ESOP in an organisation may vary depending on the size of the company and the complexity of the plan.

Generally, companies offer ESOPs to employees with no up-front costs. The company holds the offered shares in trust for growth and safety until the employees part ways with the company or retire.

The distribution of ESOP generally takes place in various ways. When the employee exercises their EOSP, they have the right to sell the shares right away or store them for prospective appreciation. If the employees decide to sell the shares, they will receive the proceeds from the sale after subtracting any taxes due on the profit made from the sale.

However, if they decide to keep the shares, they will have a stake in the firm and will receive capital gains or dividends, if stock prices rise.

There are various ESOP benefits for employees, some of which are listed below:

• Stock ownership: One of the ESOP benefits for employees is they get the opportunity to own shares in the company, allowing them to participate in the company’s growth and success. This can create a sense of ownership and alignment with company goals.
• Dividend income: Another crucial ESOP benefit for employees is the opportunity to earn additional income through dividends.
• Buy shares at a discounted rate: When exercising an ESOP, an employee can buy shares at a nominal amount, usually lower than the market value. This allows them to invest in organisations at a preferential rate.
• Retirement savings: In some cases, employees can treat their stock options as a form of retirement savings. If the company's share price appreciates over time, it can provide a valuable financial resource for the future.

Also Read: Employee Benefits In India

The employee stock ownership plan is beneficial for employers as well. Some of the significant benefits of ESOPs are listed below:

• Employee retention: ESOPs help employers attract top talent, especially in competitive industries or startups that might not be able to offer high salaries. The promise of ownership in the company can be a powerful incentive. Furthermore, the vesting period encourages employees to stay with the company for a longer period.
• Employee loyalty: Another ESOP benefit for employers is that it helps in fostering a sense of ownership and belonging among employees, which can enhance loyalty and engagement. Employees who feel invested in the company's future are more likely to go the extra mile in their work.
• Better corporate culture: By making employees shareholders, ESOPs can help build a culture of collaboration, trust and shared purpose. Employees who are part owners are likely to have a stronger sense of commitment and pride in their work, improving overall company morale.

Cost-effective compensation: Another crucial ESOP benefit for employers is that it offers cost-effective compensation. It allows organisations to offer equity to employees rather than cash, which can be especially valuable for startups or growth-stage companies with limited cash flow. This reduces the immediate financial burden on the company while still offering employees a valuable benefit.

Employee stock ownership plan comes with dual tax implications, which are:

When employees exercise ESOP rights and buy the share of the company.

When an employee sells the shares after buying them.

Tax Implications: When Employees Buy the Share 

Employees can buy the share at a rate lower than the fair market value as of the date after the vesting period. However, the tax implication will be applied to the difference between the fair market value and the exercise rate. This difference will be taxable, depending on the employee tax slab rate. 

However, for startup owners, the government has relaxed the tax implications for EOSP. Basically, startup employees do not have to pay the tax perquisite for the year they exercise the EOSP. For them, TDS on EOSP would be deferred on the following date:

Date of leaving the company.

Completion of the 5 years from the ESOP grant date.

Date when employees sell the ESOP.

 Example of Tax Implication: When Employees Buy the Share 

Let us assume Rahul exercised his ESOP and bought shares after completing the vesting period on January 1, 2024. The fair market value of shares at that time was ₹150 per share, and his exercise price was ₹85 per share.

Now, the taxable perquisite of Rahul is = Fair Market Value (₹150) - Exercise Price (₹85)

Rahul needs to pay a tax of ₹65 per share. If he bought 1000 shares, the total taxable amount would be 1000* ₹65, which is ₹65000.

Let us assume Rahul's tax slab rate is 30%. Then, as per the income tax, he needs to pay ₹19500 to the income tax department. 

 Tax Implications: When Employees Sell the Shares

When an employee sells the shares, the tax implications will be applicable to the selling price of the shares and the fair market value when the share is exercised. This profit would be subject to capital gain tax.

If gains are earned from selling the shares after 12 months of buying them, a 10% tax rate would be applied on gains exceeding ₹1 lakh. However, if the shares are sold within 12 months, a 15% tax would be applied on gains.

 Example of Tax Implication: When Employees Sells the Share 

Scenario 1: Let us take the example of Arjun, who exercised ESOP on January 1, 2022. At that time, the fair market value of the share was ₹150 per share. However, Arjun decided to sell his share within 12 months on October 1, 2022. At that time, the price of the share was ₹165 per share. 

Now the tax implication of Arjun is = Actual market value (₹165) - Fair market value (₹150)

Arjun needs to pay a tax of ₹10 per share. However, Arjun bought 1000 shares. 

The total amount for short-term capital gain = 1000*₹10 = ₹10000

The tax slab for short-term capital gain is 15%, which means Arjun needs to pay a tax of ₹1500 to the income tax department.

Scenario 2: Mohit also exercised ESOP on January 1, 2022. At that time, the fair market value of the share was ₹150 per share. Mohit decided to keep the shares for a longer period.

He decided to sell his shares on February 2, 2023. At that time, the value of shares was ₹180 per share.

The tax implication of Mohit is = Actual market value (₹180) - fair market value (₹150)

Mohit needs to pay a tax of ₹30 per share. He bought 1000 shares.

The total amount for long-term capital gains for Mohit = 1000*₹30 = ₹30000

Since the long-term capital gain is below ₹1 lakh, Mohit does not need to pay any tax. However, if it had been ₹1 lakh, the 10% rate would have applied.

ESOP is crucial for both employees and employers. It helps employers attract and retain talented employees, create a better corporate culture and offer discounted stock acquisition. Furthermore, it also helps employees understand the complexity of ESOP.

In addition to this, organisations are also investing in various business insurance plans to keep their assets protected against unforeseen situations. Some of these business insurance plans, like group health insurance, offer great benefits to employers. They help keep their workforce engaged and boost their morale.

TATA AIG group mediclaim policy can be customised to the unique needs of organisations. Our group mediclaim policy offers standardised coverage to a group of people. 

Under the plan, a range of medical services, such as doctor visits, prescription medications, surgeries, etc, are included. Secure your workforce now with our group health insurance plan.

Can anybody get ESOP benefits? 

ESOPs are typically offered to company employees, and the eligibility criteria are determined by the company’s policy. Generally, key employees, senior management or those in specific roles may be selected to receive stock options as part of their compensation package.

 Is ESOP a risky option? 

Yes, ESOPs can be a risky option. The value of the stock depends on the company's performance and market conditions, so if the company’s value decreases or does not perform well, employees may end up with stock options that are worth less or nothing.

 Can I transfer my ESOP benefits if I change the company? 

Generally, ESOPs cannot be directly transferred if you change companies, as stock options are tied to your employment with the issuing company.