Accounting and Tax Treatment of Employee Stock Option Plan

Experts from Taxmantra shed some light

As a founder, you would always want to hire the best of resources for your startup, but the problem is that the best has cost attached to it, which a startup may not be able to afford initially.  Thus, Employee Stock Option Plan (ESOPs) gives a solution to the founders, by which they can look to instill founder’s motivation among their founding team by offering stake in the business by way of ESOPs.

From long term perspective, Employee Stock Option Plan is considered as a good management tool for retention of human talent. Under this scheme, employees are provided stake in the company in the form of shares / options at reduced price than what prevails in the market. The personnel can exercise the options only after the vesting period elapses.

In this article, we have focused on the accounting and taxation treatment of ESOPS.

Accounting Treatment of ESOPs

Employers use share-based payments as a part of remuneration package for their employees. Hence the employers engaged in such arrangements with employees recognize the cost of services received over the requisite service period. The accounting value is determined by finding either fair value of the option or intrinsic value of the option. Intrinsic value means the excess of the fair value of the share at the date of grant of the option over the exercise price of the option. Fair value of an option means the market price of the option, had it been traded in the market.

When we account for employee stock options, following new accounts come into existence:

  • Employee compensation expense account – It forms part of the compensation expense account and is taken in the profit and loss account.
  • Deferred employee compensation expense – This account is created at the time of grant of options for the total amount of compensation expense to be accounted. This account is a part of the Balance sheet and forms a negative balance in the Shareholders equity or Net worth.
  • Employee Stock Options Outstanding account – It is a part of the Shareholders equity and is transferred to Share Capital, Share Premium or General Reserves. Amortized employee stock compensation expenses are taken in the Profit and loss account.

Calculation of Compensation Expense / Cost: The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest. This cost is recognized over the requisite service period with a corresponding credit to Employee Stock Options Outstanding account. The number of instruments expected to vest is estimated at the service inception date, and is revised during the requisite service period to reflect subsequent information. Total compensation cost is also revised accordingly. Employees earn the right to exercise the option after the completion of the vesting period, which is generally the service condition. The requirement that an individual remain an employee for that period is a service condition. An explicit service condition is explicitly stated in the terms of share-based arrangements (e.g., three years of continuous employee service from January 3, 2012). The objective of accounting for transactions under share-based arrangements with employees is to recognize compensation costs related to employee services received in exchange for equity instruments issued.

The Accounting treatment discussed above can be illustrated by the following numerical example.

Options granted – 500 on 01/04/2012 at Rs. 40

Vesting Period – 2 years.

Fair Value of options: Rs. 15

Fair Value per share: Rs.10

Hence, Total Employee Compensation Expense – Rs. 7500 (500×15)

The accounting entries would be as follows:

Employee Compensation Expense A/C   7500

Employee Stock Options Outstanding A/C 7500

(This entry to be made every year till the vesting period expires)

And in the year of exercising the option, the entry would be:

Bank A/C (Amount actually received)

Employee Stock Options Outstanding A/C

Equity Share Capital A/C

Security Premium A/C (if any)

Tax treatment of ESOPs

For tax purposes, ESOP benefits received by the employee will be taxable as perquisite. It will be the difference between the fair market value (FMV) of the shares on the date of exercise of the options less the exercise price. However it shall be taxable only when shares are allotted under ESOPs.

Where shares in the company are listed on a single recognised stock exchange then FMV shall be the average of opening and closing price of shares on the date of exercise of option. However, if on the date of exercise of option there is no trading in shares, the FMV shall be the closing price of the share on any recognised stock exchange on a date closest to the date of exercise of option and immediately preceding such date of exercise of option.

Where shares in the company are not listed on a recognised stock exchange then FMV shall be such value of the share in the company as determined by a category I merchant banker registered with SEBI on the specified date.

Specified date means the date of exercise of option or any date earlier than the date of exercise of option, not being a date which is more than 180 days earlier than the date of exercise of option.

The deductor can claim deduction for the compensation (as well as other expenses) is from firm’s gross income to arrive at its taxable income. Hence the deduction is allowable in the year in which the option is exercised by the employees i.e. when the liability became certain and not proportionately over the vesting period as claimed by the employee.

Startups and other businesses feel free to visit Taxmantra.com for comprehensive accounting and taxation assistance.

Alok Patnia

Alok Patnia

Alok Patnia founded Taxmantra.com to understand and address the pain points of individuals, businesses and startups. He is an expert in handling taxation issues, has great insights on the business startup issues such as choosing right business entity and also has vast experience in the field of business maintenance services such as accounting, auditing, company law compliances, service tax and other related fields. He is a qualified Chartered Accountant and a commerce bachelor from St. Xavier’s College having post qualification exposure with Ernst and Young and KPMG at Bangalore.