All you need to know about ESOPs
ESOPs, the term that gives employees the power of ownership in the firm, has been a buzzword lately. Especially since Finance Minister Nirmala Sitharaman’s second Union Budget laid emphasis on the same. While it helps retain good talent and provides cost-effective company benefit, the tax burden ESOPs in India impose on employees and the complex legalities surrounding them is cause for concern.
What are ESOPs?
ESOPs stands for Employee Stock Ownership Plans. An employee stock ownership plan gives workers ownership interest in the company. There are two types of ESOPs:
- Selective plans -The facility of owning some shares of the company is made available only to senior executives.
- All employee plans -The facility of owning some shares of the company is made available to all employees of the company.
Employee Stock Ownership Plan is a benefit scheme for the employees. However, the company or organisation puts stipulation on the employee, such as a particular amount of time of service, to gain the benefit of buying shares.
Why and how companies offer ESOPs
Companies offer stocks to employees in a phased manner. They do this to attract qualified employees to the organisation. The stocks are provided to the employees at the end of the financial year as an incentive for the work done throughout the year and in order to ensure they remain in the respective company or organisation. Many times, startups and companies that cannot provide high pay package provide stocks of the company to their employees.
The Employee Stock Ownership Plan is taxed at two different stages:
While exercising – in the form of a prerequisite. In this option the difference between the Fair Market Value and exercise price is taxed.
While selling – in the form of capital gain. The employee can sell the shares received; however, there is a certain time period only after which the employee can sell the shares. At the time of selling, if the employee gets money higher than that of Fair Market Value then he/she will be liable to pay the Capital Gains Tax. The amount of Capital Gains Tax is determined on the period of holding, i.e. from the date of exercise, to the date of sale.
Benefit of ESOPs to employers
When the employees are rewarded with stocks, they act as an incentive for them to put in their 100 percent of hard work and efforts as they themselves will also benefit when the price of their company’s shares soar up.
Rewarding the hard work and dedication of the employee’s work is necessary, but giving them stock would also remove the necessity of providing cash incentives to the employees at the same time.
The issue with ESOPs
ESOPs come with complex rules and regulations. Companies that provide it to the employees must have a proper administration system that works towards providing stock ownership to the employees. If a company does not have staff or help to look into the administration of ESOPs then it may invite certain risk issues. Upon establishing ESOPs the company must have proper administration, staff, including third-party administration, legal costs, and trustees. It must be aware of the costs that will be incurred while providing this facility.
Disadvantages of ESOPs
Often, the employees invest a large part of their savings in one investment scheme, which is not advisable. Any person saving more than 10 percent of his/her salary is warned by the investors. It is not logical to save a large amount of savings in company’s stocks, in case the company fairs poorly or runs into losses and an employee loses out on a huge amount of savings. Also, there are many unanswered accounting procedures when it comes to ESOPS. Hence the factor of uncertainty is always there.
There are a couple of tribunal decisions that are not in sync with the thought process of tax authorities but the settled fact is that ESOPs are taxable as capital gains in a circumstance where they are not exercised but transferred and the point of taxing the ESOPs is not on the day it was exercised but the date of actual allotment of the shares when ESOPS are exercised.
An ESOP plan is one of the best ways for a startup to attract and retain talent. However, the best structure to grant ESOPs is a private limited company. Hence, it is important to know all about ESOPs.
(Edited by Evelyn Ratnakumar)
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)