EMPLOYEE STOCK OPTION PLANNING
Punit Bhandari
Punit Bhandari, is a Qualified Chartered Accountant-
Senior Partner, M/s Bhatia Bhandari Associates
His Expertise: Taxation, Audits, SAP Implementation & Non-Resident Investment Solutions
An ESOP is a benefit plan that allows employees to purchase shares in their company at a predetermined price. It is a form of employee compensation that ties part of their wages to the company’s success.
How does Employee Stock Option Planning work?
An ESOP works in the following way:
- Grant of options: A company offers employees the right to purchase a specified number of shares at a predetermined exercise price. The grant date is the day the company grants the option to the employee.
- Vesting Period: Options are subject to a vesting period during which employees become entitled to exercise them. The vesting period is usually several years and may require the employee to meet certain performance metrics.
- Exercise of Options: Once options have vested, employees may exercise them within the specified exercise period. For exercising the options, the employee pays the exercise price and receives company shares in return.
- Sale of Shares: After the options are exercised, the employee can choose to hold the shares or sell them. If the current market price is higher than the strike price, the employee can sell the shares at a profit.
- Expiration of Options: If the employee does not exercise the option during the exercise period, the option expires and the employee loses the right to purchase the shares.
It can be complex and have tax complications. Employees are advised to consult with a financial advisor or tax professional before exercising their options.
What are the tax implications of ESOP?
The tax implications of employee stock option plans (ESOPs) can be complex and vary depending on the specific plan and the tax laws of a given country. Here are some general principles that often apply:
- Grant of options: Typically, there are no immediate tax implications when options are granted. However, this may depend on local tax laws and the specific structure of the ESOP.
- Exercise of options: When an employee exercises their options (ie buys shares at the exercise price), they may be liable to pay income tax. The basis of the tax is usually the difference between the fair market value of the shares at the time of exercise and the exercise price.
- Sale of Shares: When an employee sells shares, he may have to pay capital gains tax. The basis of the tax is generally the difference between the sale price and the fair market value of the shares at the time of exercise.
Because of the complexity and potential financial impact of these tax consequences, employees are strongly encouraged to consult with a tax professional before making decisions about their ESOPs.
Having discussed the types of tax implications associated with ESOPs, we will now illustrate these concepts through an example.
This example gives a brief idea of the tax implications of ESOP.
EXAMPLE:
Consider an employee who is granted 1,000 options at an exercise price of ₹ 50 per share under your company’s ESOP. This is known as a grant and usually has no tax implications at this stage.
After a certain vesting period, the employee decides to exercise your options when the market price of the stock is ₹150. This means you buy 1,000 shares at a strike price of ₹50, for a total cost of ₹50,000. However, the market value of these shares is ₹150,000 (1000 shares multiplied by ₹150 per share).
The difference between the market value and the exercise price, ₹100,000 (₹150,000 – ₹50,000), is treated as necessary income (or benefit) and is taxable at the rate of income tax in the year of exercise.
Later you decide to sell the shares when the market price is ₹200 per share. The sale proceeds are ₹200,000 (1000 shares multiplied by ₹200 per share). The difference between the sale proceeds and the market value at the time of exercise, ₹50,000 (₹200,000-150,000), is treated as a capital gain and subject to capital gains tax.
The following example illustrates the tax treatment associated with option exercise.
Suppose you are granted an option to buy 1,000 shares at a strike price of ₹100 per share. When you choose to exercise this option, the FMV of the stock is ₹ 150 per share. The difference of ₹50 per share is treated as salary income. Thus, the taxable income from the ESOP exercise would be:
Taxable Income = Number of Shares × (FMV Per Share – Exercise Price Per Share)
Substitution of values:
Taxable Income = 1000 x (₹150-₹100) = ₹50,000. This ₹50,000 will be added to your salary income for that financial year and taxed at the income tax rate applicable to you.
Tax treatment at the time of selling shares:
The below illustration is based on tax treatment at the time of selling shares, The difference between the sale price of the shares and their Fair Market Value (FMV) at the time of exercise is considered as capital gains. This amount is subject to capital gains tax.
Suppose you exercised an option and bought 1,000 shares at an exercise price of ₹100 per share. At the time of exercise, the FMV of the shares was ₹150 per share. Later, you decide to sell these shares when the market price is ₹200 per share.
The capital gain from the sale of the ESOP shares would be:
Capital Gain=Number of shares×(Sale Price per share−FMV per share at the time of exercise)
Substituting the values:
Capital Gain=1,000× (₹200−₹150) =₹50,000
This ₹50,000 will be considered as capital gains and will be subject to capital gains tax. The rate of capital gains tax depends on how long you held the shares before selling them. If you held the shares for more than one year, it’s considered as long-term capital gains, otherwise, it’s considered as short-term capital gains. The tax rates for long-term and short-term capital gains can be different.
Calculation of ESOP
Calculating the value of an employee stock option plan (ESOP) involves several steps and depends on various factors. Here’s a basic way to calculate the potential value of your ESOP:
- Number of options: This is the number of shares you have the option to buy. Your employer will provide you with this information when granting the ESOP.
- Exercise Price: This is the price at which you can buy shares in the ESOP. Again, your employer will provide you with this information.
- Estimated Future Stock Value: This is an estimate of what the stock will be worth in the future when you plan to sell it. This can be difficult to predict and may require assumptions about the company’s future performance.
- ESOP Value: The potential value of an ESOP is the difference between the estimated future value of the stock and the total cost of exercising the options.
Here is the formula:
ESOP Value= (Number of Options × Estimated Future Value per Share) − (Number of Options × Exercise Price per Share)
For example, if you have options on 1,000 shares with a strike price of ₹100 per share and you estimate that the shares will be worth ₹200 in the future, the potential value of the ESOP would be:
ESOP Value= (1000×₹200) −(1000×₹100) =₹100,000
Eligibility Criteria for ESOP
- Full-time employees are usually eligible for an ESOP, while part-time or temporary employees are not.
- Many companies require employees to remain with the company for a certain period before becoming eligible for an ESOP.
- Some companies may tie ESOP eligibility to job performance and offer it as a reward for meeting certain performance metrics.
- In some cases, ESOPs may only be offered to certain positions within the company, such as executives or key employees.
- Ultimately, the decision to grant an ESOP is often at the company’s discretion, and the company may consider other factors in addition to those listed here.
If you’re an employee interested in your company’s ESOP, the best course of action would be to speak with your Human Resources department or review your company’s policy documents.
Benefits of ESOP for Employees
Employee Stock Option Plans (ESOPs) offer several benefits to employees. Here are some of the key benefits:
- Financial Rewards: ESOPs allow employees to share in the company’s financial success. If the company is doing well and its stock price is rising, the employees can benefit financially.
- Ownership: Through ESOP, employees can become shareholders of the company and get an ownership stake. This can create a sense of belonging and motivation as employees can directly benefit from the company’s success.
- Retirement Savings: In some cases, an ESOP can be used as a form of retirement savings. Employees can potentially sell their shares back to the company or the market when they retire, providing a source of retirement income.
- Tax Benefits: Depending on the specific plan and the country’s tax laws, ESOPs may offer certain tax benefits. For example, in some cases, income from the sale of ESOP stock may be taxed at a capital gains rate that may be lower than the ordinary income tax rate.
- Attraction and Retention: Offering ESOPs can help companies attract and retain talented employees. ESOPs can be an attractive benefit that differentiates a company from its competitors.
The value of an ESOP is tied to the company’s performance, so if the company is not performing well, the value of the ESOP may decrease. Employees should carefully consider these risks and consult a financial advisor before deciding on an ESOP.
Benefits of ESOP for employers
The benefits of ESOPs are not limited to employees; employers also derive significant advantages.
Let us see the benefits of ESOP for employers:
Employee stock option plans (ESOPs) can also offer several benefits to employers. Here are some of the key benefits:
- Employee Retention: ESOPs can be a powerful tool for retaining key employees. The vesting period encourages employees to stay with the company longer to take full advantage of the ESOP.
- Employee motivation: By giving employees an ownership stake in the company, ESOPs can align employee and company interests and motivate employees to work for the company’s success.
- Attract talent: ESOPs can make a company more attractive to potential employees. They can be a competitive advantage in the labour market and help attract top talent.
- Tax Benefits: Depending on the country’s tax laws, companies may receive tax benefits for setting up an ESOP. For example, in some countries, the costs of setting up an ESOP may be tax deductible.
- Succession Planning: For private companies, ESOPs can be a useful tool for succession planning. They can provide a way to gradually transfer ownership to employees.
- Improved Company Performance: Research has shown that companies with ESOPs often outperform those without, likely due to increased employee productivity and motivation.
This article has provided an overview of how Employee Stock Option Planning (ESOP) functions, along with its associated tax implications, benefits, and valuation methods. I would like to conclude this article by stating that Employee Stock Option Plans (ESOPs) are an important part of many companies’ employee compensation strategies.
They offer a unique combination of benefits for employees and employers. For employees, ESOPs provide an opportunity to share in the company’s financial success, which can lead to significant financial rewards.
They also promote a sense of ownership and alignment with company goals. For employers, ESOPs can be a powerful tool for attracting and retaining talent, motivating employees, and even facilitating succession planning. However, ESOPs also come with challenges and risks, and their value is closely tied to company performance. Therefore, it is important that both parties carefully consider these factors and seek professional advice when dealing with an ESOP. As with any financial decision, a thorough understanding of the implications and potential outcomes is key to making informed ESOP decisions.
