What are ESOPs and its Objectives

What are ESOPs and its Objectives

What are ESOPs?

Employee Stock Ownership Plans (ESOPs) involve granting some ownership stake in the company to employees (some or all) with a view to creating ownership attitudes and aligning their interests with that of the company and its shareholders. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans and Stock Purchase Plans.

Why do companies set up ESOPs for Employees?

Objectives and benefits:

  • It is a tremendous motivator and can get employees highly involved in their jobs and focused on corporate performance.
  • It is vital tool to attract and retain quality employees, fostering in them long term attitudes.
  • As a compensation tool, ESOPs offer rewards that can exceed the expectations of employees but are still affordable to the company as they are highly performance driven.
  • Internationally, ESOPs are used for granting retirement benefits to employees and as succession plan for owners.
  • Increasingly, sheer competition dictates setting up ESOPs for employees.
  • Strategically, economically, financially or philosophically ESOPs are a win-win combination.

What are the tax implications on ESOPs?

  • When the options are given by the company, there is no tax.
  • When the options get vested, there is no tax.
  • When the employee exercises his option of buying the shares, the difference between the market value and exercise value is treated as perquisite and is taxable as per the tax bracket that the employee falls in.
  • When the employee sells the shares, the profit is treated as capital gains. If the shares sold within one year, 15% capital gains tax has to be paid just like in the usual purchase and sale of shares. If the stock is sold after 1 year, there is no tax as it is considered as long-term.
  • If the employee has ESOPs of a company that is listed abroad, and sells the shares, short-term capital gains is added to income and one has to pay tax as per the tax slab that he/she falls into.
  • For long-term capital gains, 10% tax has to be paid without indexation benefit or 20% tax has to be paid with indexation benefit.

Taxability of ESOPs

Two stages Taxability of ESOPs as follows:

First stage is when the options are exercised by the employee.The benefit,which is the difference between the fair market value(FMV) of shares on the date of which the option is exercised and the amount at which the options were granted to the employee,is treated as a prerequisite as per income tax act 1961

Second stage is when the shares are sold or transferred by the employee in which case the difference between the sale consideration and the FMV of shares treated as capital gains and subjected to capital gains tax.

ESOPs can be of great value in the long run.ESOPs are one of the ways to participate in equities.Companies can give ESOPs to employees when they are short on cash as an incentive.Employees will be more focussed on delivering results as they have a stake in the company.
ESOPs may not be suitable for people who do not want to take risk. Sometimes ESOPs may backfire resulting in very less or no value for the employee. If you want liquidity, ESOPs are not the best option as there are many rules regarding when to exercise your options. There are also tax implications which should be considered carefully.

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