Employee Stock Option Plans (ESOPs) have become a cornerstone of employee compensation, especially in startups and established companies. Designed to attract, retain, and reward employees, ESOPs offer a chance to become a company shareholder and benefit from its growth. Let’s dive into the mechanics of ESOPs and explore their tax implications.
The calculation of ESOP perk for tax purposes depends on the type of ESOP and the vesting schedule.
For non-qualified ESOPs:
The employee is taxed on the fair market value of the shares when they are allocated to the trust. This is considered as ordinary income and will be taxed at the employee’s marginal tax rate.
For example, let’s say you are granted 100 shares of non-qualified ESOP with a fair market value of $10 per share. You will be taxed on $1,000 (100 shares * $10 per share) when the shares are allocated to the trust.
For qualified ESOPs:
The employee is taxed on the difference between the fair market value of the shares when they are allocated to the trust and the purchase price of the shares. This is considered as capital gains and will be taxed at a lower rate than ordinary income.
For example, let’s say you are granted 100 shares of qualified ESOP with a fair market value of $10 per share. The purchase price for the shares is $8 per share. You will be taxed on $200 (100 shares * ($10 – $8)) when the shares are allocated to the trust.
Here are the steps on how to calculate the ESOP perk for tax purposes:
- Find the fair market value of the shares.
- Determine if the ESOP is non-qualified or qualified.
- If the ESOP is non-qualified, the employee is taxed on the fair market value of the shares.
- If the ESOP is qualified, the employee is taxed on the difference between the fair market value of the shares and the purchase price of the shares.
=IF(ESOP_Type = “Non-Qualified”, Fair_Market_Value * Number_of_Shares, (Fair_Market_Value – Purchase_Price) * Number_of_Shares)
Where:
- ESOP_Type is a text string that indicates whether the ESOP is non-qualified or qualified.
- Fair_Market_Value is the fair market value of the shares.
- Number_of_Shares is the number of shares that are being granted.
- Purchase_Price is the purchase price of the shares, if applicable.
For example, if the ESOP_Type is “Non-Qualified”, the Fair_Market_Value is $10 per share, and the Number_of_Shares is 100, the formula would return $1,000. This is because the employee is taxed on the fair market value of the shares, which is $10 per share, multiplied by the number of shares, which is 100.
If the ESOP_Type is “Qualified”, the Fair_Market_Value is $10 per share, and the Purchase_Price is $8 per share, the formula would return $200. This is because the employee is taxed on the difference between the fair market value of the shares, which is $10 per share, and the purchase price of the shares, which is $8 per share, multiplied by the number of shares, which is 100.
How ESOPs Work:
- Drafting of ESOP Scheme: Employers draft an ESOP plan detailing conditions, vesting periods, exercise prices, and other terms.
- Board Approvals: Legal compliances are met, including board or shareholder resolutions for listed companies, adhering to SEBI guidelines.
- Grant of Options: Eligible employees receive grant letters specifying grant dates, vesting details, and exercise prices.
- Vesting of Options: The period between grant and eligibility for option exercise. Factors like service duration and performance affect vesting.
- Exercise of Options: After vesting, employees can exercise options and convert them into company shares.
Tax Implications of ESOPs:
a) At Exercise:
- Taxable Perquisite: The difference between the Fair Market Value (FMV) of shares on exercise date and the exercise price is taxed as a perquisite.
- FMV Calculation:
- Listed Shares: The average of opening and closing prices on the exercise date on recognized stock exchanges.
- Unlisted Shares: FMV determined by a merchant banker on the “specified date” within 180 days before exercise.
- Tax Withholding: Employers withhold tax on perquisites, which affects an employee’s net in-hand salary.
- Concession for Eligible Start-ups: Start-ups can withhold tax within 14 days of specific events, easing the impact on net salary.
b) At Sale of Shares:
- Shares allotted under ESOPs are considered capital assets. Gains from selling these shares are subject to capital gains tax.
- Long-term Capital Gains: For unlisted shares, holding for more than 24 months qualifies as long-term capital assets. For listed shares, the period is over 12 months.
- Tax Rates: Long-term gains on listed shares exceeding INR 1,00,000 are taxed at 10%, and short-term gains are taxed at 15%. Unlisted long-term gains are taxed at 20% for residents and 10% for non-residents.
Additional Reporting:
- Employees need to report details of shares held in unlisted companies in their income tax returns.
- Shares of foreign companies allotted under ESOPs also require reporting, along with certain disclosures in Schedule FA and Schedule AL.
ESOPs offer a unique opportunity for employees to align their financial success with their company’s growth. However, the intricacies of tax implications can be complex. Seek advice from tax experts to ensure you navigate the world of ESOPs effectively and make informed financial decisions.