2. What is ESOP
• An ESOP (Employee stock
ownership plan) refers to an
employee benefit plan which offers
employees an ownership interest in
the organisation.
• ESOPs give the sponsoring
company—the selling shareholder—
and participants various tax benefits,
making them qualified plans, and are
often used by employers as
a corporate finance strategy to align
the interests of their employees with
those of their shareholders.
3. How does an ESOP Work
• An ESOP is usually formed to facilitate succession planning in a
closely held company by allowing employees the opportunity to
buy shares of the corporate stock.
• ESOPs are set up as trust funds and can be funded by
companies putting newly issued shares into them, putting cash
in to buy existing company shares, or borrowing money through
the entity to buy company shares. ESOPs are used by
companies of all sizes, including a number of large publicly
traded corporations.
• Contrary to what some people say, companies with an ESOP
must not discriminate and are required to appoint a trustee to act
as the plan fiduciary. Among other things, it is not possible for
senior employees to receive more shares or for ESOP
participants to have no voting rights.
4. Why Company offers ESOPs
to their employees?
• Organisations often use Employee stock ownership plans as a
tool for attracting and retaining high-quality employees.
Organisations usually distribute the stocks in a phased manner.
For instance, a company might grant its employees the stocks at
the close of the financial year, thereby offering its employees an
incentive for remaining with the organization for receiving that
grant. Companies offering ESOPs have long-term objectives.
• Not only do companies wish to retain employees for the long
term, but also intend to make them the stakeholders of their
company. Most of the IT companies have alarming attrition rates,
and ESOPs could help them bring down such heavy attrition
Start-ups offer stocks for attracting talent. Often such
organisations are cash-strapped and are unable to offer
handsome salaries. But by offering a stake in their organisation,
they make their compensation package competitive.
5. Benefits of an ESOP
• 1. Tax benefits for employees
• One of the benefits of Employee Stock Ownership Plans is
the tax benefit that employees enjoy. The employees do
not pay tax on the contributions to an ESOP. Employees
are only taxed when they receive a distribution from the
ESOP after retirement or when they otherwise exit the
company. Any gains accumulated over time are taxed as
capital gains. If they elect to receive cash distributions
before the normal retirement age, the distributions are
subject to a 10% penalty.
6. • 2. Higher employee engagement
• Companies with an ESOP in place tend to see higher
and involvement. It improves awareness among employees
given the opportunity to influence decisions about
Employees can see the big picture of the company’s
make recommendations on the kind of direction the
ESOP also increases employee trust in the company.
7. • 3. Positive outcomes for the company
• Employee stock ownership plans not only benefit the
in positive outcomes for the company. According to
Comparison Study conducted by Rutgers University, the
resulted in a 2.4% increase in the annual sales growth,
growth 2.3%, and increased the likelihood of company
organizational performance increases the share price of
ultimately, the balance in each employee’s ESOP account.
8. Disadvantages of ESOP
• Price per share has limitations
• Timing
• Share values are inconsistent
9. ESOP Taxation
• ESOPs have dual tax effects:
• When an employee exercises their rights and purchases
company stock
• When the employee sells the stock after purchasing it
10. The Bottom Line
• ESOPs are generally a win-win for employers and employees,
encouraging greater effort and commitment in exchange for
bigger financial rewards. However, they are not always
straightforward and can be frustrating if the participant doesn’t
fully understand the terms of their particular plan.
• Not all ESOPs are the same. Rules on actions such as vesting
and withdrawals can vary, and it’s important to be aware of them
to make the most of this benefit and not potentially miss out on a
big extra bonus.
An Employee Stock Ownership Plan (ESOP) refers to an employee benefit plan that gives the employees an ownership stake in the company. The employer allocates a certain percentage of the company’s stock shares to each eligible employee at no upfront cost. The distribution of shares may be based on the employee’s pay scale, terms of service, or some other basis of allocation.
The shares for an employee stock ownership plan are held in a trust unit for safety and growth until the employee exits the company or retires. After their exit, the shares are bought back by, and thus returned to, the company for further distribution to other employees.
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When a company wants to create an Employee Stock Ownership Plan, it must create a trust in which to contribute either new shares of the company’s stock or cash to buy existing stock. These contributions to the trust are tax-deductible up to certain limits. The shares are then allocated to all individual employee accounts. The most common allocation formula is in proportion to compensation, years of service, or both. New employees usually join the plan and start receiving allocations after they’ve completed at least one year of service.
Once ESOPs are offered, they remain in a trust fund for a specific period, called the vesting period. Employees should stay with the organization for the vesting period to avail the ownership of stock by exercising the ESOP.
Once the vesting period expires, employees get the right to exercise their ESOPs. The date on which the vesting period expires is called the vesting date.
The shares in an ESOP allocated to employees must vest before employees are entitled to receive them. Vesting, in this case, refers to the increasing rights that employees receive on their shares as they accumulate seniority in the organization.
When employees who are members of the ESOP leave the company, they ought to receive their stock. Private companies are required to buy back the departing employee’s shares at fair market value within 60 days of the employee’s departure. Private companies must have an annual stock valuation to determine the price of the shares. Where some longstanding employees are exiting the company, and the share price has accumulated substantially, the company needs to make certain that is has enough money to pay for all the share repurchases.
EXAMPLE
Consider an employee who has worked at a large tech firm for five years. Under the company’s ESOP, they have the right to receive 20 shares after the first year, and 100 shares total after five years. When the employee retires, they will receive the share value in cash. Stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others
Price per share is dependent upon the company's performance. Without viable profits, the value of the company decreases, which means the value of shares may fluctuate. ESOPs are most beneficial to employees with companies that have an established management plan, producing predictable and consistent financial results.
In order to get the most value from ESOPs, employees may have to time their exit based on company performance. Exiting the company when the stock value is lower will result in a lower payout. Therefore, it's important to consider the timing when deciding when to sell shares.
The value fluctuates with company success, and this can make planning for retirement challenging. Because of this inconsistency, if you have ESOPs for retirement, you may need to consider exploring other options in addition to this plan to ensure financial stability, such as a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA). These plans serve as additional income for individuals who hold ESOPs and are unsure or unable to predict the total value upon retirement.
Tax treatment at the time of buying the shares
Employees can purchase shares after the vesting date at a price less than the share's Fair Market Value (FMV) on that date. As a result, the difference between the FMV and the exercise price of the share is considered a pre-condition in the employee's hands and taxed at his income tax slab rate.
Tax treatment at the time of selling the shares
If the employee sells the shares, the difference between the selling price and the FMV on the date the share was exercised is taxable as capital gains.
If you sell your shares within a year of buying them, you will have to pay a 10% tax on any profits over Rs.1 lakh. If the shares are sold within 12 months, the profits are taxed at 15%.
Taxation of foreign ESOPs in India is also similar, and you would be taxed in India on the perquisites earned from a foreign company.
