What is ESOP in Salary

What is ESOP in salary, and why is it significant? Employee Stock Option Plans (ESOPs) are a pivotal element of contemporary compensation packages, offering employees a share in the company's prosperity. ESOPs in salary align employee interests with those of shareholders, acting as a potent motivational instrument. They enable employees to partake in the company's growth and profitability, thus playing a crucial role in attracting and retaining top talent. Furthermore, ESOP in salary reflects a company's acknowledgement of the value employees contribute, enhancing its appeal as a compensation tool.

Understanding ESOP terms

1. ESOP: (Employee Stock Option Plan) ESOP is a plan granting employees the right to buy company shares at a predetermined price. This price is typically lower than the market price, providing employees with an opportunity to purchase shares at a discount.
2. ESPP: (Employee Stock Purchase Plan) A plan allowing employees to purchase company shares at a discounted price. Employees can often purchase shares directly from their paycheck, making it a convenient way to invest in the company.
3. RSU: (Restricted Stock Unit) A type of equity compensation that grants employees shares upon meeting certain conditions, such as staying employed for a specified period or achieving performance goals. RSUs typically vest over a period of time.
4. Grant Date: The date the employee is offered the option to purchase company shares. This is when the terms and conditions of the ESOP or ESPP are established.
5. Vesting Date: The date the employee can exercise their option to purchase company shares. This is usually after a specified vesting period, during which the employee must meet certain conditions to earn the right to purchase the shares.
6. Vesting Period: The vesting date refers to the time employees must wait before they can exercise their options and own shares, ensuring their long-term commitment to the company.
7. Exercise Period: The ESOP exercise period refers to the time during which the employee can exercise their option to purchase company shares. This period typically lasts for a few years after the vesting date.
8. Exercise Date: The date the employee actually purchases the company shares. This is when the employee pays the exercise price and receives the shares.
9. Exercise Price: The predetermined price at which the employee can purchase the company shares. This price is typically lower than the market price, providing employees with a discount.
10. FMV: (Fair Market Value) The current market price of a company's shares. This is the price an investor would pay to purchase the shares on the open market.

Cost of ESOPs and distributions

• Grant price: The price at which options are offered to employees, often at a discount compared to the current market price, making it an attractive component of their salary.
• Vesting period: The time employees must wait before they can exercise their options and own shares, which ensures their long-term commitment to the company.
• Exercise price: The price employees pay to convert their options into shares, typically set at the grant price, which can lead to significant financial gains if the company's stock price rises.
• Fair market value: The value of the company's shares at the time of exercise, which determines the potential profit for employees when they sell their shares.
• Taxation: ESOPs are taxed at two stages - when options are exercised and when shares are sold, impacting the net benefit to employees.
  

Why do companies offer ESOPs to their employees?

Companies offer ESOPs as they act as lucrative rewards for their employees. ESOPs can be a key differentiator in attracting skilled professionals in competitive job markets. They also help in retaining employees. The vesting period associated with ESOPs encourages employees to stay with the company for a longer duration. By giving employees a stake in the company, their interests are aligned with those of shareholders, motivating them to drive company performance. ESOPs also serve as a reward for employees' dedication and hard work, recognising their contributions to the company's success. Lastly, offering ESOPs allows companies to provide competitive compensation packages without the immediate cash outlay required for higher salaries.

ESOPs from an employee’s perspective

• Ownership stake: Receiving ESOPs in their salary package gives employees a sense of ownership and investment in the company's future.
• Financial gain: There is a potential for significant financial rewards if the company's value increases, making ESOPs a valuable component of their compensation.
• Long-term investment: ESOPs encourage employees to think long-term, aligning their personal financial goals with the company's growth trajectory.
• Tax benefits: ESOPs receive favourable tax treatment, making them an attractive part of salary packages.
  

Benefits of ESOPs for employers

• Employee motivation: ESOPs serve as a powerful motivator for employees. When employees know they have a stake in the company through stock options, they are more likely to be invested in the company's success. This sense of ownership can drive employees to work harder, innovate more, and contribute positively to the company's growth. As a result, employers benefit from increased productivity and improved performance, which can lead to higher profits and a stronger competitive position in the market.
• Talent retention: One of the key challenges for employers is retaining top talent. ESOPs can be an effective tool in this regard. The vesting period associated with ESOPs encourages employees to stay with the company for a longer duration to reap the benefits of their stock options. This long-term commitment reduces employee turnover, saving the company the time and expense of recruiting and training new hires. Additionally, the promise of future financial rewards through ESOPs, coupled with the benefits of ESOP financing, can make employees more resistant to offers from competitors.
• Tax advantages: ESOPs offer several tax benefits for employers. In many jurisdictions, companies can claim tax deductions for the cost of setting up and administering ESOPs. Furthermore, when employees exercise their options, the company may receive a tax deduction equal to the difference between the exercise price and the market value of the shares. These tax advantages can result in significant savings for the company, making ESOPs a cost-effective component of employee compensation packages.
• Enhanced corporate culture: Implementing ESOPs can have a positive impact on the company's corporate culture. When employees feel like owners, they are more likely to be engaged, committed, and aligned with the company's goals and values. This sense of belonging and shared purpose can foster a more collaborative and supportive work environment. An enhanced corporate culture can lead to better teamwork, increased innovation, and a stronger brand reputation, all of which contribute to the long-term success of the company.
  

Calculating taxes for ESOPs

When an employee exercises their Employee Stock Option Plan (ESOP), they purchase the company’s shares at a predetermined exercise price. The difference between the Fair Market Value (FMV) of the shares on the exercise date and the exercise price is treated as a perquisite and is taxed as part of the employee's salary income. The employer deducts Tax Deducted at Source (TDS) on this amount. The taxable perquisite is also reflected in the employee's Form 16 and must be reported in their income tax return.

Example: Consider Ms. Priya, who works for ABC Ltd. She was granted ESOPs for 2,000 shares at an exercise price of Rs. 50 per share. On 1st April 2024, Ms. Priya exercises her options when the FMV of the shares is Rs. 120 per share. The taxable perquisite is calculated as follows:

• FMV on exercise date: Rs. 120
• Exercise price: Rs. 50
• Difference: Rs. 70
• Number of shares: 2,000
• Total taxable perquisite: Rs. 70 × 2,000 = Rs. 1,40,000

This amount of Rs. 1,40,000 is added to Ms. Priya’s salary income for the financial year and is subject to tax according to her income tax slab. Assuming Ms. Priya falls into the 30% tax bracket, the tax payable on this perquisite would be:

• Taxable perquisite: Rs. 1,40,000
• Tax rate: 30%
• Tax payable: Rs. 1,40,000 × 30% = Rs. 42,000

Tax rates for capital gains based on holding period and company type

(With effect from 23^rd July 2024)

Tax implications at the time of sale by the employee

When the employee sells the shares acquired through ESOPs, another taxable event occurs. The tax is calculated on the capital gains, which is the difference between the sale price and the FMV of the shares on the exercise date. The nature of the capital gains—short-term or long-term—depends on the holding period of the shares.

Example: Continuing with Ms. Priya’s example, she sells her 2,000 shares in two batches: one on 1st October 2024 and another on 1st May 2025. The FMV on the exercise date (1st April 2024) was Rs. 120 per share.

First sale: Short-term capital gain

On 1st October 2024, Ms. Priya sells 1,000 shares at Rs. 150 per share. Since the sale occurs within a year of exercising the options, the gain is short-term. The calculation is as follows: 

• Sale price per share: Rs. 150
• FMV on exercise date: Rs. 120
• Difference: Rs. 30
• Number of shares: 1,000
• Short-term capital gain: Rs. 30 × 1,000 = Rs. 30,000
• Tax rate: 15%
• Tax payable: Rs. 30,000 × 15% = Rs. 4,500

Second sale: Long-term capital gain

On 1st May 2025, Ms. Priya sells the remaining 1,000 shares at Rs. 180 per share. Since more than a year has passed since the exercise date, this gain is considered long-term. The calculation is:

• On 1st May 2025, Ms. Priya sells the remaining 1,000 shares at Rs. 180 per share. Since more than a year has passed since the exercise date, this gain is considered long-term. The calculation is:
  • Sale price per share: Rs. 180
  • FMV on exercise date: Rs. 120
  • Difference: Rs. 60
  • Number of shares: 1,000
  • Long-term capital gain: Rs. 60 × 1,000 = Rs. 60,000
  • Long-term capital gains exceeding Rs. 1,00,000 are taxed at 10%.
• If Ms. Priya’s total long-term capital gains for the year exceed Rs. 1,00,000, she would incur a tax liability of:
  • Long-term capital gain: Rs. 60,000
  • Tax rate: 10%
  • Tax payable: Rs. 60,000 × 10% = Rs. 6,000

What will happen to ESOPs when the company is listed?

Once the company is listed, employees have the opportunity to sell their shares in the open market, providing liquidity for their investment. The market value of shares becomes transparent with listing, which can lead to an increase in the perceived value of ESOPs for employees. Some companies may accelerate the vesting of ESOPs upon listing, allowing employees to exercise their options sooner.

Conclusion

Now that you know what ESOP is, you can understand how ESOPs in salary packages offer a win-win situation for both employers and employees. They provide a way for employees to share in the company's success while incentivising them to contribute to its growth. For employers, ESOPs are a tool to attract and retain talent, align employee interests with company goals, and foster a strong corporate culture. As companies continue to innovate in their compensation strategies, ESOPs remain a popular and effective way to reward and motivate employees.