Employee Stock Option Plan Taxation Simplified
Employee stock option plan (‘ESOPs’ or ‘Options’) [we’ve used employee stock option plans as a generic word for different equity-settled instruments] are a typical means for employers to share the wealth created by their employees as a form of remuneration. ESOPs are taxed as ordinary income upon exercise and as long-term capital gains (‘LTCG’) or short-term capital gains (‘STCG’) upon sale of shares acquired at the time of exercise, just like any other pay component. We’ll go into taxation in more depth later, but first, let’s look at the stages of an employee stock option plan life cycle, which will help us comprehend the taxing component.
In esop services whole life cycle, each Option goes through four stages:
- Grant: It is an offer given to workers to participate in the employee stock option plan (‘Plan’) where they are eligible to execute the Options as granted and vested. The firm determines the number of Options to be issued, the price at which such Options can be exercised (exercise price), the vesting duration, the timetable and conditions, the exercise period/mechanism, and other factors.
- Vesting: This is the stage at which the employee gains the right to exercise the Options in exchange for meeting specific time and/or performance requirements.
- Exercise: Employees have the option to exercise their vested options and convert them into shares by paying the exercise price and perquisite tax at the time of exercise.
- Sale: Once an employee gets shares of the firm as a result of converting an Option at the time of exercise, he or she may hold, sell, or transfer those shares in accordance with relevant laws and the Plan’s provisions. The LTCG or STCG tax will be applied based on the length of time that the shares have been held.
Let’s move on to the taxation of Options now that we’ve covered the various stages of an Option’s existence.
Employees are taxed twice on income from options: first when the options are exercised and converted into shares, and again when the shares obtained as a result of the conversion are sold.
Stage 1: During the exercise
Option perquisite income = [Fair market value (‘FMV’) of the stock at the moment of exercise less exercise price] The number of options to be exercised is X.
Individuals pay tax on perquisite income at the standard slab rate (as applicable)
Stage 2: When the shares are sold.
Gain on the selling of shares
- In the case of publicly-traded business shares
- Long-term capital gains are earned when stocks are kept for more than a year; short-term capital gains are earned when stocks are held for less than a year.
- In the case of unlisted business shares
- Long-term capital gains are earned when stocks are kept for more than 24 months, whereas short-term capital gains are earned when stocks are held for less than 24 months.
Tax on capital gains
Particulars Tax on LTCG Tax on STCG
(Listed company) 10% over and above Rs. 1 Lac Specified rate: 15%
(Unlisted company) 20% (with indexation of cost) At normal slab rate for individual
- If the business settles vested Options in cash at the moment of exercise or at any subsequent time, the tax on perquisite income will be equal to the appreciation paid in cash by the company.
- Stock Appreciation Rights are taxed similarly to employee stock option plan in that tax is due on the perquisite income of share price appreciation, i.e. (FMV of share on exercise minus Base price) X No. of Options to be exercised. Furthermore, the tax on stock sales as a result of LTCG or STCG is the same as it is for ESOPs.
Most employee stock options in the United States are non-transferable and cannot be exercised immediately, however they may be easily hedged to decrease risk. The IRS believes that unless certain circumstances are met, their “fair market value” cannot be “readily ascertained,” and hence “no taxable event” occurs when an employee gets an option grant. To be taxed upon grant, a stock option must either be actively traded or transferrable, immediately exercisable, and the option’s fair market value must be clearly ascertainable. Depending on the type of option issued, the employee may or may not be taxed upon exercising the option. Non-qualified stock options (the most common type offered to workers) are taxed as ordinary income when they are exercised.
Incentive stock options (ISO) are not taxed, but they are liable to Alternative Minimum Tax (AMT) if the employee meets certain extra tax code conditions. Most crucially, shares acquired through the exercise of ISOs must be held for at least one year following the date of exercise in order to qualify for the preferential capital gains tax treatment. Taxes, on the other hand, can be postponed or minimised by avoiding early workouts and keeping them until close expiry day, hedging along the way. The taxes levied while hedging are advantageous to the employee/optionee.
Excess tax benefits from stock-based compensation availing esop services
This item in a company’s profit-and-loss (P&L) statement is due to the disparity in timing of option expenditure recognition between GAAP P&L and how the IRS handles it, and the subsequent difference between expected and actual tax deductions.
GAAP mandates that an estimate of the options’ value be routed through the P&L as an expense at the time they are awarded. This reduces operational income as well as GAAP taxes. The IRS, on the other hand, handles option costs differently, allowing tax deductibility only when the options are exercised/expired and the full cost is known.
This indicates that cash taxes are greater than GAAP taxes during the period in which the options are expensed. On the balance sheet, the differential is shown as a deferred income tax asset. When the options are exercised/expired, the true cost is revealed, and the precise tax deduction permitted by the IRS may be calculated. Then there is a balancing up event. If the initial cost estimate for the options was too low, a larger tax deduction will be permitted than was originally expected. This ‘extra’ is processed through the P&L when it becomes known (i.e. the quarter in which the options are exercised). It increases net income (by cutting taxes) and is then subtracted from operational cashflow since it refers to expenses/earnings from a previous quarter.
Taxation of Foreign employee stock option scheme
If employee stock option scheme are awarded by foreign corporations to Indian residents, they are taxable in India. Furthermore, the taxes regulations of the nation of the firm that gives the option, as well as the double taxation avoidance agreement, must be investigated in order to comprehend the specific tax implications. Furthermore, no concessional tax on long-term capital gains under Section 112A or a concessional rate of 15% tax on short-term capital gains in respect of such shares would be available because these shares would not be offered on Indian stock exchanges because they are unlikely to be listed in India.
ESOP FOR PRIVATE COMPANIES BENEFITS
ESOP for Private companies may gain from ESOPs in one or more of the ways listed below:
- To recruit and retain talented individuals, implement the following strategies: As previously said, employee stock option scheme are constructed in such a manner that it provides employees with a sense of ownership in the firm if they stay for a period of time to reap the advantages. As a result, startups may utilise this technique to retain their brilliant employees. During the first phase, it is critical for a startup firm to maintain competent people resources, which might be promoters/directors/employees. The greatest approach to keep them is to make them feel like they are a part of the kitten that is being produced. There is no greater weapon than ESOPs to instil this sense in people.
- To encourage workers to work more and actively contribute to the company’s success: Employee stock ownership plans (ESOPs) play an important role in encouraging startup workers because they realise that the better the firm succeeds, the higher the value of their shares will be. As a result, they put in a lot of effort to help the firm expand. Employees are fully aware that if the firm does not perform well, the market value of the shares will be less than the amount paid by them to buy shares under the employee stock option scheme, therefore they play an active role in the company’s performance.
- To keep expenditures under control and risks to a minimum: Shares are issued as part of pay in lieu of cash variables and bonuses under employee stock option scheme. Startups in the early stages of their businesses are unable to pay competitive and high salaries to their employees in comparison to well-established businesses or large corporations; however, startups also require talented and motivated human resources who can perform well for the company’s future growth. As a result, by giving ESOPs, firms may retain qualified people without investing a lot of money.
Without a question, ESOP for Private companies program becoming a popular way for businesses to recruit, inspire, and retain employees. This ESOP strategy has two benefits: it reduces cash outflow and it retains deserving personnel for future growth. Employees regard this system as a long-term investment that they must compensate for through monetary benefits and incentives. When handled properly, employee stock option scheme benefit both employees and startups.