Introduction

Employee stock option plans give employers the chance to recognise and reward top performers who contribute to the expansion of their business by giving them an equity ESOP share or a cash payment based on an equity investment. Employee stock options are frequently included in total compensation packages. They serve as an effective tool to encourage long-term commitments from recipients, making them a crucial component of the growth story of a successful company.

The benefit of tax deferral should not be limited to just “qualified startups.” A scaled-down version of the same may still be required, even if it is not as appealing as the assistance offered to “qualified entrepreneurs.” 

In this post, we provide a summary of the legal environment and the several forms of ESOPs that could be taken into account. With that said, it should be noted that this essay does not cover the accounting or tax implications of ESOPs.

DEFINITIONS OF “EMPLOYEE STOCK OPTION”

The Companies Act of 1956 introduced the term “employee stock option”. It defined it as “the option granted to the whole-time directors, officers or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price.” The Companies Act of 2013 (the “2013 Act”) changed this term to include securities provided by the holding company or subsidiaries of the business offering the employee stock options as part of its scope.

REGULATORY LANDSCAPE

ESOPs can be created by issuing and allocating ESOP shares in exchange for cash:

1. Based on the fair market value of the shares
2. In exchange for a reduced amount of cash
3. In exchange for no cash at all

The pertinent provisions of the 2013 Act and the Companies (Share Capital and Debentures) Rules, 2014 relating to ESOPs conducted for cash and on a cashless basis using sweat equity are briefly discussed below.

Summary

Employee stock options may be issued under the 2013 Act, subject to several conditions, including the adoption of a special resolution by the company’s shareholders and compliance with the necessary regulations under the Share Capital and Debenture Rules (in the case of unlisted companies) and the SEBI (Share Based Employee Benefits) Regulations, 2014 (the “SEBI (SBEB) Regulations”) (in case of listed companies). Therefore, any issuing of stock options ESOPs to employees by an unlisted firm must comply with the 2013 Act as read in conjunction with Rule 12 of the Share Capital and Debenture Rules. It would be wise for the ESOP for a private company to pass a special resolution for the adoption of an ESOP Scheme because Rule 12 of the Share Capital and Debenture Rules have not yet been changed to reflect the relaxation provided to private companies and continues to require that the shareholders pass a special resolution.

ESOP Benefits For Employees

There are many advantages to ESOPs, including:

 

• Fluidity: Shareholders have the choice to sell just a portion of their shares or withdraw money gradually over time. Even after selling their ESOP share in the business, they might continue to be engaged. Furthermore, if an employee retires or quits the firm, they have the option to keep their ESOP shares, providing them with continued employee ownership of the business.
• Employee information is kept private under ESOPs. This indicates that member data is safe and secret. The terms and conditions of ESOPs are reasonable, without any ambiguous language, and they provide assistance for ESOPs to employees in times of need.
• Simple: ESOPs are a wonderful alternative for retirement planning since they are simple to transfer. They provide workers with the chance to own a piece of the business for as long as they like, and they may even sell some of it back to the business if they so choose. Owners can encourage payment and output by giving staff a stake in the company. Both employee output and organisational culture are on the rise. The business can then buy back ESOP shares and keep paying employees’ pensions when they retire.
• Leadership consistency: There may be greater management and staff retention, leading to continuity, decreased turnover, and vested interest in the business’s success. For ESOPs, Employees receive updates on plan outlines and yearly statements, are informed about the organisation’s progress and may vote. These communication channels work to bring everyone in the organisation’s interests into alignment and promote focus. Company culture motivates employees to work together toward a common objective, fostering a supportive environment at work.
• ESOP benefits to employees: When a firm gives ESOPs to its staff, it is likely to minimise employee turnover, increase job security and improve employee retention. Productivity rises in organisations that show a genuine interest in their staff members, which eventually helps the business make more money and expand more quickly. They could be able to locate and hire highly qualified applicants with the use of this as well. Generally, you may invest before taxes and get tax-deductible ESOP payments. Since ESOPs are tax-exempt trusts, cash flow grows due to compounding interest over time.

Employee Stock Ownership Plan Tips

Step 1 – Get sound advice.

• The ESOP principle may be simple, but there are numerous options for initial setups, such as whether to use leverage or no leverage financing, funding, ESOP share sale schedules, C corporations versus S corporations, employee participation, and eligibility requirements vesting schedules, and ESOP share repurchase specifics. 
• Understanding which mix of solutions is ideal for your circumstance is crucial. Expert counsel will result in time and money savings as well as the proper plan structure.

Step 2 – Meet minimum requirements.

• There are a few minimal conditions to be eligible for an ESOP, despite the fact that they are effective in a wide range of shareholder liquidity scenarios. 
• We have established several ESOPs with as few as 10 employees and as many as 25,000 people. 
• The typical-sized firm establishing an ESOP has 75 employees. In practically every industry, both public and private businesses are using ESOPs. 
• The breakdown of completed ESOPs by industry over the past several years has been around 30% services, 20% manufacturing, 20% construction, 15% finance and insurance, and 15% distribution.

Step 3 – Understand ESOP structures.

• By issuing additional shares to employees to encourage greater productivity, ESOPs give business owners a tax-efficient way to sell all or a portion of their employee ownership holdings on a schedule of their choice.

Step 4 – Collect & provide information for the feasibility study.

• If you’ve read this far but haven’t yet spoken to a Menke adviser, we advise giving us a call so we can answer any questions you might have and go over some data so we can offer some initial views on how an ESOP can benefit you.
• It is essential to first determine the goals of everyone involved before you can completely assess if an ESOP can be advantageous for your business and its employees. 
• There are frequently competing and overlapping goals. For instance, the firm’s expansion goals may conflict with the possible selling shareholders’ goals, both of which depend on the company for funding through cash. 
• Additionally, an ESOP’s effect on employees and its potential to inspire workers must be carefully addressed.

Step 5 – Receive & review the proposal for ESOP valuation.

• The financial structure of the ESOP plan is its most important component. 
• The seller and the firm might miss out on hundreds or even millions of dollars in financial rewards if the plan is not correctly established. 
• Experienced ESOP consultants can develop a variety of inventive arrangements to enhance ESOP advantages.

Step 6 – Document, Finance & E36+xecute ESOP

• Although an ESOP transaction is simple from a tax perspective, the right paperwork to guarantee these tax advantages is somewhat complicated. 
• Because of this intricacy, it may be wise for your business to engage an ESOP specialist. The result of over 30 years of expertise and over 2,000 ESOP programmes created, our paperwork. 
• We can offer cutting-edge paperwork for a fraction of what it would cost to generate from scratch because of our history and in-house legal staff. 
• Hundreds of attorneys, accountants and IRS reviewers have given our plan paperwork the thumbs up. 
• We actively participate in creating the new ESOP law, so we are aware of the effects and adjustments that new legislation will necessitate for ESOP structures and documentation.

Step 7 – Communicate ESOP Benefits to Employees

• How well the plan’s advantages are explained to the participants will have an impact on the long-term viability of your ESOP. 
• Numerous studies consistently demonstrate that there was a measurable improvement in productivity, turnover, absenteeism, and efficiency in those companies where management had taken a direct and active role in informing the employee-participants of their importance and influence on corporate profits and how those profits related to the increasing price of their shares. 
• According to the most recent study by Rutgers University in 2000 on more than 680 firms, ESOP companies saw a 2.3 per cent higher sales growth per employee per year than comparable non-ESOP companies.

Step 8 – Administer the ESOP

• We have the largest in-house legal, financial, actuarial, recordkeeping, and programming experts. We have created our specialised computer systems (ESOP COIN) to accommodate the complicated bookkeeping needed in operating ESOPs.
• Additionally, we have run across and fixed every conceivable legal, tax, and ERISA difficulty throughout the installation of over 2,000 ESOP schemes. 
• As a result, we can respond to any of your inquiries right away without resorting to time-consuming or expensive research. We are eager to collaborate with you.

ESOP Taxation And Calculation

Understanding ESOP taxation in India

There is no need to introduce ESOPs (well, if you are reading this article, we presume either you are holding ESOPs or know what they are). However, few individuals are aware of how employee stock options affect taxes. This article’s goal is to explain how ESOPs are taxed from the employee’s viewpoint.

How are ESOPs taxed in India? You need to pay tax on ESOPs as an employee arises twice: 

• First, when the shares are assigned upon exercising the vested options (taxed as salary income), and 
• Second, when the shares are sold (taxed as capital gains).

The difference between the exercise price and the fair market value of the shares (calculated as of the exercise date) is taxed as a prerequisite at the time of issuance (considered part of salary income). The value of the perk as calculated after TDS is subtracted by the employer. Your cash flow will suffer as a result since you will pay more in taxes without receiving any more income. It is important to remember that tax incidence only occurs when shares are distributed, not when options are distributed (known as a grant of options in common parlance). When an employee elects to exercise their vested options, shares are allocated, and that’s when tax is due.

Example For ESOP Valuation 

• For instance, as part of the business’s stock option plan, employer company A grants Mr. X 10,000 shares. The value of the taxable prerequisite for Mr. X would be (200 – 10) if the Fair Market Value of the shares on the date of exercise is 200 per share and the exercise price is 10. *10,000 = ₹ 19,00,000
• Assuming Mr. X has the highest tax rate, a 34.32 percent tax deduction (including a 4 percent cess) will be made on $19,000,000. A further TDS deduction of 6,52,080 is made as a result.

The employee must either sell a small number of shares or make other arrangements in order to satisfy this obligation payable at vesting.

Moving on to the second type of taxes, capital gains tax is due upon sale and is either long-term or short-term, depending on the holding period. If you’re wondering how to calculate capital gains, the cost of purchase is the fair market value on the exercise date (used to calculate the perquisite value).

Changes in Budget 2020

Startups that rely heavily on ESOPs to keep people encounter practical challenges when taxing ESOPs as perquisites. As previously stated, an employee must either sell a portion of his stock or raise money from other means to pay his TDS due. Since startup shares are frequently not listed and may not have a thriving market, finding buyers for them can be challenging. The Income Tax Act was revised to offer an exemption to “qualified startups” after taking into account numerous arguments and realising the difficulty suffered by entrepreneurs.

What are Eligible ESOP Startups? 

ESOP for private companies: A firm or an LLP that was incorporated after April 1, 2016, but before April 1, 2022, qualifies as an eligible ESOP startup. It must also carry on qualifying business as stated and fulfil the criteria relating to turnover (cannot exceed 100 crores).

What is the Relief Provided?

After 48 months have passed since the end of the applicable assessment year, from the day the shares were sold to the date the employee resigned, an eligible startup has 14 days to deduct TDS.

Therefore, the earliest date on which your employer (being an eligible startup) is required to deduct TDS would be April 14, 2026, if you are granted shares in FY 2020–21. (assuming you continue to hold the shares and are employed with the company till that date).

It’s a smart decision since the employee now has at least five years to pay tax on the perquisite income unless he decides to quit or sell his stock earlier. The employee is given a choice to keep the shares and is not compelled to sell a portion of them to pay the taxes. The fact that the assistance is exclusively given to staff members of new companies who qualify is unfair. There is a very small percentage of qualified start-ups among the overall number of businesses issuing ESOPs. Perhaps the government’s goal is to aid startups rather than the salaried class in general.

Perquisite Tax and Capital Losses:

If the value of the share declines considerably after paying tax on fair value, taxing ESOPs in the year of allocation may result in possible additional loss from a tax viewpoint.

In the aforementioned example, if Mr. X chooses to hold on to the shares by paying a tax of Rs. 6,52,080 (assuming Company A is not an eligible start-up) from his personal savings, he will have a capital loss of Rs. 18,00,000 (10,000*(200-20)) after a few years if the share value drops to say Rs. 20, which is occasionally possible.

Salary income cannot be used to offset the capital loss. Therefore, if Mr X does not have sufficient capital gains to balance the loss, he may have to carry the loss forward for the allowed amount of time before writing it off. To the degree that these losses relate to ESOPs, offsetting capital losses against salary income is unquestionably beneficial.

Conclusion

To sum up, endless ESOP benefits for employees are very important in designing an employee’s compensation plan. According to the 2013 Act, an employee stock option plan may only be formed once the company’s shareholders have approved a special resolution. However, in 2015, this criterion was eased for private enterprises, allowing them to establish an ESOP Scheme by passing merely an ordinary resolution.