Employee Stock Ownership Plan is an employee benefit plan that enables workers to have an ownership interest in the company in the form of shares of stock. The employer decides a certain percentage of the company’s stock shares to each eligible employee with no upfront cost and the distribution of these is done based on employee pay scale, terms of service, or some other basis of allocation.
The company holds the ESOP shares in a trust unit for safety and growth until the employee leaves the company or retires. The shares are bought back to the company when the employee exits by selling their shares back to the company or to other employees providing them with a source of income. for further distribution to other employees.
This plan aims to minimize incentive-related issues while also aligning the interests of the employees with the interests of the company’s shareholders. Giving employees a stake in the company transforms them from being mere employees into owners. As a result, it motivates the employees to do what is best for the shareholders, since they are shareholders as well.
Companies with a majority of employee ownership are referred to as employee-owned corporations. ESOP offers tax benefits for employees. The employees should be careful in considering the risks and benefits of participating in an ESOP, as the value of shares can fluctuate based on company performance.
How does an ESOP function
When a company wants to establish an employee stock ownership plan it should also create a trust for which to contribute either new shares of the company’s stock or cash to buy existing stock. Contributions made by the company to ESOP are tax deductible up to a certain limit and the employees can also enjoy tax exemption on the stocks allocated to them.
The shares allocated to individual employees are based on their compensation, years of service, or both. As usual new employees join the plan and will start receiving allocations after they have completed at least one year of service. The shares in ESOP allocated to employees must vest, increasing the right an employee receives on their shares as they accumulate over time before employees are entitled to receive them.
When employees who are members of ESOP exit the company, they ought to receive their stock. A private company shall buy back the retiring employee’s share at fair market value within 60 days of the employee’s departure and they should also have an annual stock valuation for determining the worth of each employee’s shares. When the employee leaves the company, retires, or resigns he will become eligible to receive his vested ESOP share and it is distributed in various ways such as company stock, cash, or a combination of both.
By giving employees a share of ESOP, individual employees directly benefit from the success of the company and will feel a sense of ownership. Thus leading to increased productivity and improved overall performance for companies with ESOP. And when there is a financial stake in the business, their morale and trust also increase. It provides tax benefits for both the company and employees. The contributions made by the company to ESOP are tax deductible and employees also enjoy tax exemptions on the stock allocated to them until it is distributed to them.
ESOPs are a powerful tool for attracting and retaining outstanding employees for a company’s long-term growth. It encourages employees to stay with the company until the vesting period, which is usually four years. This vesting process or period where the employee must work with a company to receive their share payout, motivates them to stay with a company as long as possible to earn the highest payout if they decide to leave. Additionally, by designating staff as owners, employers can guarantee their long-term commitment to the interests of the business.
One of the major drawbacks of ESOP is a high-risk investment. Employees are essentially investing their retirement savings into the success of the company and if the company doesn’t perform well employees may see a large decrease in their retirement savings.
Generally, you cannot access the funds in the ESOP account until you retire or leave the company. And when you need such funds in an emergency, you may not be able to access them promptly. Also when you leave the company before retiring you are required to pay a penalty for withdrawing funds from an ESOP account. And since all retirement schemes are invested in one company stock it leaves them more vulnerable to certain market risks which could lead to losses.
Taxation concerns also emerge when one sells one of his shares before reaching retirement age, as he will be required to pay tax on the gains made from shares.
Cost of ESOPs & Distributions
Depending on the size and complexity of the plan, setting up and maintaining an ESOP involves a variety of costs. Some of the upfront expenditures include legal fees, accounting fees, and administrative charges. .
Futhermore, Esop distributions in India takes place different ways
Employees who exercise their stock options to purchase shares have the choice to either sell the shares immediately or to keep them for potential future growth.
The earnings will be distributed to the employee, less any taxes due on the gain, in the event that they decide to sell the shares. The employee will have ownership in a portion of the company if they agree to maintain their shares. They are also eligible for dividends and capital gains if the stock price improves.
How are ESOPs taxed
As per the provisions of Income Tax Act, 1961
Tax implications gets triggered at two stages First, at the time of exercising of the option
Second, at the time where the employees sell shares.
Tax treatment while exercising the option
The taxable value is calculated under the head of income – “SALARY”.
The difference between the FMV of the shares as on the exercised date and the amount employees have paid for the subscription to shares is taxed as perquisite.
Tax Treatment while selling shares
The taxable value is calculated under the head – “CAPITAL GAIN”
The shares allotted to an employee under ESOP is considered as capital asset and any gain on sale of such asset will attract capital gain tax. The capital gain is computed on the difference between the sale price and the acquisition cost. Here, the purchase cost is the FMV of shares as on the date option exercised as specified above
- How is ESOP calculated ?
The ESOP is based on the fair market value of the company’s stock, the number of shares allocated to the ESOP, the vesting time, the exercise price of the options, and the tax implications for both the employer and the employee.
2. How does ESOP benefit the company ?
It benefits the company by attracting talented employees, motivating employees, tax benefits that increase the company’s cash flow, improving company performance and offering financial flexibility.
3. Who controls ESOP ?
The ESOPis managed by a trustee, who is in charge of managing the plan on behalf of the participants. The trustee has authority over the esop’s administration and management.
4. How are ESOP benefits distributed?
Distribution to ESOP participants is made in form of cash, shares or both .Cash is paid to employees promptly while the company shares are repurchased by ESP immediately and employees receive cash equivalents to FMV.
5. What information must be provided to ESOP participants?
A yearly statement from the employer detailing the number of shares allotted to the participant’s account in the trust as well as the shares fair market value is required.