ESOP 101: Tax Implications and Accounting of an ESOP Part 5
By Joanne Hue, published: 2023-04-06
An Employee Stock Ownership Plan or ESOP is a benefit plan that provides employees of a company the option to purchase stocks in a company at a fixed exercise price. For the sponsoring company, the shareholders, and the participants, ESOP provides various tax-related benefits, making ESOP a qualified plan.
Companies set ESOP schemes to coincide the interests of the workers with that of the shareholders. Employers often use ESOP as a strategy for corporate finance by aligning the interests of the employee with that of the shareholders and the company.
Tax Implications of an ESOP
Tax Implications of an Employee Share Option Scheme
a) Tax implications when the ESOP are exercised by the employees:
- When the employees purchase shares in the enterprise they work with, the exercise of their rights is the first taxable event. The prerequisite value that is taxable is compartmentalized within the head of income or salary.
The taxable prerequisite can be computed by identifying the difference between the Fair Market Value or the FMV on the date of exercise and the exercise price allotted for the employee. In most nations including India, the income tax laws require the calculation of the FMV under the listed shares or the unlisted shares.
- Listed Shares
The shares that are listed under-recognized share exchange on the date of exercise are known as Listed Shares. Under the listed shares, the FMV is an average of the opening and closing prices of the respective exchange.
When there is more than one recognized share stock, the FMV is the average opening and closing price of the stock exchange that observes the largest trade.
- Unlisted Shares
Unlisted Shares are not included in any recognized exchange. In the circumstances where shares are not listed in a recognized stock exchange, their FMV is determined by a merchant banker. The specified date for unlisted shares is either the date of exercise or any date 180 days prior to the exercise.
- Responsibility of the employer to withhold tax on ESOP prerequisites.
Any benefit that an employee obtained from the exercise of their tax is taxable under the salary. As employees, companies have the responsibility to deduct such taxes. The amount of tax is withheld from the employee during the allotment of shares. This means that the employee’s tax would be deducted from their payroll. Usually, the shares are allotted on the days the employee exercises their share option plan.
The deduction of the tax from the employee’s payroll impacts the employee’s salary for the month in which they exercise their rights. In order to incentivize eligible businesses and compensate for the employee’s losses, a concession is provided. This concession is limited to the period of withholding taxes. The concession allows eligible startup businesses to deduct tax from the prerequisite income within fourteen days of the plan’s exercise. These concessions are contingent on the fact that specific time has passed since the initiation of the fiscal year. They are also applicable from the date of the shares trade or from the date the taxpayer ceases to be an employee.
The definition of an eligible startup is set by the laws in the nation in which the company is based.
(b) Tax implications after the sale of allotted shares:
When an employee acquires shares under an ESOP, such shares are regarded as a capital asset. Therefore, any profits amassed through the transaction of such shares would be subject to a capital gain tax. The capital gain acquired through shares is calculated by identifying the difference between the purchase and sale prices. The FMV in this case is the purchase cost of the share on the date of exercise.
The period between the allotment f shares and its sale is known as the date of holding. Capital gains can either be short-term capital gains or long-term capital gains.
- What is the difference between Long-term and short-term capital gains?
The shares that are unlisted are known as long-term capital assets after they are held for more than two years. If the share were to be sold before two years, it would be called a short-term capital asset. For a listed share, the time period is of one year.
- Accounting and Employee Share Option Scheme
Leverages and non-leveraged ESOP are two distinct forms of ESOPs. They are identified via their funding methods and require different methods of accounting:
- Accounting a leveraged ESOP
Generally, ESOPs are leveraged. This means they borrow funds to buy shares from the shareholders that are willing to trade them to the ESOP. These shareholders are typically those who are seeking retirement and planning distribution.
The Debt of the ESOP must be recorded as a liability. When the debts are repaid, the equity of the shareholders increases and the liability reduces.
The amount of compensation expense is based on the FMV of the stocks are the amounts contributed to the ESOP. Compensation expenses also include dividends. Companies should separately identify their interests in contributions. Any plan sponsors are required to disclose interest rates, debt terms, and other significant information in the footnotes of the financial statements.
- Accounting a non-leveraged ESOP
A non-leveraged ESOP does not borrow funds to obtain shares. Its accounting is more simple in comparison to the leveraged ESOP. Employers directly fund non-leveraged ESOP through cash or stocks.
The newly issued shares, dividends, or cash funds are regarded as compensation under the balance sheet. The plan sponsors contributions are regarded as tax deductions.
Similar to leveraged ESOPS, footnotes are used in financial statements to provide information concerning the company’s funding policies, contributed amounts, a charge of expenses, and the participants covered by the ESOP.
In recent years, employees have been been able to garner massive wealth through ESO Plans. Employees of many startups have benefitted tremendously through these options. The tax implications of an ESOP are dependent on whether the employee is exercising their rights or they are selling their allotted shares. The technique of ESOP accounting is dictated by the method employed to fund an ESOP.
You may also like:
- ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
- ESOP 101: Understanding Vesting, Exercise, and Expiration Terms Part-2
- ESOP 101: The Process to Set Up an Employee Share Option Scheme Part 3
- ESOP 101: Communicating and Administering an ESOP – Part 4
- What’s an ESOP and why might I need one?
- Employee Share Option Plan Template
- ESOP – Employee Acceptance Letter Template
- How to Set up your company option scheme?