Updated July 17, 2023
Definition of Employee Stock
Employee Stock option plan is the plan which gives the opportunity to the employees of the organization for the purchase of shares within a certain period at a specified price with certain conditions attached to it, and it is for a specific class of employees to retain the employees and to motivate the employees.
Employee Stock Option Plan is the shares offered to the specific or important employees with certain conditions attached and that are to be followed or agreed to be followed before exercising the ESOP option. In ESOP, shares are generally offered lower than the market price through which the employees can earn the maximum profit. The contract between the company and the employee gives the employee the right to exercise the shares. It gives ownership to the employees in the form of shares, which motivates them to work better to contribute to the company’s growth. ESOPs are not easily transferrable before the end of the term mentioned for holding. In the case of selling the ESOP before the period said, the employee needs permission from the organization.
How Does It Work?
It works in the following manner:
- Before offering ESOP to employees, companies need to draft the ESOP scheme and get it approved by the shareholders in a general meeting.
- After resolution in the general meeting, the ESOP plan is to be put before the concerned employees in the form of a letter of the grant along with the conditions for exercising, exercise price, and period under which shares can be exercised.
- If the employee agrees to accept the option within the time mentioned, then his chance to be converted into equity and ESOP are to be granted to the employees.
Example of Employee Stock Option Plan
Z Inc. framed the scheme of the ESOP for the key managerial personnel under which the eligible employees shall have to continue the employment agreement for three years. After three years, the employee can leave and sell the shares. ESOP scheme is put before the key managerial personnel, who have two months to opt-in. The exercise price was $ 400, and the market price of the shares was $ 500. The shares will be issued after one year, and employees have two months to decide. The market price is expected to be $ 1000 after three years of the scheme declaration. Determine how ESOP will be taxed.
Ans. ESOP will be taxed in two ways at the time of issuing shares, i.e., after one year of declaration, and they are to be taxed as perquisite under salary.
- Perquisite = $ 500 – $ 400
- Perquisite = $ 100
At the time of sale, it will be taxed under capital gains, which are calculated as under:
- Capital Gain = $ 1000 – $ 500
- Capital Gain = $ 500
Employee Stock Option Plan Eligibility
Eligibility for the Employee Stock Option plan is as under:
- The employee should be a permanent employee of the organization.
- A part-time or whole-time director of the company is also eligible for ESOP irrespective of the period of service.
- An Employee or director of a holding or subsidiary company is also suitable for ESOP.
- Any Key Managerial Personnel is also eligible for ESOP in the organization.
Any Promoter or Director of the company holding more than 10 percent of the company’s equity capital is not eligible for ESOP.
Tax Implications of Employee Stock Option Plan
ESOPs are taxed in two ways.
- Firstly the difference between the exercise price and the market price is to be treated as perquisite and taxable under salary and
- Secondly, on the sale of ESOP after the term mentioned, it is taxed under the capital gains difference between the selling price and the fair value as calculated in the calculation of gratuity will be taxed under capital gains.
Who Can Opt for Employee Stock Option Plan?
The following class of Employees can opt for Employee Stock Option Plan:
- A permanent employee of the company or its subsidiary.
- Any critical managerial personnel of the company and its subsidiaries or associate companies.
- Per the company’s terms and policy, any class of employee can opt for the Employee stock option plan.
Benefits of Employee Stock Option Plan
Some of the benefits are mentioned below:
- Employee stock option plans are offered at a price lower than the market price, and it gives enormous profits on sale.
- Employee stock option plans motivate the employees to contribute to the company’s growth.
- ESOP serves as a retirement benefit for employees.
- Through ESOPs, the employee can be retained for the longer term, giving the edge over the competitor.
Disadvantages of Employee Stock Option Plan
Some of the disadvantages are mentioned below:
- The period of holding involved in the ESOP is very high.
- Legal formalities related to ESOP are very complicated and time-consuming.
- The tax implication of ESOP is problematic in nature.
- ESOPs are not easily transferrable before the end of the contract.
- Accounting of ESOP is also complex.
- Stock options are difficult to value.
- As the holding period is more, this can be very costly to the employee in the long run.
Important Terms Related to Employee Stock Option Plan
- Employee: Employee Pertains to the permanent employee.
- ESOP: It is an option for the employees, key managerial personnel, and the directors to offer shares to be exercised at a future date and a pre-determined price.
- Exercise of Option: It pertains to the agreement of the employee for the purchase of the ESOP
- Exercise Period: It refers to the period between accepting the proposal for ESOP and issuing shares under ESOP.
- Exercise Price: It is the price that the employee has to pay to the company for the grant of shares under ESOP.
- Intrinsic Value: It is the difference between the market price of the shares and the exercise price of the shares under ESOP.
- Employee Stock Option Scheme: It refers to the scheme framed by the organization for offering shares to key employees and contains the terms and conditions relating to the ESOP.
An employee Stock option plan is the plan under which the shares of the company are to be offered to critical employees like key managerial personnel, directors, etc. the purpose behind issuing an ESOP is to motivate the employees to contribute to the growth of the company and to retain the employees to gain an edge over the competitors. Before issuing the ESOP, the scheme for giving the ESOP is to be framed, and that scheme is to be approved by the members in a general meeting. The legal formalities in ESOP are time-consuming.
This is a guide to Employee Stock. Here we also discuss the definition and how employee stock works with benefits and disadvantages. You may also have a look at the following articles to learn more –