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 of time 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 basically the shares offered to the specific or important employees with certain conditions attached and that are to be followed or agree to be followed before exercising the ESOP option. In ESOP, shares are offered generally at the price lower than the market price through which the employees can earn the maximum profit. it is the contract between the company and the employee that gives employee the right to exercise the shares. It gives the ownership to the employees in form of shares which motivates them to work better to contribute in the growth of the company. ESOP’s are not easily transferrable before the end of the term mentioned for holding and in case of selling the ESOP before the period mentioned the employee needs to take permission from the organization.
How does It Work?
In works in the following manner:
- Before offering ESOP to the employees, companies need to draft the ESOP scheme and get it approved from the shareholders in a general meeting.
- After resolution in 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 within the time mentioned employee agrees to accept the option then his option 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 employees which are eligible shall have to continue the employment agreement for 3 years and after completion of three years the employee can leave and sell the shares. ESOP scheme is put before the key managerial personnel and they have given 2 months’ time to decide whether to opt in or not. 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 2 months period to decide. It is expected that the market price will be $ 1000 after 3 years of the declaration of the scheme. Determine how ESOP will be taxed?
Ans. ESOP will be taxed in two ways at the time of issue of shares i.e. after 1 year of declaration and they are to be taxed as perquisite under salary.
Perquisite = Market Price – Exercise Price
- Perquisite = $ 500 – $ 400
- Perquisite = $ 100
At the time of sale it will be taxed under capital gains, which is calculated as under:
Capital Gain = Expected Market Price – Market Price at the Time of Exercising the Option
- Capital Gain = $ 1000 – $ 500
- Capital Gain = $ 500
Employee Stock Option Plan Eligibility
Eligibility for Employee Stock Option plan is as under:
- The employee should be permanent employee of the organization.
- A part time or whole-time director of the company is also eligible for ESOP irrespective of period of service.
- An Employee or director of holding or subsidiary company is also eligible for ESOP.
- Any Key Managerial Personnel is also eligible for ESOP in the organization.
Any Promoter or Director of the company who is holding more than 10 percent of equity capital of the company is not eligible for ESOP.
Tax Implications of Employee Stock Option Plan
ESOPs are taxed in two ways
- Firstly the difference between exercise price and 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 selling price and the fair value as calculated in calculation of perquisite will be taxed under capital gains.
Who Can Opt for Employee Stock Option Plan?
Following class of Employees can opt for Employee Stock Option Plan:
- A permanent employee of the company or its subsidiary.
- Any key managerial personnel of the company and its subsidiaries or associate companies.
- Any class of employee as per the terms and policy of the company can opt for Employee stock option plan.
Benefits of Employee Stock Option Plan
Benefits of employee stock option plan are:
- Employee stock option plans are offered at the price lower than the market price and on sale, it gives huge profits.
- Employee stock option plans motivate the employees to contribute in the growth of the company.
- ESOP serves as a retirement benefit for employees.
- Through ESOPs the employee can be retained for longer term which will give the edge over the competitor.
Disadvantages of Employee Stock Option Plan
Disadvantages of employee stock option plan are:
- Period of holding involving in the ESOP is very high.
- Legal formalities related to ESOP are very complicated and time consuming.
- Tax implication of ESOP is complicated 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 period of holding is more this can prove to be very costly to the employee in long run.
Important Terms Related to Employee Stock Option Plan
- Employee: Employee Pertains to the permanent employee.
- ESOP: it is an option to the employees, key managerial personnel, and the directors for offer of shares to be exercised at future date and at a pre-determined price.
- Exercise of Option: it pertains to the agreement of employee for the purchase of the ESOP
- Exercise Period: it refers to the period between acceptance of the proposal for ESOP to the issuance of 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 the shares to the key employees and it contains the terms and conditions relating to the ESOP.
Employee Stock option plan is the plan under which the shares of the company are to be offered to the key employees like key managerial personnel, directors, etc. the purpose behind issuing ESOP is to motivate the employees to contribute in the growth of the company and to retain the employees to gain an edge over the competitors. Before issuing the ESOP the scheme for issuing 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 does employee stock work? along with benefits and disadvantages. You may also have a look at the following articles to learn more –