What is an ESOP - Meaning, Taxation, and Benefits

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What is an ESOP

ESOP Meaning & Definition

An Employee Stock Ownership Plan (ESOP) is an employee benefit scheme that provides workers with ownership stakes in their company through shares of stock. These plans can take the form of direct stock, profit-sharing, or bonuses, with the employer determining who is eligible to participate. The company establishes a trust fund with a designated number of shares at a set price for a specific period. Shares are then allocated to individual employee accounts based on their salary levels—the higher the salary, the larger the share allocation.

ESOPs are commonly utilized for succession planning, enabling company owners to sell their shares and gradually exit the business. Employers must adhere to specific rules and regulations outlined in the Companies Rules when offering employee stock ownership plans.

ESOPs can boost productivity, improve employee retention, offer tax benefits, and increase job satisfaction. Additionally, ESOPs provide a unique financing tool for companies by allowing them to sell stock to the ESOP and use the proceeds to pay off debt, among other things.

How does an ESOP work?

The company establishes an ESOP trust. The company can then either contribute cash to this trust to purchase shares from existing owners at their fair market value (FMV) or, if the current owners prefer not to sell, issue new shares.

Employees are allocated shares within this trust, usually based on their salary levels. Typically, all full-time employees are eligible to join the plan. This setup means that employees eventually gain ownership stakes in the company and acquire some voting and control rights.

Employees must go through a vesting period, during which they must meet conditions like continuous employment for a set duration or achieving specific performance goals. Once these conditions are met, the options become "vested."

Upon vesting, the employee gains the right to "exercise" the option, meaning they can buy the shares by paying the exercise price. The shares obtained through this process usually have the same rights as other shares of the same class. However, until the option is exercised and shares are allotted, the employee does not have dividend or voting rights. In some cases, companies may impose restrictions on the sale of these shares after they are purchased.

Initial Costs and Distributions of ESOPs

  1. Initial Costs: Implementation involves legal fees, accounting fees, and administrative expenses. Costs vary based on the plan's complexity.
  2. Distributions: In India, ESOP distributions can occur in various ways:
  3. Immediate Sale: Employees can sell shares immediately upon exercise, receiving proceeds minus taxes.
  4. Holding Shares: Employees can keep shares, gaining an equity stake and potentially receiving dividends or benefiting from capital gains if the stock price increases.

Why Do Companies Offer ESOPs to Their Employees?

  1. Companies use ESOPs to attract and keep talented employees.
  2. ESOPs are often given out in phases, such as at the end of the financial year, encouraging employees to stay.
  3. ESOPs align with the company's long-term objectives.
  4. Making employees stakeholders helps reduce high turnover rates, especially in IT companies.
  5. Start-ups use ESOPs to attract talent when they can't offer high salaries, making their compensation packages more competitive.

Benefits of ESOPs

For Employees

Stock OwnershipEmployees can own a part of the company’s share capital, giving them a stake in the company.
Dividend IncomeEmployees receive a share of the company’s profits in the form of dividends, increasing their income.
Discounted SharesEmployees can buy shares at a preferential rate, usually paying a nominal amount.

For Employers/Companies

Employee RetentionESOPs make it easier to retain employees as they wait for the vesting period to exercise their options.
Better ProductivityEmployees are motivated to increase productivity as they directly benefit from the company's profitability.
Attracting TalentESOPs serve as additional compensation, helping to attract and retain talented employees, especially for start-ups.

ESOP Taxation

ESOPs have two main tax implications:

  • When an employee exercises their rights and buys company stock.
  • When the employee sells the stock after purchasing it.

Let's break these down:

Tax Treatment When Buying Shares

Employees can buy shares after the vesting date at a price lower than the Fair Market Value (FMV) on that date. The difference between the FMV and the exercise price is considered a benefit and is taxed according to the employee's income tax slab rate.

For new businesses, the government has eased these tax implications. Employees at start-ups do not need to pay tax on the benefit in the year they exercise the ESOP. The tax deduction at source (TDS) on ESOPs is deferred until the earliest of the following:

  1. Five years from the date the ESOP was granted.
  2. When the employee sells the ESOP.
  3. The date the employee leaves the company.

Tax Treatment When Selling Shares

When employees sell their shares, the difference between the selling price and the FMV at the time of exercise is taxed as capital gains. If shares are sold within a year of purchase, a 10% tax is applied to profits exceeding Rs.1 lakh. If the shares are sold within 12 months, profits are taxed at 15%.

The taxation of foreign ESOPs in India is similar. You will be taxed in India on the benefits earned from a foreign company's ESOPs.

What Happens to ESOPs When the Company is Listed?

For unlisted companies, selling ESOP shares can be tough because there might not be many buyers. The Fair Market Value (FMV) of these shares is set by merchant bankers, and the capital gains tax is similar to that for debt funds.

  • Short-Term Capital Gains: If you sell shares within 36 months of buying them, the gains are taxed at your income tax slab rates.
  • Long-Term Capital Gains: If you sell shares after 36 months, the gains are taxed at 20% with indexation benefits.

When the company is listed, employees have more chances to sell their shares. The FMV is determined by the market, which can lead to better prices. It's important to know how ESOPs work, their benefits, and their tax implications. Remember the vesting period before you can exercise your options.


  • Is ESOP good for employees?

  • Is ESOP part of CTC?

  • What happens to my ESOP if I quit my job?

  • What happens to ESOPs if the company lets go of employees?

  • How to calculate ESOP?

  • How are ESOP shares allocated?