The corporate world is always in a state of flux and fluidity. There are no permanent loyalties and no permanent careers. Most talented people are game for head-hunters and companies do not mind poaching the best talent from their competitors or even other industries.
Employee attrition is a menace, and it is often a challenge to retain the best employees despite handsome appraisals and packages. In this situation, companies often reward their top-performing employees in the middle and senior management with a share of the business.
How do Employee Stock Options work?
Employee Stock options like- Restricted Stock Units (RSUs), Employee Stock Option Plans (ESOPs), or Employee Stock Purchase Plans (ESPPs) offer the employees a stake in the business of the company by offering them the shares of the company at discounted rates. By offering the employees a stake in the stock, they are offering a limitless opportunity to grow with the company.
The employees have now “skin in the game” and would be more dedicated than ever to the success of its business operations.
Such stock offers also help the companies to pay their annual packages that might look lean and mean otherwise. Therefore, to attract the best talent from premier institutions, companies often include RSU, ESOP, or ESPP as part of their annual CTC. The cash outgo of the company is limited while the number of the stocks or their options is dependent on the performance of the employee.
Though these are not part of the cash salary that an employee receives from the employer. They still form a sizeable part of their compensation, especially when exercised by the employees. This makes them liable for income tax or capital gains tax, as the case may be.
Also Check- Components of a salary slip of an employee
What are the Types of Employee Stock Options?
There are three types of Employee Stock Options- RSU, ESOP, and ESPP. We will understand each of these from the employees’ perspective. We will also explain the taxation-related rules and overall benefits or limitations of such stock-related remunerations in this article.
What is RSU?
RSU or Restricted Stock Units are offered by the employer with only one restriction or condition – they get vested in the favour of the employee after completion of the vesting period. The vesting period is the period for which there should be no discontinuity in the services of the employee by way of resignation or termination.
If the employee completes the vesting period, then the stock units or equity shares are transferred in the name of the employee to their Demat account. There are no strings attached to these shares, and the employee has the title, ownership, and control over such shares.
For example, a company offers 500 RSUs with a 3-year vesting period to its employees. It means that the employees can claim the said 500 shares after they have completed three uninterrupted years of services in the company.
After the vesting period is over, the company registrar will transfer them into the Demat accounts of the employees. If the shares are listed on the stock exchanges, then they can even sell the stocks as soon as they are credited to their account. The transfer of such RSUs is done at the fair market value (FMV) of the stock as of date.
If the employee resigns or their services are terminated before such RSUs are vested, then the employee would lose her/his claim over the RSUs. The top management can offer RSUs as a hook to keep its best talent stuck with the company for a long.
An employee would think twice before switching jobs if the company’s shares are soaring high due to its stellar performance.
Many companies also offer RSUs in a phased manner, for example, 100 RSUs each year for the next five years, with each vesting in 3-years’ time. This way they can keep the talent stick around for a longer duration.
What is ESOP?
Unlike RSUs, where the stocks are transferred unconditionally upon completion of the vesting period, ESOPs or Employee Stock Option Plans are somewhat conditional. Most big corporates have employed ESOP as one of the employee attraction and retention tools.
An ESOP is an employee stock option available to you and not something that is ranted to you. If you have been granted ESOPs, then it means that on the due date you will have the right to exercise this option, but there is no compulsion to do so.
Typically, it is a contract between the company and the employee where the company agrees to sell then its stock at a pre-determined price to the employee. The company will vest the right of exercising the option in the employee if she meets certain criteria laid down by the company related to her performance.
An employee has the freedom to exercise the option or to reject it, depending on their association with the company, their future with it, tax implications, and even portfolio’ asset allocation.
If at the time of exercising the option, the market price of the stock is above the option price, the employee stands to gain. They can sell it immediately or can hold on to it for a share in future capital appreciation and dividends. Conversely, if the market price of the stock is below the option price, you can simply not exercise the option.
In other words, irrespective of the market price of the stock, you could always buy it at the option price.
What is ESPP?
ESPP or Employee Stock Purchase Plan offers a midway to both the RSU and the ESOP. It is an employee stock option that allows the employees to buy the stock directly from the company at a discounted price to the existing market value or the fair value.
The employees can make definite contributions to a common pool of funds from their monthly salaries. Upon maturity, the pool money is utilized to buy the shares of the company at a pre-agreed discount from the current market price.
If your company offers an ESPP plan twice a year, you can participate in it twice a year. Suppose the first window is from January to June, then you can join the pool in January. Or you could choose to join the second pool starting in July.
Therefore, you must inform HR well in advance about your intent to participate in the ESPP and how much are you willing to contribute towards the pool money.
Conceptually, this makes ESPP like a Systematic Investment Plan or SIP in the stock of the company where you work. If your employer has solid business prospects, then it is a great way to participate in its growth story. (Also Read: All About SIP in Mutual Funds)
The discount offered varies from company to company and can vary between 10 to 25 percent. Generally, the discount is offered on the base price, which is usually the lower amount of the opening and the closing prices in the given window.
Therefore, even if the company stock is going downhill, you get the stock at an even greater discount, increasing your margin of safety.
For example, if the opening price of a window was Rs.100 and the closing price was Rs.70, then the base price would be the lower of the two – Rs.70. Even at a discount of 10%, you could get these shares at only Rs.63.
Conversely, if the price increases during the given window, you stand to gain much more as you will get a discount on the lower of opening and closing prices.
Benefits and Risks of Employee stock options:
As this part of the compensation package is marketable security, it comes with its own set of benefits and risks.
Benefits of RSU, ESOP, and ESPP:
You must understand that whatever option is offered to you by your employer, you are buying into the equity of the company. Therefore, you will get all the benefits that you would otherwise get by investing directly in stocks.
The major difference between a market-led investment and Employee stock options is that the employee gets a preferred allotment, better share price, or both. They also get to participate in the initial growth story of an upcoming unicorn, where the most moolah is made.
Risks associated with RSU, ESOP, and ESPP:
Similarly, just like direct equity investments, exposure to Employee stock options is into the equity of the company you work for. There are all the associated risks like:
- Over-concentration risk – most employees’ biggest or only stake is in their own company’s shares.
- Business failure risks.
- Volatility and market risks.
But as an employee, there are certain risks/factors that would apply only to you and not to other investors. These are:
- The gain on sales proceeds over the acquisition price is taxable income.
- To be able to exercise the ESOP or get an allotment through RSU or ESPP, you must stay put in the company till the entire stocks vest. It means you may have to continue even if the work environment is detrimental to you professionally and personally.
- Most banks do not consider RSUs a part of your CTC and this reduces your loan eligibility.
- If a major part of your income is in the form of Employee stock options like- RSU, ESOP, or ESPP, then it is not liquid. Even when the shares are credited to your account, you may not find liquidity for them or may have to sell them at a deeper discount.
- To be able to exercise your employee stock options you must have liquidity at the time of option maturing.
(Also Read: What is Equity?- It is much more than just stock market investment)
How are Employee Stock Options Taxed?
Basically, there would be two instances of taxation- One as a perquisite in the hands of the employee and the other on the capital gains. Let us understand the taxation under all the three types of employee stock options, in detail:
Taxation as a Perquisite:
RSU Taxation:
As the RSUs are credited directly by the company and the employee does not have to pay anything, the entire transfer is considered as income in the financial year. The company will withhold shares equal to the total tax liability and will transfer only the balance shares to the employee account.
ESOP Taxation:
As you exercise the option to buy the shares in the company at a pre-determined price, the difference in the acquisition rate and the current market price is considered as a perquisite under the head of salary and the employer deducts TDS on the same.
Let us understand the ESOP Taxation with an example. On 1st April 2021, Ramesh had provided with an option to purchase the shares of the company ABC ltd. (employer) at Rs.300 per share. The market price of the shares on that date was Rs.500 per share. Ramesh decides to exercise the option and decides to buy 100 shares for Rs.30,000 (300×100). The difference between the exercise price and market price i.e., Rs.200 per share or Rs.20,000 would be treated as a perquisite in the hands of Ramesh and the employer would deduct TDS on this amount. The rate of TDS would be the same as the tax slab rate applicable to Ramesh.
From FY 2020-21, employees of an eligible start-up need not pay income tax on the ESOP in the year in which they exercised the option. In this case, the Tax on this perquisite would be payable within 14 days of happening any one of the following events, whichever occurs earlier:
- After the expiry of 5 years from the year of allotment.
- The date of sale by the employee of the stock acquired through ESOP.
- Date of termination of employment with the company.
Since tax is not payable immediately, the employer would not deduct TDS on the same.
The eligible start-up is the one that is incorporated between 1st April 2016 and 31st March 2023 (amendment in Finance Bill 2022), has an annual turnover of less than Rs.100 crores and is engaged in specified businesses as defined by the Government.
For example, Suresh joined an eligible start-up fulfilling all the above conditions on 1st April 2021 and has been provided with an option to buy 1000 shares at an exercise price of Rs.5 per share. The vesting period is 20% at the end of each completed year of employment. Suresh exercised the option and opted to buy 200 shares for Rs.1,000 (200×5). Suppose, the market value of the share on that date is Rs.500. The tax would be applicable on the difference between the exercise price and the market value, i.e., Rs.90,000 (450×200) as under:
Scenario A- Suresh continues to work in the same company and holds the ESOPs: In this case, since the shares were purchased in FY 2021-22, the tax would be due after the expiry of 5 years, i.e., on 31st March 2027 and would be payable within 14 days, i.e., 14th April 2027.
Scenario B- Suresh continues to work in the same company but sells the allotted shares on 30th September 2024: In this scenario, the tax would become due on 30th September 2024 and would be payable within 14 days, i.e., 14th October 2025. The capital gains tax on the sale of the stock is also applicable as discussed in the upcoming sections.
Scenario C- Suresh ceases to be the employee of this company on 1st May 2024: Tax would become due on 1st May 2024 and would be payable within 15th May 2024.
ESPP Taxation:
The difference between the discounted base price and the current market price is treated as income in the financial year in which you transfer the shares.
Tax on Capital Gains
Depending on how long have you held the stock, short-term or long-term capital gains tax may apply. The longer you hold the stock (at least for a year) the less capital gains tax you pay.
In all three employee stock options as your acquisition price is over and above your sale price, the difference between them will be your capital gains.
Also Check- the 3 rules about Capital Gains Tax you may not be aware of
Applicable Tax Rates
The tax rates depend on multiple factors:
- The listing status of the company – listed or unlisted.
- Country of Registered offices of the company – India or a foreign country.
- A tax residency status of the employee – Resident Indian or Non-resident Indian.
Following are the tax rates applicable to gains from unlisted and listed shares.
| Minimum Holding Period Applicable to be Viewed as Long-Term Capital Gains | Tax on STCG | Tax on LTCG | ||
| Listed Shares | ||||
| On Indian Stock Exchanges | 1 year | 15% | 10% | |
| On Foreign Stock Exchanges | According to the tax laws of the country where the stocks are listed. It also depends on the tax residency status of the employee and is the Double Tax Avoidance Agreement is in place with that country. If the DTAA is not effective, then additional tax is payable in India. | |||
| Unlisted Shares | ||||
| 3 years | Added to Taxable Income | 20% with Indexation | ||
| 3 years | Added to Taxable Income | 20% with Indexation |
Also Read: Taxation of Mutual Funds in India
Upon Incurring a Loss
In case of incurring losses due to the share price of the company crashing, you can carry forward the losses for up to 8 financial years. You must show the losses in your tax return to adjust them against future capital gains. (Also Read: How to carry forward and set off losses?)
When you do not exercise the Employee stock option.
On the date of the vesting, the employees may not exercise their right buy passing on the opportunity. If you have not exercised the right, there is no income or capital gains.
Are employee stock option plans a good idea?
Here are some of the important considerations which you should look at before opting RSU, ESOP, or ESPP:
- Employee stock options are great opportunities to build an equity portfolio for young professionals. As the time is on your side, you can manage the volatility and the risks far better than most.
- If one of your major financial goals is nearby, then you should opt for a package with a higher take-home salary.
- A larger amount for the CTC on your payslip increases your chance to get more and better terms on loans.
- As most people switch jobs very often, they insist on having cash benefits rather than Employee stock options to avoid long-term commitment issues.
Conclusion:
Employee stock option plans like- RSU, ESOP, and ESPP are becoming a norm with companies. They can attract the best talent without putting any strain on their finances. The employees get to ride the wave and enjoy the uphill journey from the front row.
Just like any other equity-related instrument, you must be able to digest the volatility in the long-term trends of the share prices.
