How are ESOPs taxed? All you need to know

Employee Stock Ownership Plans or ESOPs have become a popular way to incentivise employees, as it gives them a chance to own a part of the company in future at a pre-determined price, also known as exercise price. They have a lock in period (vesting period) after which employees can buy or exercise the shares. Though they look attractive to opt for given they are offered at a discounted rate to employees it is important to understand that there is a tax element to the benefit offered.

First let's see how ESOPs work. On April 1 2022, suppose the company grants an employee 100 shares, at an exercise price of Rs 100 per share. Let's assume that the vesting period is two years. At any point after April 1, 2024, he can pay Rs 100 a share and get the shares. If the market price on August 1, 2024 is Rs 200, he can sell the shares and make money. However, if the market price is Rs 60, he need not exercise the option. He can instead wait for the stock price to rise.

The next question is how are ESOPs taxed? There are two instances when ESOPs get taxed in the hands of an employee. First when they are exercised second when the shares are sold. In the first instance, it is treated as a perquisite and taxable as income under the head salaries. In the second instance when sold in the market it is treated as a capital gain.

"The benefit derived by an employee from allotment of ESOP is taxable in the hands of the employee as a prerequisite and forms a part of his income under the head Salaries.  The perquisite value on which tax is required to be paid is the difference between the fair market value (FMV) of the stocks allotted less the amount if any, recovered from the employee," said Neeraj Agarwala, Partner, Nangia Andersen LLP.

"It is pertinent to note here that subsequently when the employee sells the shares allotted, he would again need to pay capital gains tax.  However, for capital gains purposes, the cost of the shares sold would be the FMV considered for perquisite tax.  Hence there would be no double taxation of the same income," Agarwala added.

Is there any difference in tax treatment for listed and unlisted shares? The expert says that from a perquisite tax point of view, there is not much difference. When listed shares are allotted, the tax is calculated based on the traded price in a stock exchange, whereas in the case of unlisted shares, fair market value is required to be determined by the merchant banker.

One important point to keep in mind is the time when one would have to pay taxes?

"ESOPs are taxed in the year when options are exercised and the taxes are required to be paid in that year itself.  However, in the case of start-ups, additional time has been provided for the deposit of such ESOP.  Employees have 4 years from the end of the assessment year in which shares are allotted, or the date on which the shares are sold or such person ceases to be an employee of that company whichever is earlier would be the due date for discharging the tax liability," explained Agarwala.

ESOPs come with the vesting period and are not immediately handed over to employees. If you are looking for immediate liquidity, then it is not meant for you.

"ESOPs may not suit someone looking for liquidity in the near term. Moreover, exercising the options makes sense only if the market price of the stock is more than the grant price.  After you exercise the option, you have to pay tax on the difference between the exercise price and the fair market value of the stock (average of opening and closing prices)," points out Neha Nagar, founder and CEO, TaxationHelp.in.

Also read: How you can make the most of your employee stock options

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