Employee stock ownership plans (ESOPs): How do ESOPs work & their taxation

Income Tax Income from Salary
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ESOPs, short for Employee Stock Ownership Plans, are forming a huge part of salary packages these days, especially in startups and growing companies. With ESOPs, you get to own a piece of the company you work for, giving you a chance to grow your wealth as the business succeeds (skin in the game you know).

How do ESOPs work?

ESOP is an employee benefit plan provided by companies, where apart from the cash component, you also get a share in the company.

However, ESOP is a stock ‘option’ plan, not actual stocks i.e. you are given the right or ‘option’ to buy the company’s shares on a future date and at a price lower than the market price.

Now, there are some important dates and events you should know about.

  • Grant date: This is the date when the company gives you the stock options.

  • Vesting period: This is the time you need to wait before you can fully earn your stock options. Most companies have a vesting period of four years, which means you won’t have access to all the stock options granted before four years. The stock options are either vested yearly, bi-annually, quarterly or even monthly based on the company policy.

  • Vesting date: When you officially earn the right to exercise your stock options.

  • Exercise period: The time frame during which you can buy the shares after they have been vested. The company decides this when ESOPs are granted. If you don’t exercise your options in this period, they’ll lapse.

  • Exercise date: This is the actual day when you decide to buy the shares.

  • Exercise price: This is the price you’ll pay for each share at the time of exercise. This is also pre-decided when the ESOPs are granted. This price will be lower than the market price of the company.

How are ESOPs taxed?

Because there are so many events in the entire process, the taxation also takes place in stages.

One, when you exercise the ESOPs.

And two, when you sell the shares.

Let’s understand one by one.

  1. At the time of exercise

This is when you actually buy the shares at the exercise price. At this stage, the difference between the exercise price and the fair market value (the current value of the shares) is considered taxable income. This amount is taxed as ‘income from salary’.

For example:

Say the company grants you 1000 shares with an exercise price of ₹100 per share. At the time of exercising, the fair market value (FMV) of each share is ₹300.

So, the difference of ₹200 per share (₹300 - ₹100) becomes taxable income. For 1000 shares, that’s ₹2,00,000 (₹200 x 1000) taxed as your salary income. The tax liability will depend on the tax slab you fall in.

Now that you have exercised the stock options, you will have the shares in your demat account.

Further, the exercise date will become your date of acquisition and the FMV (₹300 in this case) on the same will become your cost of acquisition.

  1. When you sell the shares

If you sell the shares for more than the exercise price, the profit you make is considered a capital gain.

Example:

Continuing from the previous example, let’s say you decide to sell the shares later when the market price has risen to ₹700 per share.

If you sell all 1000 shares at ₹700 each, you’ll make a profit of ₹400 per share (₹700 - ₹300), or ₹4,00,000 in total.

Now, the tax rate will differ depending on how the shares are sold.

There could be multiple ways of liquidating your ESOPs.

  • You sell the stocks when the company is still unlisted: In this case the tax rates would be as follows:

    Tax rate for ESOPs when the company is unlisted.
    Tax rate for ESOPs when the company is unlisted.789×130 9.08 KB

  • You sell the stocks after the company gets listed: Your company might go for an IPO and get listed. You’ll then be able to trade these stocks on the public exchanges.

    Tax rate for ESOPs when the company is listed.
    Tax rate for ESOPs when the company is listed.794×135 8.85 KB

  • You sell the stocks in a buyback: A buyback means you sell the shares back to the company. In this case the entire amount received (not just profits) will be taxable at your slab rate under income from other sources. Moreover, you’ll be able to claim the cost of acquisition as a capital loss. Here’s a detailed read on taxation of buybacks.

If you have ESOPs from a foreign company, regardless of whether it is listed or not, it’ll be taxed just like unlisted shares.

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Hi, Assume I applied for 1 share of X company for 100rs. on ESOP and i have paid tax(TDS) as 31.2 Rs. .Now after 1 year the price of the share is 50rs. how can I get refund of excess tax paid 15.6rs. now.Pls reply

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Hi @Deeban_Thangavelu

The difference between the cost of acquisition and the sale price is your capital loss or capital gains.
This is reported under the head of “Income from Capital Gains”.
When reporting income under this head, you can claim only certain expenses. As per the law, any tax paid (TDS) cannot be claimed as an expense.

In your case, if the share price falls to ₹50 from ₹100, then there is a capital loss (long term loss or short-term loss, depending upon the holding period). This capital loss can be set off and carried forward.

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So is it correct to assume I am taxed twice? First when I exercise I am taxed the perquisite tax, and then assuming the share price is up, a capital gain tax?

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Hi @Tanuj_Joshi

Yes, ESOPs are taxed in 2 instances as correctly mentioned by you.

When you sell those shares, you can reduce the capital gains by the amount of the cost of the acquisition of those shares.

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Hi I would like to know how is ESOP liquidation taxed? My wife has been notified by her employer about ESOP liquidation. So would like to know what’s percentage that gets taxed? Will the employer TDS and share the amount?

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Hi @Jayadev_Nair

You can read about the ESOPs Taxation in the hands of an Employee - Learn by Quicko.

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Hi @Shrutika_Shah ,
First of all your article was a nice read. There is not much info available on ESOPs and their taxation. I have a question about unlisted shares becoming listed.

Let’s say I have 1 ESOP that has and excercise price of 10 Rs and FMV of 100 at the time of exercise.
Tax liability = (100-10)*0.3 (Assuming tax slab to be 30% and not taking in account for cess for the calcualtion) = 27
I pay 10(ExercisePrice) + 27(Tax) = 37Rs and I am given a share cetificate for 1 share of the unilsted company,
Let’s say I exercise it on 1 Jan 2024 and am granted the share on the same day as well (Ignoring 30-60 day grace period between the actual grant).

Now let’s say on 1 Oct 2024 the company beomes listed. How will that affect my taxation?

LTCG % of unlisted and listed shares is different and also the time duration is also different for change from STCG to LTCG.
As I have been holding the share since 1 Jan 2024 and on 2 Jan 2024 it is a listed share, can I sell it on 2 Jan 2024 and just pay 10% LTCG or there is someting else that takes place when the comany goes through IPO?
For the sake of values let’s say the initial listing price is 200Rs and the rate at 2 Jan 2024 is 250Rs if we want to make use of these values.

P.S. Thanks in advance. I am currently working with a start up and thinking of exercising my ESOPs so that I can decrease my net tax liability on these and am in the process of exercising them. Would be really helpful to gain the info on the above example as well.

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Hi @Shrutika_Shah

My company offered me a one time payment to not exercise my ESOPs. At the time of payment, I had not been employed by the company for a long time. Under which head would this income come under and how will it be taxed?

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Hey @Anish_Sharma,

I am in touch with my team for this query and will get back to you with the answer.

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Hey @Lokesh,

Such one-time payment can be reported as “Profit in lieu of Salary” while filing the ITR. It will be taxed as ‘income from salary’.

Hope this clarifies!

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