- ESOP — Employee Stock Ownership Plan — Meaning, Working & Benefits
- Why Company offers ESOPs to their employees?
- ESOPs from an employee’s perspective
- Tax Implication of ESOPs
- Benefits of ESOPs for the employers
- Problems related to ESOPs for the employers
- What Is ESOP (Employee Stock Ownership Plan)?
- How does an ESOP work?
- Uses for ESOPs
- Benefits of an ESOP
- Disadvantages of an ESOP
- Best practices for beginning an ESOP
- 1. Select a team of advisors
- 2. Conduct a feasibility study
- 3. Perform annual valuations
- 4. Communicate the value to employees
- ESOP FAQs
- Why do companies use ESOPs?
- Are ESOP accounts tax-deferred?
- What is the difference between 401(k) and ESOP?
- How an Employee Stock Ownership Plan (ESOP) Works
- ESOP Rules
- Major Tax Benefits
- Employee Stock Ownership Plan (ESOP) — How an ESOP Works
- How an ESOP works
- 1. Tax benefits for employees
- 2. Higher employee engagement
- 3. Positive outcomes for the company
- 1. Lack of diversification
- 2. Limits newer employees
- 3. Dilutive
- Related Reading
- Employee Stock Option Plan (ESOPs) | How this Scheme Works?
- How does Employee Stock Options Work?
- How Employee Stock Options affect the EPS?
- Taxes on Employee Stock Option Plan
- #1 – When Option is Allotted
- #2 – When Employee Sells his Stock
- Examples of ESOPs
- Example #1
- Example #2
- Recommended Articles
- Employee Stock Ownership Plan (ESOP) Facts
- Major Uses of ESOPs
- Employee Ownership and Corporate Performance
- How ESOPs Work
- How Employees Fare
- Examples of Major ESOP Companies
- For Further Reading at NCEO.org
ESOP — Employee Stock Ownership Plan — Meaning, Working & Benefits
An organization grants ESOPs to its employees for buying a specified number of shares of the company at a defined price after the option period (a certain number of years).
Before an employee could exercise his option, he needs to go through the pre-defined vesting period which implies that the employee has to work for the organization until a part or the entire stock options could be exercised.
Why Company offers ESOPs to their employees?
Organizations often use Employee stock ownership plans as a tool for attracting and retaining high-quality employees. Organizations usually distribute the stocks in a phased manner. For instance, a company might grant its employees the stocks at the close of the financial year, thereby offering its employees an incentive for remaining with the organization for receiving that grant.
Companies offering ESOPs have long-term objectives. Not only companies wish to retain employees for a long-term, but also intend making them the stakeholders of their company.
Most of the IT companies have alarming attrition rates, and ESOPs could help them bring down such heavy attrition Start-ups offer stocks for attracting talent. Often such organizations are cash-strapped and are unable to offer handsome salaries.
But by offering a stake in their organization, they make their compensation package competitive.
ESOPs from an employee’s perspective
With ESOPs, an employee gets the benefit of acquiring the shares of the company at the nominal rate, and sell them (after a defined tenure set by his employer) and make a profit.
There are several success stories of an employee raking in the riches together with founders of the companies. A very notable example is of Google when it went public.
Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions too.
Tax Implication of ESOPs
Employee stock ownership plans is considered as perquisites with respect to taxation.. On the other hand, for an employee, ESOPs are taxed at two below-mentioned instances –
While exercising – in form of a prerequisite. When an employee exercises his option, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxed as a perquisite.
While selling – in the form of capital gain. An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax.
The capital gains would be taxed depending on the period of holding. This period is calculated from the date of exercise up to the date of sale. Equity shares which are listed on the recognized stock exchange are considered as long-term capital if they’re held for more than 12 months i.e. 1 year.
In case the shares are sold within 12 months, these are then considered as short term. Presently, long-term capital gains (LTCG) on the listed equity shares are exempt from tax.
However as per the recent amendments in Budget 2018, Sale of equity shares that are held for more than a year on or after 1st April 1, 2018 would attract tax at the rate of 10% and cess of 4%. Short-term capital gains (STCG) are taxed at a rate of 15%.
Benefits of ESOPs for the employers
Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee put in his 100 percent. Although motivation, employee retention and awarding hard work are the key benefits which ESOP brings to the employers, there are several other noteworthy advantages too.
With the help of ESOP options, organizations could avoid the cash compensations as a reward, thus saving on immediate cash outflow. For organizations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.
Problems related to ESOPs for the employers
It’s easy to pitch the benefits of ESOPs for the companies considering the liquidity and succession alternatives. However, there are good reasons not to go for ESOPs.
Employee stock ownership plans have complex rules and need significant oversight.
Although outsourcing this function to external advisors and ESOP TPA (Third Party Administration) firms could manage it, the ESOP company requires some internal personnel for championing this program.
In case a company doesn’t have the staff to do the ESOP work properly, they could risk issues and potential violations.
Once the ESOPs are established, the company needs a proper administration including the third-party administration, trustee, valuation, legal costs.
Company owners and the management must be aware of the ongoing costs.
In case the cash flow which is dedicated to ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP scheme isn’t a good fit for such a company.
For companies requiring significant additional capital for carrying on business operations, they must avoid ESOPs.
The ESOP schemes use the cash flow of the company for funding purchase of shares from its shareholders.
In case a company requires the funds for additional working capital or capital expenditures, the ESOP transactions would compete with this necessary requirement, creating a crisis situation for the management.
What Is ESOP (Employee Stock Ownership Plan)?
An employee stock ownership plan is an employee benefit plan that provides employees with ownership shares in the company. ESOP is also sometimes called a stock purchase plan.
How does an ESOP work?
The employer decides on the number of shares of the company each eligible employee can receive and allocates shares to individual accounts the pay scale or the length of service. As long as the employees work for the company, they accumulate shares. When they leave, the employer has the obligation to buy back the shares at market value.
Companies usually establish ESOPs as a corporate financial strategy and to adjust the advantages of their employees with those of their shareholders.
ESOPs are set up as trust funds. To fund them, the company can issue new or treasury shares, put them into the ESOP fund and deduct their value from taxable income. The company can also put cash in to buy existing company shares from public or private owners.
Uses for ESOPs
Several uses companies can make of ESOP include:
- To buy shares: Company owners can use an ESOP to create a quick market for their shares. They can make tax-deductible cash contributions to the ESOP and buy out a departing owner’s shares.
- To borrow money at a lower cost: The company can use the ESOP fund to borrow cash and buy company shares or shares of existing owners. Then, the company can make tax-deductible contributions to the ESOP fund to reimburse the loan. In this approach, both the principal and interest are deductible.
- To offer an additional employee benefit: A company can offer stock shares from an ESOP to employees. Companies often combine an ESOP with a saving plan.
Related: How to Motivate Your Employees
Benefits of an ESOP
Advantages of an ESOP include:
- When employees receive an ownership interest in the company, they are motivated to increase the value of their shares. It gives them more drive to invest themselves and work in the best interest of all shareholders.
- Employees who own shares have excellent reasons to stay in the company, which can decrease turnover.
- Employees are not taxed on their shares until they leave the company or retire. Stocks remain in the ESOP until then. When the time comes, they have the choice to sell it back to the company or on the open market.
Related: How to Reduce Employee Turnover
Disadvantages of an ESOP
ESOPs have a few disadvantages:
- The cost of establishing an employee stock ownership plan is substantial, so it may be challenging for many small businesses to create one.
- Not all business entities can establish employee stock ownership plans. For example, partnerships and most professional corporations are not authorized to set up an ESOP.
Best practices for beginning an ESOP
It is essential for the success of your ESOP that you structure it according to the company’s abilities and the shareholders’ needs. Here are some steps to help you build a successful ESOP:
- Select a team of advisors
- Conduct a feasibility study
- Perform annual valuations
- Communicate the value to employees
1. Select a team of advisors
Select a team of reliable advisors, including administrative, financial, fiduciary and legal professionals to tailor an ESOP that meets the needs of the shareholders, is sustainable and creates value.
2. Conduct a feasibility study
There should be an exploration process during which you perform a feasibility analysis. With the team of experts previously selected, test various hypotheses regarding the value of the company, the expected ESOP benefit delivered to employees over time, financing options and the size of the transaction. Verify that your company cashflow can handle the requirements of the plan.
3. Perform annual valuations
Determine the fair price of the shares through an external yearly valuation if you are a private company. Public companies can find their value on the public market. Employees need to know the market value of their shares, since the employer is obligated to buy it at this price when they leave the company.
4. Communicate the value to employees
When communicating the stock package, it is best to describe it as a dollar value the current valuation rather than a percentage of ownership in the company. It is a more effective communication as the dollar value is easier to grasp for the employee. For start-ups that don’t have an accurate valuation of the company yet, a percentage is the only way to communicate.
Here are some answers to common questions about ESOPs:
Why do companies use ESOPs?
There are many reasons why companies use ESOPs, including:
- An ownership plan can attract top recruits. In start-ups, it also helps to attract early employees.
- As employees become equity owners, their interests align with the long-term goals of the organization.
- The longer employees work for the company, the more stocks they accumulate. Therefore, employees are encouraged to remain in the company.
- Tangible employee contributions increase corporate value, and by giving employees a slice of that value, the company rewards them.
- Shares usually pay off at the employee’s exit, so it encourages employees to build the company for long-term success.
Are ESOP accounts tax-deferred?
Employees only pay taxes when they receive the value of their shares as they retire or leave the company and sell their stocks.
They can defer the taxes to pay on the distribution of their accounts, and at potentially favorable rates.
They have the option to pay current tax on the distribution, with any gains accumulated over time taxed as capital gains or to roll over their distributions in an IRA or other retirement plans.
What is the difference between 401(k) and ESOP?
A 401(k) plan enables employees to save for retirement by making contributions from their paychecks. The employees can withdraw the money when they retire, are taxed on that amount of money and are penalized if they withdraw it earlier.
An ESOP is a trust fund employers create to allocate company shares to employees. The employers’ contributions to the plan are tax-deductible, and employees do not pay taxes on their shares until distribution. The employees receive the money when they leave the company without penalty, not only at retirement.
How an Employee Stock Ownership Plan (ESOP) Works
Employee ownership can be accomplished in a variety of ways. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit sharing plan.
Some employees become owners through worker cooperatives where everyone has an equal vote. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan.
Almost unknown until 1974, ESOPs are now widespread; as of the most recent data, 6,460 plans exist, covering 14.2 million people.
Companies can use ESOPs for a variety of purposes. Contrary to the impression one can get from media accounts, ESOPs are almost never used to save troubled companies—only at most a handful of such plans are set up each year.
Instead, ESOPs are most commonly used to provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars.
In almost every case, ESOPs are a contribution to the employee, not an employee purchase.
An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.
Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
The 2017 tax bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, at which point the limit decreases to 30% of EBIT (not EBITDA).
In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.
New leveraged ESOPs where the company borrows an amount that is large relative to its EBITDA may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change. This change will not affect 100%-ESOP owned S corporations because they don't pay tax.
Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula.
As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting.
Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.
When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares.
In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues.
In public companies, employees must be able to vote all issues.
Major Tax Benefits
ESOPs have a number of significant tax benefits, the most important of which are:
- Contributions of stock are tax-deductible: That means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, albeit this means existing owners will be diluted.
- Cash contributions are deductible: A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.
- Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible: The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.
- Sellers in a C corporation can get a tax deferral: In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
- In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
- Dividends are tax-deductible: Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
- Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates: The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.
Note that all contribution limits are subject to certain limitations, although these rarely pose a problem for companies.
As attractive as these tax benefits are, however, there are limits and drawbacks. The law does not allow ESOPs to be used in partnerships and most professional corporations.
ESOPs can be used in S corporations, but do not qualify for the rollover treatment discussed above and have lower contribution limits. Private companies must repurchase shares of departing employees, and this can become a major expense.
The cost of setting up an ESOP is also substantial—perhaps $40,000 for the simplest of plans in small companies and on up from there. Any time new shares are issued, the stock of existing owners is diluted.
That dilution must be weighed against the tax and motivation benefits an ESOP can provide. Finally, ESOPs will improve corporate performance only if combined with opportunities for employees to participate in decisions affecting their work.
This article is about ESOPs in the U.S., which follow specific U.S. tax and retirement plan laws. A benefit plan in another country called an ESOP may be very different. For example, an «ESOP» in India is a stock option plan, which has nothing to do with a U.S. ESOP.
For a book-length orientation to how ESOPs work, see Understanding ESOPs.
For an infographic that visually explains ESOPs, see How an ESOP Works at ESOPinfo.org.
Employee Stock Ownership Plan (ESOP) — How an ESOP Works
An Employee Stock Ownership Plan (ESOP) refers to an employee benefit plan that gives the employees an ownership stakeStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus in the company. The employer allocates a certain percentage of the company’s stock sharesStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms «stock», «shares», and «equity» are used interchangeably. to each eligible employee at no upfront cost. The distribution of shares may be the employee’s pay scale, terms of service, or some other basis of allocation.
The shares for an employee stock ownership plan are held in a trust unit for safety and growth until the employee exits the company or retires. After their exit, the shares are bought back by, and thus returned to, the company for further distribution to other employees.
An Employee Stock Ownership Plan invests in the employer’s company. The goal of the plan is to align the interests of the employees with the interests of the company’s shareholders.
By giving the employees a stake in the company, the employees move from being only workers to being owners of the company.
The plans motivate employees to do what is best for the shareholders, since they are shareholders as well.
Companies with a majority employee-ownership are referred to as employee-owned corporationsCorporationA corporation is a legal entity created by individuals, stockholders, or shareholders, with the purpose of operating for profit.
Corporations are allowed to enter into contracts, sue and be sued, own assets, remit federal and state taxes, and borrow money from financial institutions. and are similar to worker cooperatives. The difference with an employee stock ownership plan, as compared to a worker corporative, is that with an ESOP the company’s capital is not evenly distributed.
Senior employees are allocated more shares than newly hired employees, and therefore, the latter exercise less voting power during shareholder meetings.
How an ESOP works
When a company wants to create an Employee Stock Ownership Plan, it must create a trust in which to contribute either new shares of the company’s stock or cash to buy existing stock. These contributions to the trust are tax-deductible up to certain limits.
The shares are then allocated to all individual employee accounts. The most common allocation formula is in proportion to compensation, years of service, or both.
New employees usually join the plan and start receiving allocations after they’ve completed at least one year of service.
The shares in an ESOP allocated to employees must vest before employees are entitled to receive them. Vesting, in this case, refers to the increasing rights that employees receive on their shares as they accumulate seniority in the organization.
When employees who are members of the ESOP leave the company, they ought to receive their stock. Private companies are required to buy back the departing employee’s shares at fair market value within 60 days of the employee’s departure.
Private companies must have an annual stock valuation to determine the price of the shares.
Where some longstanding employees are exiting the company, and the share price has accumulated substantially, the company needs to make certain that is has enough money to pay for all the share repurchases.
1. Tax benefits for employees
One of the benefits of Employee Stock Ownership Plans is the tax benefit that employees enjoy. The employees do not pay tax on the contributions to an ESOP.
Employees are only taxed when they receive a distribution from the ESOP after retirement or when they otherwise exit the company. Any gains accumulated over time are taxed as capital gains.
If they elect to receive cash distributions before the normal retirement age, the distributions are subject to a 10% penalty.
2. Higher employee engagement
Companies with an ESOP in place tend to see higher employee engagement and involvement. It improves awareness among employees since they are given the opportunity to influence decisions about products and services.
Employees can see the big picture of the company’s plansCorporate StrategyCorporate Strategy focuses on how to manage resources, risk and return across a firm, as opposed to looking at competitive advantages in business strategy in the future and make recommendations on the kind of direction the company wants to take. An ESOP also increases employee trust in the company.
3. Positive outcomes for the company
Employee stock ownership plans not only benefit the employees but also result in positive outcomes for the company. According to the National ESOP Comparison Study conducted by Rutgers University, the adoption of ESOPs resulted in a 2.
4% increase in the annual sales growth, annual employment growth 2.3%, and increased the lihood of company survival.
An improved organizational performance increases the share price of the company and ultimately, the balance in each employee’s ESOP account.
1. Lack of diversification
Employees who are members of ESOP concentrate their retirement savings in a single company. This lack of diversification is against the principle of investment theory that advises investors to invest in different companies, industries, and locations.
Worse still, the employees lock their savings into the same company that they depend on for salaries, wages, insurance, and other benefits. If the company collapses, then the employee faces the risk of losing both their income and their savings.
Examples include the Enron and WorldCom company collapses where employees lost most of their retirement savings.
2. Limits newer employees
An Employee Stock Ownership Plan is designed in a way that limits benefits to newer employees. Employees who enrolled in the plan earlier benefit from the continuous contribution to the plan, giving them a higher voting power.
This is, however, different for newer employees who, even in stable companies, may not accumulate as much in savings as the longstanding employees.
Therefore, newer employees are given limited opportunity to participate in crucial decisions during annual general meetings and other forums.
Share ownership in an Employee Stock Ownership Plan is dilutive, meaning it reduces the percentage of ownership that each share holds. As more employees join the company, they are allocated shares to their accounts in the plan.
This reduces the overall percentages of the shares held by older members in the plan.
The dilution also affects voting power, since employees who hold high voting power, owing to their higher number of shares, end up with reduced voting powers after new members are admitted.
Thank you for reading CFI’s guide to an employee stock ownership plan. CFI is the official provider of the Financial Modeling & Valuation Analyst certificationFMVA® CertificationJoin 350,600+ students who work for companies Amazon, J.P. Morgan, and Ferrari . To continue learning and advancing your career, these additional resources will be helpful:
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Employee Stock Option Plan (ESOPs) | How this Scheme Works?
Employee stock option plan (ESOP) is an “option” granted to the company employee carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price).
These are complex call options granted by the companies as a part of the remuneration package.
When stock options are exercised in large quantities, it can have a significant impact on the total number of outstanding shares thereby diluting the EPS and negatively affecting the valuations of the firm.
Employee Stock Options is different from exchange-traded options as they are not traded and don’t come with put component. Also, please note that the pre-determined price is also called a Strike Price or the Exercise price.
How does Employee Stock Options Work?
Have a look at this options table from Colgate’s 2014 10K. This table provides details of Colgate’s outstanding stock options along with its weighted average exercise price.
Source – Colgate SEC Filings
- Employers issue Stock Options under the Stock Option Compensation Plan
- Stock Options can be exercised if the Market Price is greater than the Exercise Price or the strike price. (in-the-money)
- Once stock options are exercised, the company issues “shares” to the holder of the option.
- This, in turn, increases the total number of outstanding shares.
- Earnings Per Share (Net Profit/number of shares outstanding) decreases as the denominator increases.
How Employee Stock Options affect the EPS?
To understand this concept, you should be aware of two important terminologies – Options Outstanding and Options Exercisable.
- Options Outstanding is the total number of outstanding options issued by the Company, but not necessarily vested. These options may be in-the-money or out-of-money. In Colgate, Options outstanding are 42.902 million.
- Options Exercisable – Options that are vested as of now. These options again could be in-the-money or out-of-money. For Colgate, Options exercisable are 24.946 million.
Let us take the example of Colgate 2014 10K; as noted above, there are 24.946 million employee stock options that are exercisable. For considering the effect of dilution, we only take the “options exercisable” and not the “Options outstanding,” as many of the outstanding options may not have vested.
Let us compare the average exercise price of $46 with the current market price of Colgate. As of the closing of June 13, 2016, Colgate was trading at $76.67. Since the Market Price is greater than the exercise price, all 24.946 million are in-the-money and therefore, will increase the total number of shares outstanding will be 24.946.
Basic EPS of Colgate
- Net Income 2014 of Colgate = 2,180 million
- Basic Shares = 915.1 million
- formula of Basic EPS = 2180/915 = $2.38
Impact of Stock Options on Diluted EPS of Colgate
- Net Income 2014 of Colgate = 2,180 million
- Oustanding Shares = 915.1 million + 24.946 million = 940.046
- Diluted EPS = 2180/940.046 = $2.31
As you can see that the EPS decreased from $2.38 to $2.31 due to the impact of stock options;
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If the amount of stock options issued by the company is large, it can have a significant impact on the EPS of the company, thereby negatively affecting the valuation of the firm. Do have a look at the PE ratio for further details.
Taxes on Employee Stock Option Plan
Here we are going to discuss the taxes on the employee stock option plan –
#1 – When Option is Allotted
At the time of allotment of share on the exercise date, the difference between the fair market value at the time of exercise date and the price employee had paid at the time of subscription or at the time of exercise calculated accordingly. The value which we get after calculating the difference between the market value and the value at the time of subscription and that taxable value called prerequisite value. The difference which calculated eligible for tax deducted at source.
#2 – When Employee Sells his Stock
In the second situation, when an employee opts to sell his share, the profit made by the employee is considered a capital gain. Taxes are applicable to capital gain, and it is calculated by the difference between fair market value on the exercise date and the sale value of the share.
Examples of ESOPs
For more clarification take help of the following example
ESOP taxation – while exercising the option – First condition for taxation
- Prerequisite value of ESOP (at the time of allotment)
- Market value = 120
- Exercise price = 70
- and the number of shares allocated under ESOP is 6000
Calculation of Prerequisite value of ESOP
Prerequisite value of ESOP = (fair market value- price at the time of exercise)* No of share
The above value is the prerequisite value of ESOP that is 300000, and this 300000 is the part of the salary of the employee, and it will be taxable at the time of allotment of share.
ESOP taxation- At the time of sale(capital gain)
- Sale proceeds at a price = 100
- fair market value at the time of allotment of share = 80
- Number of share 6000
Calculation of Capital Gains
Capital Gain = (Sale proceeds – Fair market value at the time of allotment of share)*No of share
= (100-80)*6000 = 120000
So, in this case, the tax will be applicable to the capital gain that is 120000, and the tax rate will depend upon the holding period.
This has been Guide to Employee Stock Option and its definition. Here we discuss how employee stock option plan (ESOP) Works along with examples, taxation issues, and more. You can learn more about financing from the following articles –
Employee Stock Ownership Plan (ESOP) Facts
In addition, we estimate that roughly 9 million employees participate in plans that provide stock options or other individual equity to most or all employees. Up to 5 million participate in 401(k) plans that are primarily invested in employer stock. As many as 11 million employees buy shares in their employer through employee stock purchase plans.
Eliminating overlap, we estimate that approximately 32 million employees participate in an employee ownership plan. These numbers are estimates, but are probably conservative. Overall, employees now control about 8% of corporate equity. Although other plans now have substantial assets, most of the estimated 4,000 majority employee-owned companies have ESOPs.
Major Uses of ESOPs
About two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held company.
Most of the remainder are used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner. Less than 10% of plans are in public companies.
In contrast, stock option or other equity compensation plans are used primarily in public firms as an employee benefit and in rapidly growing private companies.
Employee Ownership and Corporate Performance
A 2000 Rutgers study found that ESOP companies grow 2.3% to 2.4% faster after setting up their ESOP than would have been expected without it. Companies that combine employee ownership with employee workplace participation programs show even more substantial gains in performance.
A 1986 NCEO study found that employee ownership firms that practice participative management grow 8% to 11% per year faster with their ownership plans than they would have without them. Note, however, that participation plans alone have little impact on company performance.
These NCEO data have been confirmed by several subsequent academic studies that find both the same direction and magnitude of results.
How ESOPs Work
See our infographic on how an ESOP works
Companies set up a trust fund for employees and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares.
If the plan borrows money, the company makes contributions to the plan to enable it to repay the loan. Contributions to the plan are tax-deductible. Employees pay no tax on the contributions until they receive the stock when they leave or retire.
They then either sell it on the market or back to the company. Provided that an ESOP owns 30% or more of company stock and the company is a C corporation, owners of a private firm selling to an ESOP can defer taxation on their gains by reinvesting in securities of other companies.
S corporations can have ESOPs as well. Earnings attributable to the ESOP's ownership share in S corporations are not taxable.
In other plans, approximately 800 employers partially match employee 401(k) contributions with contributions of employer stock. Employees can also choose to invest in employer stock.
In stock option and other individual equity plans, companies give employees the right to purchase shares at a fixed price for a set number of years into the future. (Do not confuse stock options with U.S.
ESOPs; in India, for example, employee stock option plans are called «ESOPs,» but the U.S. ESOP has nothing to do with stock options.)
How Employees Fare
Participants in ESOPs do well. A 1997 Washington State study found that ESOP participants made 5% to 12% more in wages and had almost three times the retirement assets as did workers in comparable non-ESOP companies.
According to a 2010 NCEO analysis of ESOP company government filings in 2008, the average ESOP participant receives about $4,443 per year in company contributions to the ESOP and has an account balance of $55,836.
People in the plan for many years would have much larger balances. In addition, 56% of the ESOP companies have at least one additional employee retirement plan.
By contrast, only about 44% of all companies otherwise comparable to ESOPs have any retirement plan, and many of these are funded entirely by employees.
Examples of Major ESOP Companies
ESOPs can be found in all kinds of sizes of companies. Some of the more notable majority employee-owned companies are Publix Super Markets (200,000 employees), Amsted Industries (18,000 employees), W.L.
Gore and Associates (maker of Gore-Tex, 10,720 employees), and Davey Tree Expert (10,500 employees) (see our Employee Ownership 100 list).
Companies with ESOPs and other broad-based employee ownership plans account for well over half of Fortune Magazine's «100 Best Companies to Work for in America» list year after year.
For Further Reading at NCEO.org
Below are a few good starting points at our main website; see our Find Your Resource page to explore further, especially the «Start Here» pages: