Employee stock option plans, or ESOPs, were created with the idea of distributing ownership duties among staff members and keeping talent on board, which is critical for startups. To minimize cash outflow and attract and retain people, startups are increasingly creating an ESOP pool prior to funding as it is a tax-efficient strategy.

Do you wish to offer Employee Stock Ownership Plans (ESOPs) to your staff members but are unsure of the tax implications for your startups? Don’t worry. Here’s an explanation of the tax implications of ESOP:

Overview of Employee Stock Option Plan

An Employee Stock Option Plan (ESOP) is an employee benefit plan that allows startups to give staff members ownership stakes in the company. Employee stock ownership plans (ESOPs) provide eligible employees the option to purchase the company’s stock after a vesting period, provided they meet the requirements specified in the company’s ESOP scheme.

Employees can purchase company shares at a predetermined price after fulfilling any vesting requirements. The employees are essentially offered three different types of ESOPs. These are issued as common stock, stock appreciation rights, and stock options.

ESOP Taxation

Taxation of ESOPs is dependent on a number of circumstances, and it can be either exercised or sold. Here are the factors that form the basis of the ESOP’s tax treatment:

  • The type issued to the employee
  • The option used by the employee
  • Retire time chosen by the employee

These components make up the cost of taxes put on ESOPs and play a part in deciding it.

ESOPs are subjected to two different tax treatment. Now, let’s be more specific about the tax implications.

Taxation of ESOP at the time of Exercise: In this case, the shares are assigned to the employee after the end of the vesting term. The difference between the share’s fair market value on the exercise date and the exercise price is taken into account when the employee exercises this option.

Section 17 of the Income Tax Act of 1961 will apply to this. The employer company should deduct the TDS on this employee’s exercise. The employer is also under an obligation to file on or before the 7th day of the next month. This part of the ESOP will be included in the employee’s total income on FORM 16.

ESOP Taxation Paid by the Employee at the Time of Sale: The profits from the sale of the ESOPs are subject to capital gains taxes for the employee. Capital gains tax is the difference between the ESOP’s Sale Price and its Fair Market Value on the exercise date.

There are two different kinds of capital gains: long-term and short-term. Selling an ESOP within 24 months of exercising any of the abovementioned choices results in a short-term capital gain. Selling an ESOP after 24 months of exercising any of the aforementioned options results in a long-term capital gain.

Factors to Consider for ESOP Taxation

Here are some of the factors to consider for ESOP taxation:

  • Listed on a reputable Indian stock market

Gains of more than INR 1,000,000 attained in a single year are considered long-term capital gains. In addition to any applicable surcharge and cess, they are liable to 10% tax. There is no indexation applied to them. Short-term capital gains are subject to a 15% tax rate (plus any applicable cess and surcharge).

  • Disclosures

Several additional disclosures are now included on income tax return forms for assets owned overseas. Your income tax return’s schedule FA might ask you to disclose your foreign holdings. This holds true if you own RSUs or ESOPs from an international company. There are disclosure obligations for residents.

  • Not available on a respectable stock exchange

Resident taxpayers are subject to a 20% tax rate (plus surcharge and cess) by the tax authorities. 10% (plus surcharge and cess) of non-residents’ income is taxed by the government. In short-term capital gains the total income is included.

Final thoughts

ESOPs are expected to grow more prominently as an important component of Indian startups as long as the rules are supportive. The ESOPs are taxed in a few different ways. The ESOP should be issued in conjunction with those for best results.

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