What is ESOP (Employee Stock Ownership Plan)? How it Works?

esop (employee stock ownership plan)

What is ESOP?

ESOP or Employee Stock Ownership Plan is a corporation program in which company set aside stock for the benefit of employees as a group.

Organisation go for employee stock ownership plan as they provide income tax benefits to them. On the other hand, contributions to the plan are tax deductible employee compensation. In simple and short words it leads to win win situation for both company as well as employees.

There are variety of ways to get Employee Stock Option Plan. Employees can buy stock through stock option, directly, as a bonus shares or can receive it through profit sharing plan. If an employee goes for this plan, then he has to accept the lower fixed pay. It is very important that employees should do cost benefit analysis before taking any decision with respect to the plan.

How ESOP Works?

It is one of the employee benefit plan. A company set up a trust fund. In this trust fund, company contributes either its own share or cash to buy existing shares. Employee stock ownership plan can also borrow money to buy new or existing shares with the company making cash contribution in it so that employees can repay the loan.

Without giving any consideration to how the plan has acquired stock, company’s contribution to the plan are tax deductible within certain limits. When employees leaves the company, they receive their stock. This stock is bought back by the company at the market value.

Uses of Employee Stock Ownership Plan

  • It is used to borrow money at a lower after tax cost.
  • A company can issue new shares or treasury towards the ESOPs after deducting their value from taxable income. Hence resulting in creating addition benefits for the employees.
  • Use to attract or retain the talented workforce.

Tax Implications in ESOPS

In this plan, tax benefit can be availed at two stages –

  1. On exercise of the option
  2. On sale of the shares

On exercise of option, the difference of fair market value and EP will be taxable with the employer holding the necessary tax. Whereas on the sale of shares, the difference between selling price and market value will be taxed as capital gains tax. The tax rate varies with the time period for which the shares are held.

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