Employee stock ownership plan

An employee stock ownership plan (ESOP) is an employee-owner method that provides

a company's workforce with an ownership interest in the company. In an ESOP, companies provide
their employees with stock ownership, often at no up-front cost to the employees. ESOP shares,
however, are part of employees' remuneration for work performed. Shares are allocated to
employees and may be held in an ESOP trust until the employee retires or leaves the company. The
shares are then sold.
History[edit]
In the mid-19th century, as the United States transitioned to an industrial economy, national
corporations like Procter & Gamble, Railway Express, Sears & Roebuck, and others recognized that
someone could work for the companies for 20 plus years, reach an old age, and then have no
income after they could no longer work. The leaders of those 19th-century companies decided to set
aside stock in the company that would be given to the employee when she or he retired.
In the early 20th century, when the United States sanctioned an income tax on all citizens, one of the
biggest debates was about how to treat stock set aside for an employee by her employer under the
new U.S. income tax laws.
ESOPs were developed as a way to encourage capital expansion and economic equality. Many of
the early proponents of ESOPs believed that capitalisms viability depended upon continued growth,
and that there was no better way for economies to grow than by distributing the benefits of that
growth to the workforce.
[21]

In 1956, Louis Kelso invented the first ESOP, which allowed the employees of Peninsula
Newspapers to buy out the company founders.
[22]
Chairman of the Senate Finance Committee,
Senator Russell Long, a Democrat from Louisiana, helped develop tax policy for ESOPs within
the Employee Retirement Income Security Act of 1974 (ERISA), calling it one of his most important
accomplishments in his career.
[23]
ESOPs also attracted interest of Republican leaders
including Barry Goldwater, Richard Nixon, and Gerald Ford, andRonald Reagan.
[24]

In 2001, the United States Congress enacted Internal Revenue Code section 409(p), which
effectively requires that S ESOP benefits be shared equitably by investors and workers. This
ensures that the ESOP includes everyone from the receptionist to the CFO.
[25]

Rules[edit]
To establish an ESOP in the United States, a firm sets up a trust and makes tax-deductible
contributions to it. Each plan is different, though typically plans include all full-time employees with a
year or more of service. The ESOP can be funded by tax-deductible corporate contributions to the
ESOP.
Discretionary annual cash contributions are deductible for up to 55 percent of the pay of plan
participants and are used to buy shares from selling owners. Alternatively, the ESOP can borrow
money to buy shares, with the company making tax-deductible contributions to the plan to enable it
to repay the loan. Contributions to repay principal are deductible for up to 25 percent of the payroll of
plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this
amount over 25 percent. Sellers to an ESOP in a closely held company can defer taxation on the
proceeds by reinvesting in other securities. In S corporations, to the extent the ESOP owns shares,
that percentage of the company's profits are not taxed: 100 percent ESOPs pay no federal income
tax, but the profit distribution to the participants is taxed, just as in any S corporation. Employees do
not pay taxes on the contributions until they receive a distribution from the plan when they leave the
company; taxes can be deferred by the departing employee by rolling the amount over into
an Individual Retirement Account (IRA).
ESOP accounts vest over time, typically following one of two formulas: in the first, vesting starts at
two years and completes at year six; in the second, participants becomes 100 percent vested after
four years. When employees leave the company, they receive their vested ESOP shares, which the
company or the ESOP buys back at an appraised fair market value. ESOP participants are required
by law to be allowed to vote their allocated shares at least on major issues, such as closing or selling
the company, but are not required to be able to vote on other issues, such as choosing the boards.
Forms[edit]
Like other tax-qualified deferred compensation plans, ESOPs must not discriminate in their
operations in favor of highly compensated employees, officers, or owners. In an ESOP, a company
sets up an employee benefit trust, which it funds by contributing cash to buy company stock,
contributing shares directly, or having the trust borrow money to buy stock, with the company making
contributions to the plan to enable it to repay the loan. Generally, at least all full-time employees with
a year or more of service are in the plan.
No other nation
[according to whom?]
in the world has laws that sanction an arrangement that is the same
as the U.S. ESOP. The ESOP model is tied to the unique U.S. system encouraging private
retirement savings plans, and tax policies which reflect that goal.
lan shows that S ESOP companies performed better in 2008 compared to non-S ESOP firms, paid
their workers higher wages on average than other firms in the same industries, contributed more to
their workers retirement security, and hired workers when the overall U.S. economy was pitched
downward and non-S ESOP employers were cutting jobs.
[26]
Scholars estimate that annual
contributions to employees of S ESOPs total around $14 billion.
[21]
Critics say, however, that such
studies fail to control for factors other than the existence of the ESOP, such as participatory
management strategies, worker education, and pre-ESOP growth trends in individual companies.
Advantages and disadvantages to employees[edit]
In a U.S. ESOP, just as in every other form of qualified pension plan, employees do not pay taxes on
the contributions until they receive a distribution from the plan when they leave the company. They
can roll the amount over into an IRA, as can participants in any qualified plan. There is no
requirement that a private sector employer provide retirement savings plans for employees.
Some studies conclude that employee ownership appears to increase production and profitability,
and improve employees' dedication and sense of ownership.
[31][32][33][34][35]
ESOP advocates maintain
that the key variable in securing these claimed benefits is to combine an ESOP with a high degree of
worker involvement in work-level decisions (employee teams, for instance). Employee stock
ownership can increase the employees' financial risk if the company does poorly,
[36]

ESOPS, by definition, concentrate workers' retirement savings in the stock of a single company.
Such concentration is contrary to the central principle of modern investment theory, which is that
investors should diversify their investments across many companies, industries, geographic
locations, etc.
[27]:811[37]
Moreover, ESOPs concentrate workers' retirement savings in the stock of the
same company on which they depend for their wages and current benefits, such as health
insurance, worsening the non-diversification problem.
[37]:811
High-profile examples illustrate the
problem. Employees at companies such as Enron and WorldCom lost much of their retirement
savings by over-investing in company stock in their 401(k) plans, though these specific companies
were not employee-owned. Enron, Polaroid and United Airlines, all of which had ESOPs when they
went bankrupt, were C corporations. Most S corporation ESOPs offer their employees at least one
qualified retirement savings plan like a 401(k) in addition to the ESOP, allowing for greater
diversification of assets. Studies in Massachusetts, Ohio, and Washington state show that, on
average, employees participating in the main form of employee ownership have considerably more
in retirement assets than comparable employees in non-ESOP firms. The most comprehensive of
the studies, a report on all ESOP firms in Washington state, found that the retirement assets were
about three times as great, and the diversified portion of employee retirement plans was about the
same as the total retirement assets of comparable employees in equivalent non-ESOP firms. The
Washington study, however, showed that ESOP participants still had about 60% of their retirement
savings invested in employer stock. Wages in ESOP firms were also 5 percent to 12 percent higher.
National data from Joseph Blasi and Douglas Kruse at Rutgers shows that ESOP companies are
more successful than comparable firms and, perhaps as a result, were more likely to offer additional
diversified retirement plans alongside their ESOPs.
Opponents to ESOP have criticized these pro-ESOP claims, that many of the studies are conducted
or sponsored by ESOP advocacy organizations and criticizing the methodologies used.
[37][38]
Critics
argue that pro-ESOP studies did not establish that ESOPs results in higher productivity and wages.
ESOP advocates agree that an ESOP alone cannot produce such effects; instead, the ESOP must
be combined with worker empowerment through participatory management and other techniques.
Critics point out that no study has separated the effects of those techniques from the effects of an
ESOP; that is, no study shows that innovative management cannot produce the same (claimed)
effects without an ESOP.
[27]:36

In some circumstances, ESOP plans were designed that disproportionately benefit employees who
enrolled earlier, by accruing more shares to early employees. Newer employees even at stable and
mature ESOP companies can have limited opportunity to participate in the program, as a large
portion of the shares may have already been allocated to longstanding employees.
[39]

Pro-ESOP advocates often maintain that employee ownership in 401(k) plans, as opposed to
ESOPs, is problematic. About 17 percent of total 401(k) assets are invested in company stock
more in those companies that offer it as an option (although many do not). Pro-ESOP advocates
concede that this may be an excessive concentration in a plan specifically meant to be for retirement
security. In contrast, they maintain that it may not be a serious problem for an ESOP or other
options, which they say are meant as wealth building tools, preferably to exist alongside other plans.
Nonetheless, ESOPs are regulated as retirement plans, and they are presented to employees as
retirement plansjust as 401(k) plans are.
Conflicts of interest[edit]
Because ESOPs are the only retirement plans allowed by law to borrow money, they can be
attractive to company owners and managers as instruments of corporate finance and
succession.
[27]:1416
An ESOP formed using a loan, called a "leveraged ESOP," can provide a tax-
advantaged means for the company to raise capital.
[27]:1415
According to a pro-ESOP organization,
at least 75 percent of ESOPs are, or were at some time, leveraged. According to citing ESOP
Association statistics as cited in
[27]:1416
. In addition, ESOPs can be attractive instruments of
corporate succession, allowing a retiring shareholder to diversify his or her company of stock while
deferring capital gains taxes indefinitely.
[40]

Company insiders face additional conflicts of interest in connection with an ESOP's purchase of
company stock, which most often features company insiders as sellers, and in connection with
decisions about how to vote the shares of stock held by the ESOP but not yet allocated to
participants' accounts.
[27]:1619
In a leveraged ESOP, such unallocated shares often far outnumber
allocated shares, for many years after the leveraged transaction.
[27]:1921

Other forms of employee ownership[edit]
Stock options and similar plans (stock appreciation rights, phantom stock, and restricted stock,
primarily) are common in most industrial and some developing countries. Only in the U.S., however,
is there a widespread practice of sharing this kind of ownership broadly with employees, mostly (but
not entirely) in the technology sector (Whole Foods andStarbucks also do this, for instance). The tax
rules for employee ownership vary widely from country to country. Only a few, most notably the U.S.,
Ireland, and the UK, have significant tax laws to encourage broad-based employee ownership.
[41]
In
India, employee stock option plans are called "ESOPs.
[20]

The most celebrated (and studied) case of a multinational corporation based wholly on worker-
ownership principles is the Mondragon Cooperative Corporation.
[42]
Unlike in the United States,
however, Spanish law requires that members of the Mondragon Corporation are registered as self-
employed. This differentiates co-operative ownership (in which self-employed owner-members each
have one voting share, or shares are controlled by a co-operative legal entity) from employee
ownership (where ownership is typically held as a block of shares on behalf of employees using an
Employee Benefit Trust, or company rules embed mechanisms for distributing shares to employees
and ensuring they remain majority shareholders).
[43][44]

Different forms of employee ownership, and the principles that underlie them,
[45]
are strongly
associated with the emergence of an international social enterprise movement. Key agents of
employee ownership, such as Co-operatives UK and the Employee Ownership Association (EOA),
play an active role in promoting employee ownership as a de factostandard for the development of
social enterprises.
[46]

Other varieties of employee ownership include:
Direct purchase plans[edit]
Main article: Employee stock purchase plan
Direct purchase plans simply allow employees to buy shares in the company with their own, usually
after-tax, money. In the U.S. and several foreign countries, there are special tax-qualified plans,
however, that allow employees to buy stock either at a discount or with matching shares from the
company. For instance, in the U.S., employees can put aside after-tax pay over some period of time
(typically 612 months) then use the accumulated funds to buy shares at up to a 15% discount at
either the price at the time of purchase or the time when they started putting aside the money,
whichever is lower. In the U.K. employee purchases can be matched directly by the company.
Stock options[edit]
Stock options give employees the right to buy a number of shares at a price fixed at grant for a
defined number of years into the future[2]. Options, and all the plans listed below, can be given to
any employee under whatever rules the company creates, with limited exceptions in various
countries
As bulls power stock markets,
several CEOs cash their ESOPs
CEOs and promoters of Indias marquee companies may have a few tips for retail
investors looking for cues to enter and exit the markets. Several top corporate honchos
used the market rally in May and June this year to sell shares earned through ESOPs
and book some profits.
The sale took place typically on days when everyone else was buying heavily for
instance on May 16, when the election results were announced and the Sensex jumped
by a massive 6 per cent intra day.
Bombay Stock Exchange data show that the earning by 11 prominent corporate
citizens from the bull run was Rs 138 crore. (The Indian Express considered sales of
shares worth Rs 1 crore and above for the analysis.)
Over the last four months, the Sensex has risen 24 per cent. Big names that sold shares
in the companies they run include A M Naik of Larsen and Toubro, Keki Mistry &
Renu Sud Karnad** of HDFC Ltd, Shikha Sharma*** of Axis Bank and Paresh
Sukthankar of HDFC Bank.
Naik, chairman of L&T, sold the most amounting to 3.45 lakh shares which,
going by the value of the shares on the date of sale, was worth more than Rs 60 crore.
The L&T stock has risen 35 per cent between May 1 and June 9, when it closed at Rs
1,752 per share.
Over the past two years, as the markets tanked, promoters and senior executives
largely held on to their shares. Retail investors, on the other hand, have begun to move
into the market only now, when the markets are booming.
As per BSE data, on May 1, 2014, total buy orders in the retail category were only Rs
153.78 crore. But as of June 17, they had jumped to Rs 18,744 crore.
Renu Sud Karnad, MD of HDFC Ltd, sold 2,08,277 shares from her holdings in the
period between May 16 and June 10, earning over Rs 19 crore. Keki Mistry, vice-
chairman and CEO of HDFC Limited, sold 1,55,000 shares between May 16 and June
9 for around Rs 14 crore.
Shikha Sharma, MD and CEO of Axis Bank, sold shares worth Rs 7.9 crore between
May 16 and May 26. Romesh Sobti, CEO and MD of IndusInd Bank, sold 1,45,000
shares worth Rs 7.8 crore.
Senior employees at most private sector companies earn shares of their companies
under the employees stock ownership plan (ESOP). They can purchase the shares at a
predetermined price, and are then free to sell them in the market after the expiry of the
lock-in period, if there is one.
As the bull phase tapered after the first week of June, the sale of shares by company
chiefs too dwindled.
**An HDFC spokesperson said both Mistry and Karnad sold the shares to exercise
ESOPs and have used the money to purchase more shares as there is an exercise
period for the same. Both have bought far more shares than they sold. The only way
such professionals can raise money to exercise Esops is by selling shares.
***An Axis Bank spokesperson said the transaction referred to pertains to sale of
ESOPs undertaken by employees of the Bank in the normal course, Further, the
proceeds from the sale of such shares are, many a times, used by employees to
purchase additional exercisable ESOPs due to them, which has been done in case of
the referred transaction.

Indian cos prefer ESOP as compensation over
other tools: Survey
A significant number of Indian companies prefer employees stock options as a compensation tool
over other forms of equity-linked incentive plans to attract and retain top talent, says a survey by
KPMG.

The survey, conducted among 350 firms, including MNCs as well as listed and unlisted Indian
companies, said that nearly 64 per cent of Indian companies have implemented a Employee Stock
Option Plan (ESOP).

In contrast, 36 per cent of foreign companies have implemented ESOPs.

ESOP is the practice of companies giving staff members shares in their company as part of their
salary. Under the ESOP plan, companies provide their employees the opportunity to acquire shares
at a reduced price over a period of time. "Companies consider ESOPs as an incentive tool which
enhances productivity, motivates employees and increases employees' interest in the company?s
overall performance," the survey noted.

Out of the 203 firms (including 116 Indian firms), having active ESOPs or who were considering
implementing a ESOPs, 95 per cent stated that their compensation plans are linked to equity shares
and the remaining 5 per cent said that it is linked to warrants and other securities.

The main reason for increasingly awarding equity incentives to employees are attracting and
retaining talent, the survey noted.

It said Indian companies continue to adopt conventional equity linked plans because firms have yet
to evolve plans which are linked to warrants/other securities that carry a lower risk of fluctuations as
compared to equity shares. Besides, 47 per cent of the respondents said that companies generally
provide a window of two to five years to exercise vested options with no lock-in thereafter.

Information, communication and entertainment (ICE) sector dominates the ESOP space followed by
financial services and private equity and the manufacturing and consumer goods sector,
respectively.

However, this plan is yet to penetrate into other sectors.

The survey said that stock option plans have a positively impacted employees. Nearly 40 per cent of
the respondents said that ESOPs have definitely motivated their employees towards better
performance.

Besides, 11 per cent indicated that they have improved the company's profitability. Furthermore,
around 29 per cent of respondents felt that ESOPs have improved retention and brought in a sense
of ownership.



How is ESOP Valuation done
A) Accounting Valuation
The Accounting Valuation is needed for working out the Employee Compensation Cost at the time of ESOP Grants
Itself which is apportioned over the vesting period of ESOP.
There are two methods of doing ESOP Valuations- Intrinsic Value Method & Fair Value Method.
" ESOP Valuation (both for Accounting of Compensation Expense by
company and for perquisite Tax payable by the employees) plays a significant
role in the success of any ESOP scheme"
Intrinsic value method
Intrinsic Value is the excess of the market price of the share under ESOP over the exercise price of the Option
(including upfront payment, if any) Example: - A company grants an ESOP to its employees whose current market
price (CMP) of the share is Rs 100 which can be exercised after 2 years for Rs 70. In this case the intrinsic value of
options shall be Rs 30/- (100 70).
However if the CMP was Rs.50 instead, there would be no intrinsic value of the option since the exercise price is
more than CMP and in this case options could not be exercised and instead stand lapsed.
Fair Value Method
The fair value of an ESOP is estimated using an option-pricing model like, the Black-Scholes or a binomial model.
For undertaking fair valuation of ESOPs, the Black-Scholes model is mostly preferred as it takes into account the
various other factors like Time Value, Interest Rate, Volatility, Dividend yield etc. These factors are not considered
under Intrinsic Value method which may lead to under estimation of Employee Compensation Cost.
The Black Scholes Model considers various external factors that affect the value of the ESOP whereas the intrinsic
value method considers only factors internal to the Option offered. To compute the value of ESOP options through
Black- Scholes the following variables have to be considered:-

Tax Treatment of ESOPs Allotment
Treated as Perquisite: Allotment of ESOPs are taxed as perquisite which is the difference between the
Fair Market Value (FMV) of the shares on the date of exercise of the option and the price recovered
from the employee. Such FMV of the securities has to be calculated on the date on which the
option is exercised by the employee. Vide circular no.710 dated July 24, 1995, the Central board of
Direct Taxes (CBDT) clarified that shares issued to employees at less than market price amounted
to a perquisite under section 17(2)(ii). However, to remove any uncertainty with regard to
taxability of such benefits, a new sub-clause (iiia) was added to section 17(2) by the Finance Act,
1999 to provide that when any share, security etc. was offered directly or indirectly by the
employer, the difference between market value of the stock and the cost at which it was offered was
to be taxed as perquisite in the year in which the right was exercised.
Tax Liabilities on Employee while selling of ESOPs
When the employee sells the shares subsequently, the gains will be taxed as capital gains. The
capital gains will have to be computed as the difference between the sale proceeds and FMV of the
shares that was considered by the employer while computing the perquisite value including any
expenditure incurred wholly in connection with the sale. The capital gains tax implications would
depend upon the period of holding of shares from the allotment date and whether security
transaction tax (STT) has been paid.
At the time of sale, any gain beyond tax value of the shares may be subject to capital gains tax,
depending on whether the shares are listed in India and the period of share holding with regards to
determine Short Term Capital Gains (STCG) or Long Term Capital gains (LTCG). For listed shares
where the STT is paid, there would be no tax if shares are held for more than one year, but the
same is taxed at 15.45% if held for less than one year. In case of unlisted shares, the tax rate is
20.60% if held for more than one year and in case of holding period is less than a year, it is taxable
at normal rates of taxes (based on the income slab).
Tax Planning:
Short Term Capital Gains (STCG) from listed shares which are subject to STT can be adjusted with
any Capital Loss (except long term losses from equity shares and units of equity oriented mutual
funds), losses from House Property, losses from Business or Profession (other than speculation or
depreciation) in the same financial year in which such STCG arise.
There is nothing can be done for the unlisted shares which are sold and you incur STCG. These
gains will get added to your income and taxed at normal rate based on your income slab. But with
regards to unlisted Long Term Capital Gains (LTCG on listed shares are tax free if sold at
recognised stock exchange), you can save 20.60% of tax liability with the benefits available under
section 54EC and section 54F.
The section 54EC of the Income-tax Act, 1961 allows a deduction in respect of LTCG arising from
sell/transfer of any long term capital asset (for example, any immovable property, jewellery or
shares) which was held for a period exceeding three years. In case of shares, the holding period
should be 1 year. Investments done in bonds under section 54EC (such as REC/NHAI Bonds)
within six months from the date of sale provide exemption of LTCG to the extent of investment.
Section 54F is available to all those assets other than residential houses properties (available to
person who is an individual or HUF). So for claiming long term capital gains arising to
shareholders, this section can be utilized. As per this section under the Income Tax Act, 1961; tax
on LTCG from the transfer/sale of these shares will not be chargeable if the entire net sales
considerations is utilized purchase of a new residential house within a period of one year before, or
two years after the date of transfer/sale. The sale consideration can also be utilised to save taxes
within a period of 3 years in construction of residential house.

EMPLOYEE STOCK OPTION PLANS
1 |Page
CHAPTER 1INTRODUCTION
Organizations are run and steered by people. It is through people that goals are set andobjectives
realized. The performance of an organization is, thus, dependent upon the sumtotal of the
performance of its members. According to Peter Drucker, an organization is like atune. It is not
constituted by individual sounds but by their synthesis. The success of anorganization, therefore,
depends on its ability to accurately measure the performance of itsmembers and use it objectively
to optimise them as vital resources.The performance of the organisation is astutely linked to
employee emotions such asownership and loyalty. Without them, employees fail to effectively work
in synchronisationwith the goals and vision of the employees. A sense of employee ownership and
loyalty isimportant if the organisation would like to achieve its goals. Organisations whose
employeesexperience a heightened sense of ownership and loyalty are less likely to have
absenteeism,lower rates of employee turnover and lesser chances of failure to meet goals.One such
way to ensure that employees feel a sense of ownership and responsibility isthrough employee
stock options.An Employee Stock Option Plan (ESOP) is a benefit plan for employees which makes
themowners of stocks in the company. ESOPs have several features which make them
uniquecompared to other employee benefit plans. Most companies, both at home and abroad,
areutilising this scheme as an essential tool to reward and retain their employees. Currently,
thisform of restructuring is most prevalent in IT companies where manpower is the main asset.The
idea behind stock options is to align incentives between the employees and shareholdersof a
company. Shareholders want to see the stock appreciate, so rewarding employees whenthe stock
goes up ensures, in theory, that everyone is striving for the same goals.


EMPLOYEE STOCK OPTION PLANS
2 |Page
CHAPTER 2EMPLOYEE COMPENSATION MANAGEMENT
Compensation refers to all forms of financial returns, tangible services and benefitsemployees
receive in exchange for their contribution to the organization. It determines theirstandard of
living, their attitude towards the company and influences their motivation towork. There has to be
a fairness in compensating the workers according to the work done bythem.
It is an important aspect from the employer and the employees point of view and to strike a
balance between them it is important to select the system of wage payment
carefully.Compensation payable to an employee includes 3 components:1.

Basic compensation for the job (wage/ salary)2.

Incentive compensation for the employee on job (dearness allowance, profit sharing, bonus)3.

Supplementary compensation paid to employees (fringe benefits and employeeservices).
Dearness allowance-
Dearness allowance is paid to employees in order to enable them to face the increasing rise
in prices of essential commodities. In general, there are three methods of grating DA-1.

A uniform fixed rate of DA in accordance with each point of rise
.2.Flat rate of DA irrespective of wages to all the workers.
3.DA at rates varying according to income groups

Bonus-
In addition to the basic wage and dearness allowance, bonus also constitutes an important
component of employees earnings in India. Bonus thus means payment as an incentive to
regularity of attendance, or to encourage good work or a payment for some special oradditional
service rendered by labour.
OBJECTIVES OF COMPENSATION PLANNING-
Some of the important objectives that are sought to be achieved through effectivecompensation
management are:
1.

Attract talent-
Compensation needs to be high to attract talented people as firms compete to hire servicesof
competent people and the salaries offered must be high enough to motivate them toapply.
2.

Ensure equity-
Pay should equal the worth of a job. Similar jobs should get similar pay. Likewise morequalified
people should get better wages.
3.

New and desired behavior-
Pay should reward loyalty, commitment, experience, risks taking, initiative and otherdesired
behaviors. When company fails to reward such behaviors employees go in searchof better avenues.
4.

Control costs-
The costs of hiring people should not be too high. Effective compensation managementensures
that workers are neither overpaid nor underpaid