COMPLETE STUDY OF EMPLOYEE STOCK

OWNERSHIP PLANS (ESOP)

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TABLE OF CONTENT

➢ Understanding ESOP
➢ Why ESOP
➢ ESOP Rules
➢ Uses of ESOP
➢ To whom ESOP be issued
➢ The process to issue ESOP
➢ Allotment of ESOP
➢ Disclosures To Be Made While Issuing ESOP
➢Upfront Costs and Distributions
➢Problems Related to ESOP for Employers
➢ Major Tax Benefits.
➢ Conclusion.
Understanding Employee Stock Ownership
Plans (ESOP)
An ESOP is commonly established to aid in
the transition of ownership within a privately
held company, enabling employees to
purchase company stock. ESOPs are created
as trust funds and can be funded through
various means, such as the issuance of new
shares, cash investments to acquire existing
company shares, or borrowing funds to
purchase company shares. ESOPs are
utilized by companies of all sizes, including
numerous large publicly traded corporations.
Since ESOP shares form part of employees'
compensation packages, companies can
utilize ESOPs to maintain the focus of plan
participants on the company's performance
and the appreciation of share prices. By
providing plan participants with a vested
interest in the company's stock performance,
these plans are purported to motivate
participants to act in the best interests of
shareholders, as they themselves become
shareholders.
Why ESOP?
Employee stock ownership plans (ESOPs) are
frequently utilized by organizations as a
means to attract and retain talented
employees. Typically, these stocks are
distributed gradually over time. For example,
a company may allocate stocks to its
employees at the end of each fiscal year,
providing them with an incentive to remain
with the organization in order to receive this
grant. Companies that implement ESOPs
have long-term objectives, aiming not only to
retain employees for an extended period but
also to transform them into stakeholders of
the company.
In the IT industry, where high attrition rates
are a common concern, ESOPs can help
mitigate this issue. Start-up companies, in
particular, often face financial constraints
that prevent them from offering competitive
salaries. However, by offering employees a
stake in the organization through ESOPs, they
can make their compensation packages
more appealing and competitive.
ESOP Rules
An Employee Stock Ownership Plan (ESOP)
functions as a type of employee benefit plan
that shares similarities with profit-sharing
plans. Within an ESOP, a company
establishes a trust fund and contributes new
shares of its own stock or cash to purchase
existing shares.
Alternatively, the ESOP can borrow funds to
acquire new or existing shares, with the
company providing cash contributions to the
plan for loan repayment. It is worth noting
that company contributions to the trust are
tax-deductible, subject to certain limitations
outlined in the 2017 tax bill.
The tax bill sets a cap on net interest
deductions for businesses at 30% of EBITDA
(earnings before interest, taxes, depreciation,
and amortization) for four years, which
subsequently decreases to 30% of EBIT
(excluding depreciation and amortization)
thereafter. Consequently, starting in 2022,
businesses will subtract depreciation and
amortization from their earnings when
calculating the maximum deductible interest
payments. This change affects new
leveraged ESOPs that borrow a significant
amount relative to their EBITDA, potentially
resulting in lower deductible expenses and
higher taxable income.
Shares in the trust are allocated to individual
employee accounts, typically including all
full- time employees over the age of 21, with
some exceptions. Allocations can be based
on relative pay or a more equitable formula.
As employees gain seniority within the
company, they accrue an increasing
entitlement to the shares in their account
through a process called vesting. The vesting
period ranges from three to six years,
depending on whether it is achieved all at
once (cliff vesting) or gradually.
Upon leaving the company, employees
receive their allocated stock, which the
company must repurchase at its fair market
value (unless there is a public market for the
shares). Private companies are required to
undergo an annual external valuation to
determine the share price. In private
companies, employees generally possess the
right to vote their allocated shares on
significant matters like closures or
relocations, while the company can choose
whether to grant voting rights on other
issues, such as the board of directors. In
public companies, employees typically have
voting rights on all matters.
Uses for ESOP
ESOPs can be utilized by owners of
privately held companies as a means to
facilitate the purchase of shares from
departing owners. By establishing an
ESOP, the company can make tax-
deductible cash contributions to the plan,
which are then used to buy out the shares
of the owner. Alternatively, the ESOP can
borrow funds specifically for the purpose
of acquiring the shares.
One distinct advantage of ESOPs is their
ability to borrow money, resulting in lower
after-tax costs. The ESOP can borrow
cash, which is subsequently used to
purchase company shares or shares from
existing owners. To repay the loan, the
company makes tax-deductible
contributions to the ESOP, allowing both
the principal and interest to be deducted.
Implementing an ESOP can also serve as
an additional employee benefit for the
company. The company has the option to
issue new or treasury shares to the ESOP,
deducting their value (up to 25% of
covered pay) from taxable income.
Alternatively, the company can contribute
cash and use it to purchase shares from
existing public or private owners. In the
case of public companies, which account
for approximately 5% of ESOP plans and
about 40% of plan participants, ESOPs
are often combined with employee
savings plans. Instead of matching
employee savings with cash, the
company matches them with stock from
the ESOP, often at a higher matching
level.
To Whom Can The ESOP Be Issued?
According to Rule 12(1) of the Companies
(Share Capital and Debentures) Rules, 2014,
Employee Stock Ownership Plans (ESOPs)
can be issued to specific categories of
employees. These include:
Permanent employees of the company,
whether working in India or outside of
India.
Directors of the company, including both
whole-time or part-time directors, with the
exception of independent directors.
Permanent employees or directors of
subsidiary companies, holding
companies, or associate companies,
whether in India or outside of India.
However, there are certain employees to
whom a company cannot issue ESOPs.
These include:
Employees who belong to the promoter
group or hold the status of a promoter
within the company.
Directors who, either individually or
through any body corporate or via their
relatives, hold more than ten percent of
the company's outstanding equity shares,
either directly or indirectly.
It's important to note that these two
conditions mentioned above do not apply to
startup companies for a period of ten years
from the date of their incorporation.
Process Of Issue Of ESOP
The issuance of Employee Stock Option
Plans (ESOPs) is governed by Section 62(1)
(b) of the Companies Act, 2013, and Rule 12
of the Companies (Share Capital and
Debentures) Rules, 2014. The procedure for
issuing ESOPs, as outlined in the Rules, is
similar to the process specified in the
Securities and Exchange Board of India
Employee Stock Option Scheme Guidelines
for listed companies. The steps involved in
issuing ESOPs by a company
are as follows:
Prepare the draft of the ESOP in
accordance with the Companies Act,
2013, and Rules.
Draft a notice for the board meeting,
including the resolution to be passed
during the meeting.
Send the notice of the board meeting to
all directors at least seven days prior to
the meeting.
Pass a board resolution for the issuance
of shares through ESOP, determine the
price of shares to be issued, and set a
time and date for calling a general
meeting to pass a special resolution for
issuing ESOPs.
Share the draft minutes of the board
meeting with all directors within fifteen
days after its conclusion and file the
MGT-14 form with the Registrar of
Companies to record the board
resolution.
Issue a notice for the general meeting to
all directors, auditors, shareholders, and
secretarial auditors of the company at
least twenty-one days before the
meeting.
Pass a special resolution in the general
meeting for the issuance of shares under
the ESOP to employees, directors, and
officers of the company.
File the MGT-14 form with the Registrar
of Companies within thirty days of
passing the special resolution in the
general meeting, along with the required
documents.
Provide options to employees, directors,
and officers of the company for
purchasing shares under the ESOP.
Maintain a 'Register of Employee Stock
Options' in Form No.SH-6, recording the
details of the ESOPs granted to
employees, directors, or officers of the
company.
If a private company intends to issue
ESOPs, it must ensure that its Articles of
Association (AoA) authorize the issuance
of shares through ESOPs. If the AoA does
not authorize it, the company should hold
an extraordinary general meeting to
amend the AoA and include provisions
for the issuance of shares through ESOPs
before proceeding with the board
meeting to pass the resolution and obtain
shareholder approval for the ESOP
scheme.
Allotment of ESOP
There are three key terms that primarily
revolve around the timing of issuing shares
through an Employee Stock Option Plan
(ESOP) to employees. They are as follows:
Grant: Grant refers to the issuance of
stocks to employees, indicating their
eligibility for ESOP. The company has the
discretion to determine the exercise price
while offering the option of ESOP to
employees.
Vest: Vest signifies the employees' right
to apply for the shares that have been
granted to them. There must be a
minimum period of one year between the
grant of the option and the vesting of the
option in the ESOP scheme.
Exercise: The exercise period is when
employees can exercise their option to
purchase the shares. The company has
the flexibility to specify any lock-in period
for the shares issued after the option is
exercised. Until the shares are issued
upon exercising the option, employees do
not have the right to receive dividends,
vote, or enjoy the benefits of being a
shareholder with respect to the ESOP
granted to them.
Disclosures To Be Made While Issuing ESOP
The company should make the following
disclosures in the explanatory statement
annexed to the notice for passing the special
resolution for the issuance of ESOP-
The total number of stock options which
is to be granted,
The identified class of employees who
can participate in the ESOP,
Requirements of vesting period of ESOP,
Maximum period within which the
options can be vested,
The exercise price and process of
exercise,
The lock-in period, if any,
The grant of the maximum number of
options for an employee,
The methods used by the company to
value its options,
The conditions of lapsing of the options
vested in employees,
A statement that the company will
comply with the applicable accounting
standards.
Upfront Costs and Distributions
Companies frequently offer employees
ownership in the form of shares without any
initial costs. These provided shares are often
held in a trust by the company to ensure their
safety and growth until the employee either
retires or resigns from the company.
Distributions from the ownership plan are
typically tied to vesting, which determines the
proportion of shares earned based on each
year of service.
Once employees become fully vested, the
company "purchases" the vested shares from
them when they retire or resign. The funds
from this purchase are then given to the
employee either as a lump sum or in regular
periodic payments, depending on the
specifics of the plan. After the company
acquires the shares and makes the payment,
it may choose to redistribute or eliminate the
shares. It's important to note that employees
who resign or retire are not able to take the
shares of stock with them; they only receive
the cash payment. In the case of terminated
employees, their eligibility for benefits is
typically limited to the amount they have
vested in the plan.
Employee-owned corporations are
companies where the majority of shares are
held by their own employees. These
organizations are similar to cooperatives, but
with the distinction that the company does
not distribute its capital equally among
employees. In many cases, voting rights may
be granted only to specific shareholders, and
senior employees may receive a greater
share of benefits compared to newly hired
employees.
Problems related to ESOP for Employers
When considering the drawbacks of
Employee Stock Ownership Plans (ESOPs),
it's important to recognize that while they
offer liquidity and succession alternatives,
there are valid reasons for companies to
avoid them. Here are the points highlighting
the reasons:
Complexity and Oversight: ESOPs come
with intricate rules and require significant
oversight. While external advisors and
ESOP TPA firms can assist with
managing the process, the company still
needs internal personnel to champion the
program. Without adequate staff to
handle ESOP-related work, there is a risk
of issues and potential violations.
Administrative Requirements: Once an
ESOP is established, proper
administration is crucial. This includes
engaging third-party administrators,
trustees, valuation experts, and incurring
legal costs. Company owners and
management should be aware of the
ongoing financial commitments
associated with maintaining an ESOP.
Cash Flow Constraints: Implementing an
ESOP requires a dedicated portion of the
company's cash flow to fund the
purchase of shares from shareholders.
If this commitment limits the availability of
cash for long-term reinvestment in the
business, the ESOP may not be a suitable
option. This is particularly relevant for
companies that require significant additional
capital for day-to-day operations or capital
Competition for Funds: ESOP
transactions can compete with a
company's need for funds for working
capital or capital expenditures. If a
company is in a situation where it
requires the funds for these essential
requirements, the presence of an ESOP
can create a crisis for management, as
they must prioritize between fulfilling
operational needs and meeting ESOP
obligations.
It is important for companies to carefully
evaluate their specific circumstances and
financial goals before deciding whether an
ESOP is the right fit for their organization.
Major Tax Benefits
Employee stock ownership plans (ESOPs)
have implications for taxation, both as
perquisites and capital gains, for employees.
Here is a comprehensive breakdown of the
tax aspects associated with ESOPs:
Taxation at the Time of Exercising the
Option:
When an employee exercises their ESOP
option, they are taxed on the difference
between the Fair Market Value (FMV) of the
shares on the exercise date and the exercise
price. This difference is treated as a
perquisite and is subject to taxation.
.
Taxation at the Time of Selling the Shares:
If an employee decides to sell their ESOP
shares after purchasing them, any gains from
the sale are subject to capital gains tax. The
tax liability depends on the period of holding
the shares, calculated from the date of
exercise to the date of sale.
Long-Term Capital Gains: Listed equity
shares held for more than 12 months are
considered long-term capital assets.
Presently, long-term capital gains on
listed equity shares are exempt from tax.
However, as per the amendments in
Budget 2018, equity shares sold after
holding them for more than a year on or
after April 1, 2018, attract a tax rate of
10% along with a cess of 4%.
Short-Term Capital Gains: If the shares
are sold within 12 months of exercise,
they are considered short-term capital
assets and taxed at a rate of 15%.
ESOPs provide several significant tax
benefits, including:
Tax-Deductible Stock Contributions:
Companies can issue new shares or
treasury shares to the ESOP, and these
contributions are tax-deductible.
However, existing owners may
experience dilution of their ownership.
Deductible Cash Contributions:
Companies can make discretionary cash
contributions to the ESOP on a yearly
basis and receive tax deductions for
them. These contributions can be used to
buy shares from current owners or build
up a cash reserve in the ESOP for future
use.
Tax-Deductible Contributions for Loan
Repayment: Contributions used to repay
a loan taken out by the ESOP to buy
company shares are tax-deductible.
Whether the shares are existing, new, or
treasury shares, the contributions are
made with pretax dollars.
Tax Deferral for Sellers in C Corporations:
In C corporations, when the ESOP owns
30% of all shares, sellers can reinvest the
proceeds from the sale in other securities
and defer tax on the gain.
Tax Benefits in S Corporations: In S
corporations, the percentage of
ownership held by the ESOP is not
subject to federal income tax. This
means that there is no income tax on the
ESOP's share of profits, and it may not be
subject to state income tax either.
Tax-Deductible Dividends: Reasonable
dividends used for ESOP loan repayment,
employee distributions, or reinvestment
by employees in company stock are tax-
deductible.
Favorable Tax Treatment for Employees:
Employees are not taxed on the
contributions made to the ESOP. Instead,
they are taxed on the distribution of their
accounts, potentially at favorable rates.
Employees can roll over their
distributions in an IRA or another
retirement plan or choose to pay current
tax on the distribution, with any
accumulated gains being taxed as capital
gains. However, early distributions before
the normal retirement age may be subject
to a 10% penalty.
It's important to note that there may be
certain limitations on contribution limits, but
these limitations typically do not pose
significant issues for companies.
.
Conclusion
In conclusion, Employee Stock Ownership
Plans (ESOPs) serve as a valuable tool for
companies to facilitate ownership transition,
attract and retain talented employees, and
align the interests of employees with those of
the shareholders. By offering employees a
stake in the company through ESOPs,
companies can enhance employee
motivation and foster a sense of ownership
and loyalty.
ESOPs can help mitigate high attrition rates,
particularly in industries like IT, by making
compensation packages more appealing and
competitive. Additionally, ESOPs provide a
means for privately held companies to
facilitate the purchase of shares from
departing owners and can offer tax
advantages through deductible stock and
cash contributions. However, implementing
and managing an ESOP requires careful
consideration. The complexity and oversight
involved, along with administrative
requirements and potential cash flow
constraints, are factors that companies
should evaluate. Competing for funds
between ESOP obligations and operational
needs can also pose challenges.
Nevertheless, the tax benefits associated
with ESOPs, such as tax-deductible
contributions and potential capital gains tax
advantages for employees, make them an
attractive option worth considering.
Overall, ESOPs provide companies with a
mechanism to create a shared sense of
ownership and align the interests of
employees and shareholders. When
implemented thoughtfully and in line with the
company's goals and resources, ESOPs can
be a valuable tool for fostering employee
engagement, retention, and long-term
success.