ESOP stands for Employee Stock Ownership Plan. In simpler words, ESOPs are qualified employee benefit plans, where in the employee receives stock options of the company, very much similar to a profit sharing structure.It is a participative stock plan where the shareholders are participants of company’s performance and thus a mutual growth is ensured to some extent. Also, ESOPs are a wonderful mode of availing tax benefits, both for the company as well as the employees. Main question people have regarding ESOP is How ESOP works in India. Well we will try to explain it in very simple terms
How ESOP works In India?
A trust fund is set up by the company in which the company contributes fresh shares of its own or puts in cash to purchase existing shares. These shares could be acquired by employees and thus they can reap the benefit of stocks as well as saving on their taxes through this contribution.
In normal conditions, any employee over the age of 21 can be a participant to these shares. The preference to the level and limit of shares is given on the basis of seniority of the employees. This concept is called vesting. In case of employee leaving the company, the later has to buy those shares from them at current market rates. This is how ESOP works in India and normally in most part of the world.
How ESOP gives Tax Benefit?
The contributions made towards ESOPs are tax deductible. That implies that company can issue new shares to the ESOP and get a current cash flow benefit. The cash used to buy shares from existing owners or for the purpose of building a cash reserve in ESOP are all tax deductible and thus it’s a wonderful mode of saving for the company.
Moreover, the cash which is used by the company to repay an ESOP loan is tax deductible to the extent that even the dividends which could be used to repay an ESOP loan are deductible from taxable income. It is a preferred source of tax saving for employees as well, in a way that any amount spent on their contribution towards ESOP is tax-free and in this way ESOP gives Tax benefits as well. In some cases, these contributions are prone to certain limitation; however, they do not pose any limitations for the company, as such.
Applications of ESOPs
ESOPs can be a medium for three major functions, i.e. buying departing owners’ shares, lower after-tax borrowings and create and ensure an employee centric benefit plan. All these three functions in some or the other way help company to a significant level. These are innovative custom made provisions designed to ensure mutual benefit to the company as well as its employees and hence solidify the company-employee bond.
Drawbacks and Limitations of ESOP
No matter how great they sound or actually are, there are surely some limitations and drawbacks associated with ESOPs. By law, ESOPs cannot be used in partnerships and are not subject to any roll-over treatment. The fact that private companies have to purchase the shares of employees who are leaving the company makes ESOPs a little expensive and complicated affair for the company. Moreover, the cost associated with setting up of an ESOP is quite significant for smaller companies and that is certainly a cause of concern.