That happens because ESOPs are taxed at two stages. First, when the shares are allotted following exercise of the options, the benefit received by the employee is taxed as a salary perquisite. Later, when the shares are eventually sold, any further gain is taxed as a capital gain.
So, how does the first tax hit work, and what can employees do to avoid getting caught short of cash?
Why exercising ESOPs can leave you with a tax bill
When an employee exercises ESOPs, the difference between the fair market value (FMV) of the shares on the exercise date and the exercise or strike price is used to determine the taxable perquisite.
Suppose an employee can buy a share for ₹100 when its FMV is ₹500. The ₹400 difference is treated as a taxable perquisite and added to salary income.
Now imagine the employee exercises 10,000 such options.
The employee would need ₹10 lakh to buy the shares. At the same time, the taxable perquisite would amount to ₹40 lakh.
And that is where the problem begins.
If the company is unlisted, the employee may have no easy way to sell those shares. They could therefore be sitting on shares worth ₹50 lakh on paper while having to find cash for both the ₹10 lakh exercise cost and the tax arising from the ₹40 lakh perquisite.
In other words, ESOP wealth can be illiquid while the tax liability is very real.
Don’t exercise simply because your ESOPs have vested
Vesting and exercising are two different things.
Vesting generally gives an employee the right to exercise an option. It does not necessarily mean exercising immediately is the best financial decision.
If the company’s ESOP plan provides a sufficiently long exercise window, an employee can consider waiting until there is greater visibility on a liquidity event such as a buyback, secondary sale or IPO.
That could reduce the risk of committing a large amount of cash to shares that may remain illiquid for years.
But employees need to check their ESOP agreement carefully. Some plans provide only a limited period to exercise vested options after leaving the company. Waiting too long could therefore mean losing the options altogether.
Build an ESOP war chest
Employees sitting on valuable vested ESOPs should also calculate how much cash they may eventually need.
And there are two numbers to consider.
The first is the exercise cost — the amount required to actually buy the shares.
The second is the potential tax bill arising from the difference between the exercise price and FMV.
The larger that gap becomes, the larger the taxable perquisite can become.
Building a dedicated pool of savings for exercising ESOPs can therefore prevent an employee from having to suddenly dip into emergency savings or borrow money when an exercise deadline approaches.
This becomes particularly important for employees considering leaving their company, since departure can trigger a limited exercise window under some ESOP plans.
Some startup employees can defer the tax
There is an important relief available to employees of certain eligible startups.
Under the special ESOP tax-deferral framework, the perquisite continues to be recognised as income in the year of allotment, but payment of the tax attributable to the ESOP can be postponed.
For employees of an eligible startup under Section 80-IAC, the tax becomes payable within 14 days of the earliest of three events: the expiry of 48 months from the end of the relevant assessment year, the employee selling the shares, or the employee leaving the company.
This can make a major difference because the employee may not have to immediately find cash for the ESOP tax at the time the shares are allotted.
However, DPIIT recognition alone does not automatically make a startup eligible for this benefit. The Income Tax Department notes that the startup must satisfy the requirements for an eligible startup under Section 80-IAC.
Employees should therefore check their employer’s eligibility rather than assume that working for a recognised startup automatically gives them the tax deferral.
Understand how you will eventually get your money out
The headline value of ESOPs can be misleading if there is no way to sell the shares.
Before spending substantial amounts to exercise options, employees should understand the likely path to liquidity.
Is the company planning an IPO? Does it periodically conduct employee buybacks? Are secondary sales permitted? Is there any other mechanism through which employees can sell shares?
The further away the likely liquidity event, the more carefully an employee needs to think about exercising.
There is also a second tax event to remember. When the employee eventually sells the shares, any capital gain is calculated using the FMV considered for ESOP taxation as the cost of acquisition. The holding period begins from the date the shares are allotted.
ESOPs need tax planning, not just wealth planning
ESOPs can become one of the most valuable parts of an employee’s compensation if the company grows substantially.
But looking only at how much the options are worth on paper can be a mistake.
Before exercising, employees should know the exercise price, current FMV, potential perquisite tax, exercise deadline and likely route to eventually selling the shares.
Most importantly, they should know where the cash required to exercise the options and meet the tax liability will come from.
The objective isn’t necessarily to eliminate the tax. It is to time and plan the exercise so that a potentially valuable ESOP holding does not unexpectedly turn into a cash-flow problem.
