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Profit booking in Esops can be taxing

October 27, 2010 09:45 IST
Employee stock option plans, or Esops, are touted as one of the best tools to create long-term wealth. These are the shares an employee gets of his/her employer at a discounted rate to the current market price.

With the stock market nearing its all-time high, there are chances that selling your shares granted under Esops will give you handsome returns, unless you are an employee at a telecom company.

Experts say employees should sell off their Esops if they have a liquidity requirement such as buying a house or emergency cash. It is because Esops are a part of a person's equity portfolio. You need to stay invested in equities for at least five years to benefit from the investment.


Current options

What to do


Selling to book profit

Sell in tranches to avoid short-term capital gains tax

A perquisite tax depending on the income slab and a short-term capital gains tax of 15%

Selling to offset short-term losses

Calculate the amount you want to offset and sell the accordingly. Hold the rest for the long term

Perquisite tax depending on your income slab

Fresh Esop

Do not exercise until you want to sell. Else, you'll need to pay perquisite tax


Esop price higher than the current market value

They are equity investments. Take a 3-5 year view


However, if you want to book profits, the entire transaction depends on taxes.

Sachin Mahajan, an employee of a listed bank, is facing a similar dilemma. Two years ago, when he joined the bank, he was allotted 900 shares under his Esop. Mahajan has an option of buying 300 shares every year from the employer at a discounted price of Rs 995 a share. At present, he can pay Rs 6 lakh to get 600 shares. The current market value of these shares is Rs 14 lakh, a straight profit of 130 per cent.

Taxes involved in this transaction are at two different levels. If Mahajan exercises the option, his employer will transfer the shares to his demat account, and he will then need to pay a perquisite tax.

To compute the perquisite tax, he needs to calculate the difference between the current market price (Rs 14 lakh) and the price at which his employer has offered the stock (Rs 6 lakh). The amount will be added to his income, and he will be taxed according to the relevant slab. For Mahajan, the amount totals Rs 8 lakh, and he will fall under the 30 per cent tax bracket.

The second part of taxation will arise if he decides to sell the shares. For stocks held for less than one year, one needs to pay a short-term capital gain tax of 15 per cent on the profits booked. For shares held for more than a year, there is no tax. An investor also has an option to offset the short-term capital gains against short-term capital loss.

Govind Pathak, director, Acorn Investments Advisory Services, suggests that Mahajan should exercise and sell the shares to the extent where both his buying price and taxation are covered. He can sell the remaining stocks after a year or use them to fund the next lot of 300 shares that he will get under his Esop next year.

"Before selling Esops, you should be clear about your objective, as to what you are going to do with the money," says Surya Bhatia, a certified financial planner.

If you have an appetite for equities, use the money to diversify your portfolio into other stocks. "The portfolios of many investors, who get Esop options, tend to be skewed towards one company and one sector. If you are booking profits, use the opportunity to diversify in other stocks," says Rajesh Saluja, CEO and managing partner, ASK Wealth Advisors.

For sectors such as telecom, where the current market prices are lower than the prices granted under the Esop, you can forego the option. If you believe in the sector and the company, you can still buy the shares in the open market at a cheaper rate.

When the markets rally, many companies increase the scope of their Esops from senior employees to lower down. If you get an Esop at the current level, you don't need to worry about a price correction later.

"Every employer provides two-three years on average for an employee to exercise the Esop at a pre-determined price. This is the best part: there is no downward risk in Esops. If the employee feels the price is not right, it's better not to exercise the option," says Tarun Gulati, founder and CEO of Just Esops, a consultancy that helps companies design Esop schemes.

Tinesh Bhasin in Mumbai
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