ESOPs 101 — Know your stocks (Part 2)
Did you know there is another compensation structure similar to ESOPs? Well, it's called RSUs and this post is dedicated to what it is all about and how you can save tax on both RSUs and ESOPs.
Illustration: Karthikeyan Ganesh
A couple of weeks ago, I had written part one of ESOPs 101 — Know your stocks where Vaidhy and I discuss how hiring is a huge challenge for startup founders, and what everyone should know about ESOPs, the new compensation structure for hiring, and retaining great talent. We talked about why accepting an ESOP offer means signing up for the long haul, why it can seem like a gamble, and why you should familiarize yourself with the various clauses in an ESOP.
Similar to ESOPs, there is another kind of compensation structure called RSUs. In part 2 of this series, we’ll discuss RSUs in detail, how different or similar it is to ESOPs, and how to plan your tax savings for both RSUs and ESOPs.
What are RSUs?
Short for restricted stock units, RSUs are shares that a company gives you directly. But, you won’t be able to sell or transfer these shares until you meet the necessary vesting conditions. As long as you continue to work with the company, RSUs will not expire.
If you think about it, they don’t seem to be any different from ESOPs. But that is not entirely true.
How are RSUs different from ESOPs?
One, you don’t have to spend money to buy them after they vest. They are automatically vested and are converted to stocks once you meet the required vesting conditions.
Two, if you work for a startup that hasn’t gone public yet, then there is an additional vesting condition known as the Liquidity Event. A liquidity event is when the company gets acquired or goes public. This means the shares are not vested until one of the two events happen.
Let’s assume there is a liquidity condition. In that case, you will have a double trigger vesting. You need to meet both the time-based and liquidity-based vesting conditions if you want to vest your shares.
Always remember, there is a liquidity event vesting condition for a company that hasn’t gone public.
What’s the big deal about RSUs?
RSUs are of great value for employees. When the company grows, it’s Fair Market Value (FMV), which we will discuss in part 3 of this series, also increases. Employees who join the company later will have to shell out a lot of money to buy the shares and pay the taxes. Those who leave the company sooner will not be able to buy the shares. So most companies move from ESOPs to RSUs once they are past the 5-6 years of their journey.
Additionally, for ESOPs you have to pay the FMV and tax on top of it when you leave the company. It will be a sizable burden for most people as they may not have cash ready on hand. Sometimes, they may have to take a loan for something that they won’t be able to sell. So a lot of employees don’t buy the shares. But in the case of RSUs, you don’t have to pay anything to buy the shares and they don’t add to the financial burden that comes from FMV or taxes even if you leave the company.
ESOPs are my favorite instrument as you can plan and save a bit of tax but RSUs are the ideal instrument for most people.
Why is there a double trigger?
It’s simple. When RSUs are vested, they become shares and you need to pay taxes on the FMV on the date of vesting. Since there is no market for you to sell, the double trigger exists to save you from paying those taxes.
You might wonder how this can be beneficial for the employee. When RSUs are vested they become shares. Any share given by the company is a perquisite and will be taxable. So you will have to pay tax. But there is no opportunity for you to sell the shares.
On the other hand, when it comes to ESOPs, you take a conscious decision to buy the shares and will pay the tax only when you buy them. So you can plan a bit better. That said, in RSUs if there is no double trigger shares will vest every quarter for which you will pay tax and you may not be able to sell them for the next 5 years.
Do RSUs and ESOPs have the same tax treatment?
No, they don’t. And understanding the tax impact on ESOPs and RSUs is super important. If you can plan well and plan ahead, you can save a bit on tax.
Now there are two kinds of tax when it comes to RSUs and ESOPs.
- Perquisites taxed as part of salaries
- Capital gains — short term and long term
Let’s discuss them in detail.
Perquisites are benefits provided by the company to the employee over and above his/her salary. This includes both monetary and non-monetary benefits. ESOPs and RSUs are two such perquisites. For perquisite taxes, the liability to withhold and pay taxes is with the employer, i.e. Tax Deducted at Source (TDS).
When you buy ESOPs, you need to pay the tax that is calculated on the difference between the exercise price and the FMV on the date of purchase. You will pay the exercise price to your employer.
Let’s go back to the example we discussed in part 1 of this series. You have 1000 units of stock at 1 USD exercise price each. The FMV on the date of purchase is 10 USD. You will pay 1000 USD to the US parent company (the issuer of the shares). At the same time, you will be liable to pay tax on the difference of 9000 USD (10000 USD - 1000 USD).
This perquisite tax is withheld from your salary as TDS by your employer, the Indian entity. Once the tax is deducted, the employer will transfer the amount to the government against your PAN number. If you need help determining the exact tax payable, talk to your payroll team.
Since you won’t be paying to buy the RSUs, the perquisite tax applies to the $10000 FMV as there is no exercise price. You will pay the calculated tax amount to your employer. In most cases, the employer will sell a part of your shares to cover the taxes and deposit the balance shares in your trading account. As mentioned earlier, all of this happens only when the company goes public.
Generally, any asset sold for a profit or a loss is a capital gain or loss. In the case of RSUs and ESOPs, stocks are the assets. If you sell them for a price higher than the FMV at the time of purchase, it is a capital gain. If you sell them for a price lower than the FMV at the time of purchase, it is a capital loss.
The period of holding between the date of sale and the date of purchase/vesting will decide whether the gain is a short term capital gain or a long term capital gain. At this point, the tax treatment is the same for both ESOPs and RSUs.
If your company’s shares are not listed on the Indian Stock Exchange, the shares are treated as unlisted shares. This is the case even if they are listed on a stock exchange outside India.
Short-term capital gains
For a listed company’s shares, if the holding period is less than 1 year, the gains are treated as short-term capital gains. The tax rate on short-term capital gains is 15% plus surcharge and cess.
In case your company is unlisted, then it is treated as short-term capital gains and the holding period is less than 2 years. The tax rate on short-term capital gains on the sale of unlisted shares is the regular tax rate applicable as per your income i.e. the slab tax rates applicable to your salary.
Long-term capital gains
For listed companies, the holding period should be more than 1 year for it to be treated as long-term capital gains. The tax rate is 10% plus surcharge and cess.
For unlisted companies, the holding period should be more than 2 years to be considered as long-term capital gains. The tax rate for long-term capital gains on unlisted shares is 20% plus surcharge and cess.
Note: Indexation is a component that plays an important role in calculating the capital gain or loss. You can read more about it here.
How can I plan my exercise and save on taxes?
If you are sure your startup will grow fast and you can save money to buy shares, look to buy them at the first chance you get. By buying shares early on, you will pay perquisite tax when the difference between FMV and exercise price is less. This way you pay less tax but enjoy a longer holding period for the shares.
When it’s time to sell the shares, you will pay 20% plus surcharge and cess as compared to 30% plus surcharge and cess. This way you save 10% on the tax.
Additionally, you can plan to buy a few shares each year instead of buying them all at a time, so that your income does not attract the surcharge each year.
While all of this might read well, this is not advisable for everyone. If the startup fails, the shares you purchase might become worthless and you may stand to lose all the money you invested. As we always say, do your due diligence and invest at your own risk.
Another important point to note is that any sale of shares will attract advance tax payment. Make a note of all the due dates and pay the advance tax on time to avoid interest and penalties.
FEMA — a frequently asked question
Most often when discussing RSUs and ESOPs, people ask about RBI and its related compliances. If your parent company is a US company, then when you buy stocks, you are essentially paying in USD. People want to know if there are compliance-related requirements that they need to adhere to when sending money in USD to a company registered outside India.
There’s something called the Foreign Exchange Management Act (FEMA). It was introduced in 1999 to govern all foreign exchange transactions. Later, in the year 2004, the Reserve Bank of India (RBI) introduced what’s called the Liberalised Remittance Scheme (LRS). This allows any resident individual to remit up to $25,000 outside India in a financial year.
The following year, in 2015, this limit was increased to $2,50,000. So, there are no additional filing or compliance-related requirements when you send money under the LRS scheme up to $250,000 per financial year.
And with that, we come to the end of part 2 of this series.
In the last part of this series, we’ll cover the benefits introduced under the Start-up India Program, FMV, 409A, valuation, and other frequently used terms. Meanwhile, if you have any questions, drop them as comments and we will be happy to answer them for you.