So far in our ESOP series, we have looked at the role of the value of your company and the timing of granting shares will affect the success of your ESOP. Today, we will uncover a few of the missteps owners take in regards to taxes and ESOPs

Tax Implications

Because taxes have varying aspects, they can cause a lot of confusion and trouble for business owners who each have their own situation and solution to their individual problems. Your employees specifically may come into many problems, damaging their trust for the plan due to a lack of understanding.

An employee receiving share options from your company and gaining monetary benefit from it would prefer they be “taxed” only when they had received their compensation, not at any point earlier. Unfortunately though, there are some countries who will enforce taxes on this plan as soon as you are granted the option, making this a sensitive situation you need to watch out for.

Just as the timing of when an ESOP will be taxed can vary, the tax rate will also vary considerably for different situations, specifically because a holder converts the shares into cash through at least two steps:

• The holder will “exercise” the option, turning the option into equity stock (subjected to a higher tax rate because it is taxed as salary or remuneration benefits)
• The holder of the equity stock sells the stock to others (considered capital gain tax, typically lower than salary tax)

Let’s look at an example to get a closer look at how taxes will affect the impact of your ESOP.

If we assume that, at the beginning of the year, a share is worth $10 and the exercise price is $8, as a holder exercising your option, you would pay the company $8 to buy a share that is worth $10, making a profit of $2.  

Moving to Q4 of 2021, the price of the company has grown to $15. The capital gain of holding your share is the difference of $15 and $10, meaning you would make a $5 gain.

The tax rate on the $2 gain would be different from that of the $5 gain due to the difference in the nature of each occurrence, one being taxed as a salary benefit and the other as capital gain. 

For those using ESOPs to the incentivise the employees of their company, this can pose some issues, but there are different mechanisms to mitigate the risks.

Because so many elements can change, the tax implications of ESOPs set up a common pitfall for many small businesses establishing their plans. To properly use an ESOP to its fullest potential, monitoring how and when taxes will be enforced is crucial to maintaining your plan.

The next time we return will be the last instalment in our series about how business owners face can improve in setting up ESOPs. We will take a look at the actual items you put on your option plan, aiding you in seeing possible consequences that can come from a lack of planning.

If you have any questions regarding your company's ESOP, please don't hesitate to reach out to Katherine directly: k at cancangroup dot com