Employee Stocks Unveiled!

Recently due to strong quarterly results of my organization, the stock price showed a significant upward trend. There was suddenly a buzz of activity going around within my team members & fellow employees. I could really sense the excitement on all the floors of our office. Everyone wanted to figure out when to sell their vested stocks & which ones to sell! As a fall-out, I received many queries from my colleagues. Some of those were generic & some very specific. I wanted to cover the generic aspects in today’s article.

There are 3 ways (other than buying the same from stock exchange) in which an employee can acquire stocks – Employee Stock Option Plan (ESOP), Restricted Stock Units (RSU) & Employee Stock Purchase Plan (ESPP). We will discuss the first 2 since those are the most popular forms today. There are further classifications within ESOP & RS. We will restrict this article to the most common forms i.e. Non Qualified Stock Options & Restricted Stock Units.

Before we start understanding ESOP & RSU, I am assuming that you are generally aware of key terminologies like – Grant, Grant Price, Vesting, Exercise, Exercise Price, Fair Market Value etc. Most of these terms are explained here:
http://financial-dictionary.thefreedictionary.com/Employee+Stock+Option+-+ESO.

There are 3 major events that happen in the life cycle of ESOP or RSU – Grant, Vesting & Exercise/ Sell. ESOPs are granted at a grant price which is normally the fair market price of the stock on the day of the grant. Vesting happens as per the details of the plan. Only the vested stocks can be exercised or sold.

Let’s see how one can determine whether to sell ESOP or RSU depending on the market conditions. Refer to Table 1 that has an illustration. Let us assume that an employee received both ESOP & RSU on the same date. The vesting rules for these are different & hence the number of stocks vested today will be different. Assuming that he/ she sold the entire ESOPs today, the total gain would be $ 3,556. Similarly for RSUs it would be $ 1,099.

Now let’s consider some other facts – Assume that the employee is working in India office of this US corporation. He/ she expects the stock price to go up by around 10% in next few months. So now he/ she is pondering if she can sell ESOPs or RSUs or both? I would recommend booking partial profits in any case (remember our principle of realized gains?). However in this illustration, I would also recommend selling RSUs first if one expects the stock to go up further. Why? Look at Table 2 now.

In this example, just 10% of expected price increase will mean > 40% increase in profits in case of ESOP! But in any case, are there any other reasons why one would recommend selling RSU? Well, it is simple really. First, regular profit booking or loss cutting should happen, irrespective of the type of your holding. Second, if you expect the stocks to rise by 10% over 1 year, then it is probably better to book the profits (by selling RSUs first) in US markets & invest the money in Indian market where you probably can expect to gain at a faster rate (assuming that exchange rates will more or less remain the same).

Converse is true as well. If you expect the stock price to go down in future, then it is better to sell ESOPs first in the above example.

As far as the tax implications in India are concerned, there are 2 types of taxes that come in play – Fringe Benefit Tax & Capital Gains Tax. In India, employer needs to pay FBT to the Income Tax Deptt. The triggers are different for both ESOP & RSU. Legally, the employer has an option to recover this tax from the employee. Refer to Table 3 for an example of FBT & Capital Gains Tax implications. Please note that this is a simplistic example to enable quick understanding for the readers.

The capital gains tax needs to be paid by the employee through advance tax system since there is no tax deduction at source.

In a nutshell – There are definitely some quirks associated with ESOP or RSU, however when one wants to determine the timing of sell, it is just the same as any other stocks that you held. Periodic realization of gains once the price reaches your target, still remains as one fundamental principal whether the shares are from ESOP, RSU or open market.