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Employee Stock Option Plans (ESOPs) are now a regular part of compensation structures in many Indian startups and growing companies. They are used to reward long-term contributions and give employees a stake in the company’s growth.
While ESOPs can be valuable, they also come with tax and compliance considerations that are often misunderstood. Tax liability depends on when the options are exercised, when shares are sold, and how the company is structured.
This guide explains ESOP taxation in India in a straightforward manner. It covers how ESOPs work, the stages at which tax applies, tax benefits, and practical points to consider before making ESOP-related decisions.
An Employee Stock Option Plan (ESOP) is a scheme through which a company grants employees the right to purchase shares at a predetermined price after fulfilling certain conditions. These conditions are usually time-based and linked to continued employment.
ESOPs are commonly issued by unlisted startups, private companies, and listed entities.
Companies offer ESOPs primarily to attract and retain top talent by aligning employee interests with long-term company success, motivating them to drive performance that boosts stock value. This creates a sense of ownership and loyalty, turning employees into committed stakeholders who contribute to a stronger workplace culture and higher productivity.
For cash-strapped startups, ESOPs serve as a cost-effective alternative to high salaries, enabling them to reward contributions without immediate financial strain while enhancing overall business resilience and growth.
Here are few ways ESOPs can benefit employees
Companies in India implement ESOPs under the Companies Act, 2013, and SEBI guidelines for listed firms, granting eligible employees the right to buy company shares at a predetermined exercise price after meeting specific conditions. The process begins with board and shareholder approval of an ESOP pool, followed by issuing grant letters that outline a vesting schedule, often a 4-year cliff with a 1-year minimum lock-in to encourage retention.
Once vested, employees exercise options by paying the fixed price (usually below fair market value, determined by a SEBI-registered valuer for unlisted companies), acquiring shares they can hold or sell for profit, subject to any lock-in periods or tax implications under the Income Tax Act.
The ESOP process in India follows these stages:
The company grants stock options to eligible employees, specifying the number of options, exercise price, vesting schedule, and other conditions. At this stage, employees only receive a right to buy shares in the future, not actual ownership.
Vesting refers to the period during which employees earn the right to exercise their ESOPs. In India, the minimum vesting period is one year. Vesting usually occurs gradually, provided the employee continues to remain in service.
Once options vest, employees can choose to exercise them by paying the exercise price. Upon exercise, the employee acquires ESOP shares, and this event triggers perquisite tax under ESOP taxation in India.
After exercising ESOPs, employees can either hold the shares or sell them, subject to company policies and liquidity availability. When ESOP shares are sold, capital gains tax applies based on the holding period and whether the company is listed or unlisted.
The vesting period of ESOPs refers to the time an employee must remain with a company to earn the right to exercise their stock options. Until ESOPs vest, employees do not have ownership rights over the shares. In India, ESOP vesting periods typically range from three to five years, with most companies applying a one-year cliff followed by periodic vesting.
Understanding how vesting works is important because it affects ESOP taxability, employee retention, and the timing of exercise.
The most common vesting structures in ESOPs in India are outlined below.
Under a cliff-based vesting structure, employees do not receive any vested ESOP shares until they complete a minimum continuous service period, known as the cliff. This period is usually one year, as mandated by Indian regulations. If an employee leaves the company before completing the cliff period, all granted ESOPs lapse and cannot be exercised. Once the cliff is completed, a predefined portion of ESOP shares vests at once.
Graded vesting allows ESOP shares to vest gradually over time after the cliff period is completed. Instead of vesting all options at once, employees earn a fixed percentage of their ESOP shares at regular intervals, such as annually or quarterly. This structure is widely used in Indian startups because it encourages long-term retention while giving employees incremental ownership as they continue their tenure.
Employee Stock Options (ESOPs) are an important part of compensation for startup employees in India. Understanding how ESOPs are taxed helps employees plan for taxes and manage cash flow. ESOP taxation occurs at two distinct stages: exercise and sale, each governed by separate tax rules.
Before diving into taxation, it is important to understand Fair Market Value (FMV). FMV is the price at which a company's shares would sell on the exercise date. It is key for calculating taxes both at the exercise stage and when you sell the shares.
FMV is important because:
When you exercise ESOPs, you buy shares at a price lower than their FMV. The difference between FMV and the exercise price is treated as a perquisite and is taxed as part of your salary income.
Formula:
Perquisite value = (FMV on exercise date − Exercise price) × Number of shares exercised
When you sell ESOP shares, the capital gain is calculated as the difference between the sale price and the FMV at the time of exercise.
Formula:
Capital Gain = Sale Price − FMV at Exercise
Unlisted shares:
Short-term (≤24 months): taxed at your regular income tax slab.
Long-term (>24 months): 12.5%
Here are some key tax benefits that start-up employees enjoy
ESOPs shield employees from upfront tax on unrealized gains at exercise.
Unlisted startup shares held >24 months qualify for 12.5% LTCG tax vs. higher slab rates
Perquisite tax triggers only when value is realised through:
• Share sale (secondary, exit, post-IPO)
• Employee exit from company
• 48-month deadline from FY-end
ESOPs give startup employees a direct stake in the company's growth. As the startup scales toward an IPO or acquisition, the value of those shares can grow significantly, turning early commitment into substantial long-term wealth
ESOP rules for private companies and startups
Key requirements include:
ESOPs must be approved by:
Private companies have more flexibility in:
Companies must share ESOP details such as:
Even with flexibility, companies must maintain proper documentation and comply with accounting and tax regulations.
ESOPs without proper planning, taxes can significantly reduce actual returns. Since ESOP taxation in India happens at multiple stages, employees should follow a structured approach to manage tax liability, cash flow, and timing decisions.
Exercising ESOPs triggers perquisite tax based on Fair Market Value (FMV), even if the shares cannot be sold immediately. Employees should evaluate whether the company has a clear exit or IPO roadmap and whether the current FMV is justified. Exercising too early in a fast-growing startup can result in high tax on paper gains.
Under Section 192(1C), eligible startup employees can postpone paying perquisite tax until a liquidity event occurs. This prevents situations where employees pay large taxes without receiving cash. Tax becomes payable only on sale of shares, exit from the company, or after the deferral period ends.
For unlisted ESOP shares, long-term capital gains apply after 24 months and are taxed at 12.5%. This is usually lower than income-tax slab rates. Holding shares longer can therefore significantly reduce tax compared to selling immediately after exercise.
Many employees underestimate the combined impact of perquisite tax, TDS, and capital gains tax. Understanding the full tax outflow in advance helps avoid cash-flow stress and prevents any shocks during ITR filing. This is especially important for high-value ESOP grants.
Accurate documentation ensures correct reporting of ESOP income and capital gains in your Income Tax Return. Key documents include FMV certificates, Form 16, exercise confirmations, and sale agreements. Proper records also help in case of tax scrutiny or clarification requests.
Also read: Employee compensation choices: 6 types explained
Many employees miss ESOP benefits due to simple mistakes. Avoid costly errors and make the most of your stock options.
ESOPs represent strategic deferred compensation, delivering value to employees via equity appreciation tied to company performance. This rewards their efforts by sharing created wealth. It aligns employee interests with those of the company and shareholders to reduce organizational conflicts. Over time, ESOPs have benefited both employers and employees. Organizations that understand the instrument in depth and analyze its modalities from all angles can optimize these advantages.
If you’re a growing company looking to bring structure and clarity to your equity journey, Qapita helps you manage ESOPs, cap tables, and compliance in one platform
Book a demo to understand how we can simplify your equity management process.
Qapita provides a comprehensive ESOP management platform that brings cap table tracking, ESOP workflows, grant and vesting visibility, and compliance support all in one place, making it easier for companies to manage equity and give employees clear insight into their stock options.
ESOPs are typically taxed at two stages in India. The first is at exercise, where the difference between the Fair Market Value (FMV) and the exercise price is treated as a perquisite and taxed as salary. The second is at sale, where any gain is taxed as capital gains. There is usually no tax at the time of grant or vesting.
Employees can efficiently track and manage their stock options using ESOP management platforms such as Qapita, which provides a single dashboard to view vesting schedules, vested and unvested options, FMV updates, and upcoming tax events.
Startups typically create an ESOP pool approved by the board and shareholders, with defined vesting schedules, commonly four years with a one-year cliff. The exercise price is linked to the Fair Market Value, and detailed plan rules are framed in line with the Companies Act, 2013.
Key documents include the ESOP scheme document, board and shareholder resolutions, grant letters, and a valuation certificate from a registered valuer, all compliant with the Companies Act and (if listed) SEBI regulations.
