Startups often face a unique challenge: they want great talent, but they don’t always have the cash to offer competitive salaries. That’s where Employee Stock Option Plans (ESOPs) come in. They’re a popular tool used by early-stage companies to attract and retain skilled people — while giving them a real stake in the future of the business.
But ESOPs haven’t always been simple. For employees, the tax burden came too early, sometimes even before seeing any real money. The government recognised this issue and made changes specifically for eligible startups. In this blog — Part 4 of the M2K Startup Series — we’ll unpack how ESOPs are taxed, what’s changed for startups, and what problems still remain.
General ESOP taxation
Let’s begin with how ESOPs are normally taxed, even before any sale happens.
There are two stages where tax comes into play:
1. When the option is exercised
This is when the employee decides to buy the shares. The tax here is treated as salary income, and the calculation works like this:
- Suppose the fair market value (FMV) of the share on the exercise date is ₹100
- The exercise price paid by the employee is ₹60
- The taxable perquisite = ₹100 – ₹60 = ₹40
This ₹40 is taxed as part of their salary, even though they haven’t sold the shares or made any real money yet.
2. When the shares are sold
This is where capital gains tax comes in. Let’s say the employee later sells those shares for ₹150. If the FMV at the time of exercise was ₹100, the gain is:
- ₹150 – ₹100 = ₹50 → taxed as capital gains
So even though the employee only receives cash on sale, some tax is due earlier, at the time of exercise. And that’s exactly what made things difficult — especially when the shares weren’t liquid or the company’s future was still uncertain.
To ease that burden, the Finance Act 2020 introduced a change. Now, for eligible startups, the tax on the first part (the perquisite) is deferred. But there are some conditions, and that’s where we’re headed next.
ESOP taxation for Startups
For startups that qualify as ‘eligible’, the tax payment on the ESOP perquisite isn’t due immediately. Instead, the deduction and payment of tax can wait until one of the following happens — whichever comes first:
- The employee leaves the company
- The employee sells the shares
- 48 months pass from the end of the assessment year in which the shares were exercised
Whichever of these occurs first triggers the tax payment window. From that point, the startup has 14 days to deduct and deposit the tax.
Even though the payment is deferred, the tax calculation must still be done in the year of exercise. The value of the perquisite is locked in using the tax rates applicable at that time — not at the time of the actual payment.
So, for example, if an employee exercised shares in FY 2022–23 but doesn’t sell them or leave the company until 2026, the tax is still calculated using the 2022–23 rates. Only the payment is postponed, not the valuation.
There’s one more thing to keep in mind: if the company doesn’t deduct the tax, the employee is liable to pay it. So startups must stay on top of this — the onus shifts fast.
Issues yet to be addressed
While the deferral is a step in the right direction, the policy is far from perfect. Several concerns still remain, and they affect how useful this tax benefit actually is for employees in real scenarios.
1. Employees might still have to sell shares to pay tax
Even with the 48-month extension, if the employee leaves the company, the clock starts ticking. In many cases, the only way to afford the tax bill is to sell the shares — assuming they can. If the shares aren’t listed or easily sellable, this creates a serious cash crunch.
2. Not all startups are covered
The benefit only applies to startups that meet very specific criteria:
- Must be incorporated between April 1, 2016 and March 31, 2022
- Must be DPIIT-recognised
- Must be approved by the Inter-Ministerial Board of Certification (IMB)
This narrows the pool of eligible companies significantly. Many DPIIT-recognised startups don’t have IMB approval and therefore can’t claim the benefit.
3. Ongoing eligibility is unclear
There’s no clarity on whether the startup must remain eligible after the options are exercised but before the trigger event (sale or resignation) happens. For example, if a company loses its “eligible” status a year after exercise, does the benefit still hold? This grey area hasn’t been addressed.
4. 48 months isn’t always enough
Even after the 48-month period, the employee might not have sold their shares — especially in unlisted companies. So they might still not have any money in hand, but now they’re facing a tax bill. The deferral only delays the problem; it doesn’t solve it.
In other words, it’s relief — but it’s temporary.
Final thoughts
The move to defer ESOP tax for startup employees was long overdue. It recognised the unique challenge that startups — and their teams — face: betting on long-term success without short-term liquidity.
By deferring the perquisite tax payment, the law gives employees more time. But unless the company is eligible and stays that way, the benefit doesn’t apply. And even when it does, the actual problem — paying tax before having cash — still happens in some cases.
So what should startups do?
- Make sure you’re IMB-approved — not just DPIIT-recognised
- Track ESOP exercises closely — because tax calculations start the moment it’s exercised
- Inform employees upfront about how and when tax may hit them
- Plan vesting schedules and share liquidity events (like buybacks or secondaries) to help employees manage their exposure
And for employees: don’t exercise options blindly. Know what year you’re doing it in, understand what tax rate applies, and check if your company qualifies as eligible.
The intent of this policy is good. But until more clarity and flexibility come in, employees and founders need to be very strategic in how ESOPs are issued, exercised, and taxed.
