What are Tax-Advantaged ESOP’s

Before we start….


I should really use my “what is” illustration for this post, but I decided I deserved a celebratory cupcake, so I’m using that instead.  I apologize for any confusion.

Okay. Now, to business.

Let’s start with a key definition

First, you will need some tools in order to fully appreciate this post.  Do you have a job where you receive a monthly paystub?  Or a friend or family member with one? Yes? Fantastic!

Grab your (or their) most recent paystub.  If you scroll down, after the detail of the base pay, overtime compensation and travel compensation, you are likely to see a number of items that start with the word “שווי” (shovy, or “value” in English).

Value of meals—שווי ארוחות Value of telephone—שווי טלפון
Value of gifts – שווי מתנות Value of car—שווי רכב

In each of the above cases, the employer is adding the value of a good, service or benefit that was provided to you as part of your employment compensation, in addition to your salary, but not in cash.  In English these are referred to alternatively as non-cash/ in-kind compensation, fringe benefits, benefits/ payments in kind, and so on.

And why is your employer adding this detail?
So it can be taxed, of course.   🙁
There are no free lunches, not even those provided by your employer.

Where options come into this

As we’ve discussed here and here, an option gives you the right to buy a share of a company. Generally, this will be at a stated price, with an expectation that, by the time you exercise the option to buy the share, the share will actually be worth more than you have to pay for it.  That is, in the best case scenario, you will be able to buy a share of a company, at a discount.

That right is worth something. Accordingly, the value of that right should be calculated and it should be added to your paystub, together with the value of all of the other non-cash compensation items.

But wait!  What if my company fails? It’s a startup!

Yeah, that’s the problem.  Unlike benefits like meal plans or gift cards which have identifiable monetary values (even if you personally believe that the hideous knickknack you received for Purim wasn’t worth jack, and certainly not the NIS 50 showing up in your paystub), or benefits like telephone plans, where Mas Hachnasah (Israeli Tax Authority (ITA)) has decreed “it’s worth X”, options are fuzzy.  They might end up being worth something. They might end up being worth nothing.  Even if you exercise the options when you leave a company, assuming the company is still private, you might not have any ability to resell them.  The shares may end up being worth something if and when the company exits.  However, if the company folds, or is sold at a low valuation, they may end up being worth nothing.

And if you already paid tax on “the benefit”?  Money for nothing.

Tax Advantaged Option Plans to the Rescue

To solve this problem, many countries have established programs by which employers can grant options to their employees and taxation is deferred to a later point in time.  Exact details vary (wildly) from country to country, but the general theme of these plans is to push off the payment of tax until one can say “yes, the employee actually received a benefit and we can measure and tax it”.  For example….

  • You might be taxed if and when you exercise the options to buy shares, and then only to the extent of the discount you received (that is, the price you have to pay is less than the fair market value of the shares on the day you exercise). You would then also pay capital gains if you subsequently sell the shares for more than the market value on the exercise date.
  • You might be taxed only if and when you exercise the options AND sell the shares

Each country has its own delightful and delightfully confusing collection of tax legislation governing ESOP’s. Frequently the legislation will include myriad requirements regarding what type of companies and what class of employees are eligible, stipulations regarding how the plan is to be managed, hoops in the form of local tax authority approval processes (for an example, see here), myriad initial and ongoing reporting requirements (such as these) and so on.   In short, if you are going to set up an ESOP, get professional guidance.  If you are going to set up an ESOP covering multiple countries, make sure you have that professional guidance for each country because what flies in Country A very likely will not fly in Country B.