What Is an Employee Share Scheme & How Do They Work?

Employee share schemes offer employees an ownership stake in the company. These programs align employee and shareholder interests, fostering a shared commitment to long-term success. By providing an opportunity for wealth creation beyond regular salary, these plans can influence employee motivation and retention. They aim to create direct participation in the company’s growth and financial performance.

What is an Employee Share Scheme

An employee share scheme provides employees with the chance to become owners of the company, often through shares or share-linked instruments. This arrangement allows individuals to benefit directly from the company’s appreciation in value. Companies implement these schemes to attract and retain skilled talent in competitive markets.

These programs incentivize employees by linking their financial well-being to company performance, encouraging dedication and productivity. When employees hold an ownership interest, they tend to make decisions that benefit the company, fostering a culture of shared responsibility. This sense of ownership can enhance employee engagement and cultivate a cohesive work environment.

For employees, a primary benefit is the potential for wealth accumulation, especially if the company’s value increases. Beyond financial gains, having a stake can instill a feeling of belonging and personal investment. This aligns individual goals with corporate objectives, making employees feel like direct participants in the company’s journey.

Common Types of Employee Share Schemes

Several common types of employee share schemes exist, each with a distinct structure designed to meet varying company and employee objectives. These plans generally fall into categories that either grant actual shares or provide rights linked to share value. Understanding the mechanics of each type is essential for both employers and employees.

Stock options grant an employee the right, but not the obligation, to purchase company shares at a predetermined price (exercise price) within a certain timeframe. There are two main variations: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). While both give the holder the right to buy shares, their tax treatment differs upon exercise.

Restricted Stock Units (RSUs) represent a promise from the employer to deliver company shares or their cash equivalent to the employee at a future date, after certain conditions are met. These conditions relate to continued employment over a specified vesting period. Unlike stock options, employees do not purchase RSUs; instead, they are awarded and settled as shares or cash.

Employee Stock Purchase Plans (ESPPs) allow eligible employees to purchase company stock at a discounted price through regular payroll deductions. These plans provide a way for employees to acquire shares, often offering a discount of up to 15% off the market price. Employees contribute funds over an offering period, and the accumulated funds are used to purchase shares on a designated purchase date.

Phantom stock and Stock Appreciation Rights (SARs) are types of equity compensation that do not involve the issuance of company shares. Instead, they provide employees with a cash payment tied to the appreciation in the company’s stock value over a period. Phantom stock pays out a bonus equivalent to the value of shares, while SARs pay out the increase in value of shares from a grant date.

How Employee Share Schemes Work

Employee share schemes follow a lifecycle from initial grant to eventual sale of shares, involving several stages that employees navigate. The process begins with the grant or award, when the company communicates the terms of the share scheme to the employee. This step sets the number of shares or options, the exercise price (if applicable), and the conditions for earning the award.

Following the grant, the award enters a vesting period, during which the employee earns the right to the shares over time. Vesting schedules are tied to continued employment or the achievement of performance targets. Common vesting structures include “cliff vesting,” where all shares become available at once after a set period, or “graded vesting,” where shares become available incrementally over several years. If an employee leaves before a cliff vesting period is complete, they may forfeit all unvested shares. Graded vesting offers a gradual accumulation of ownership.

Once vested, the shares or options enter the exercise or settlement phase. For stock options, the employee can choose to “exercise” the option by purchasing the shares at the predetermined exercise price. For Restricted Stock Units (RSUs), settlement occurs when the company delivers the shares to the employee, as vesting conditions have been met. The employee does not pay to receive RSUs, unlike stock options.

After shares are acquired through exercise or settlement, employees have the ability to sell them. However, company policies or insider trading regulations may impose restrictions on when and how shares can be sold. Employees should be aware of any limitations that might affect their ability to liquidate their holdings.

Taxation of Employee Share Schemes

The taxation of employee share schemes involves distinguishing between ordinary income and capital gains. Tax implications depend on the type of scheme and the timing of events, such as grant, vesting, exercise, and sale. Understanding these distinctions is important for managing tax liabilities.

For Non-Qualified Stock Options (NQSOs), taxation occurs at the time of exercise. The difference between the fair market value of the stock on the exercise date and the exercise price is treated as ordinary income. This amount is subject to federal income, Social Security, and Medicare taxes, and will be reported on the employee’s Form W-2.

Restricted Stock Units (RSUs) are taxed at the time of vesting. When RSUs vest, the fair market value of the shares on that date is considered ordinary income and is subject to federal, state, and payroll taxes. Employers often withhold a portion of the shares to cover these tax obligations.

Employee Stock Purchase Plans (ESPPs) have specific tax rules. Income is not recognized at the time of purchase. When shares acquired through an ESPP are sold, any discount received on the purchase price is taxed as ordinary income. Any additional gain beyond this discount and the original purchase price is taxed as a capital gain.

When shares acquired through these schemes are sold, any profit or loss is subject to capital gains tax. If held for one year or less after acquisition, any gain is a short-term capital gain, taxed at the employee’s ordinary income tax rate. If held for more than one year, the gain is a long-term capital gain, typically taxed at lower, more favorable rates. The cost basis for shares includes the amount paid for the stock plus any income recognized and taxed at acquisition or exercise.