An ESOP (employee stock option plan) gives an employee the right, but not the obligation, to buy a set number of company shares at a fixed price, called the exercise price, after a waiting period. If the company’s value rises, the gap between that fixed price and the share’s real value is the employee’s reward. In India, tax normally arises twice: when you exercise (buy) the shares, the gain is taxed as salary; when you sell, any further gain is taxed as capital gains. Employees of certain startups can defer the first tax for up to five years.
How an ESOP works, step by step
- Grant. The company offers you options under its ESOP scheme, stating the number of options, the exercise price and the vesting schedule. Nothing is taxed at grant.
- Vesting. You earn the right to exercise your options over time. Indian company rules require at least one year between grant and vesting (Rule 12(6)(a), Companies (Share Capital and Debentures) Rules, 2014).
- Cliff. Many startups use a “cliff”: nothing vests for the first year, then a block vests at once (often a quarter of the grant), and the rest vests monthly or quarterly. A four-year schedule with a one-year cliff is common, but it is a company choice, not a legal requirement.
- Exercise. Once options vest, you can pay the exercise price and receive actual shares. This is the first tax point.
- Liquidity. You can turn the shares into cash only if someone buys them: through a company buyback, a sale to an investor, an acquisition of the company, or after an IPO.
If you leave the company, unvested options usually lapse. The period in which you can still exercise vested options is set by the scheme, so read it before you resign.
A mini-glossary
| Term | What it means |
|---|---|
| Option | A right to buy one share at a fixed price in future |
| Exercise price (strike price) | The fixed price you pay per share when you exercise |
| Grant date | The date options are given to you |
| Vesting | The schedule over which you earn the right to exercise |
| Cliff | An initial period with no vesting, followed by a block vesting |
| Exercise | Paying the exercise price to convert vested options into shares |
| Fair market value (FMV) | The value of a share for tax purposes on the exercise date |
| Perquisite | A non-cash benefit taxed as part of salary |
| ESOP pool | The block of shares a company sets aside for employee options |
| Buyback | The company (or an investor) buying shares back from holders |
Who can get ESOPs
ESOPs are generally meant for employees and directors. Promoters and directors who hold more than 10% of the company are normally excluded, but startups can grant options to them too. The Ministry of Corporate Affairs extended this window for startups from five to ten years from incorporation in August 2019 (PIB, February 2023).
How ESOPs are taxed
From 1 April 2026, the Income-tax Act, 2025 replaced the Income-tax Act, 1961. The section numbers changed, but the two-stage structure stayed.
Tax point 1: at exercise (taxed as salary)
The value of shares allotted to an employee free or at a concessional price is a perquisite under section 17(1)(d) of the 2025 Act. Section 17 values it as the fair market value of the share on the date you exercise, minus what you actually paid. This amount is added to your salary and taxed at your slab rate, and your employer deducts tax at source.
For listed companies, fair market value comes from the stock exchange price. For unlisted startups, the income-tax rules require a valuation by a SEBI-registered merchant banker.
The catch: you owe this tax even though you have not sold anything and may not be able to sell for years.
The startup deferral
Employees of an “eligible start-up” can delay paying this tax. Under section 289(3) of the 2025 Act, the tax is payable within 14 days of the earliest of:
- the end of 60 months from the end of the relevant tax year;
- the date you sell the shares; or
- the date you leave the employer that gave you the shares.
The employer’s tax deduction is aligned to the same timeline (section 392(3)). Under the 1961 Act the corresponding window was 48 months from the end of the assessment year, so older explainers still quote that figure. If your shares were allotted before April 2026, check with a tax professional which rule applies to you.
The government lists this deferral among its main tax measures for startups (PIB, February 2026).
“Eligible start-up” here has a narrower meaning than DPIIT recognition. It refers to the startup tax-holiday provision (section 140 of the 2025 Act), which, as enacted, covers companies and LLPs incorporated between 1 April 2016 and 31 March 2030, with turnover up to ₹100 crore and a certificate from the Inter-Ministerial Board. Many DPIIT-recognised startups do not hold that certificate, so ask HR whether yours does.
Tax point 2: at sale (capital gains)
When you sell, the gain over the fair market value already taxed at exercise is a capital gain. Under the 2025 Act:
- Unlisted shares are long-term if held for more than 24 months, and long-term gains are taxed at 12.5%. Short-term gains are taxed at your slab rate.
- Listed shares are long-term if held for more than 12 months. Long-term gains above ₹1.25 lakh a year are taxed at 12.5%; short-term gains at 20%.
The holding period generally runs from when the shares are allotted, not from the grant date.
Illustrative example (hypothetical, round numbers): you exercise 1,000 options at ₹10 each when the fair market value is ₹510. The perquisite is (₹510 − ₹10) × 1,000 = ₹5,00,000, taxed as salary. Three years later you sell at ₹800 a share. The capital gain is (₹800 − ₹510) × 1,000 = ₹2,90,000, taxed as a long-term gain on unlisted shares.
Buybacks and other ways to cash out
Because most startups are years from an IPO, companies sometimes run ESOP buybacks or arrange secondary sales to investors so employees can sell some shares. These are at the company’s discretion: there is no right to a buyback unless your scheme or agreement says so.
The tax treatment of buybacks changed in Budget 2026-27. The Budget memorandum proposed that, from tax year 2026-27, money received on a buyback be taxed as capital gains rather than as dividend income, with a higher effective rate for promoters.
What can go wrong
- Paper gains, real tax. Without the startup deferral, you may pay tax at exercise on shares you cannot sell.
- Dilution. New funding rounds and pool top-ups reduce your percentage, though not necessarily your value (How startup funding works in India).
- Down rounds. If the company raises money at a lower price, your options can end up “underwater”, with an exercise price above the share’s value (What is a down round).
- Leaving early. Unvested options lapse, and a short post-exit exercise window can force a quick, expensive decision.
The point: An ESOP is a right to buy shares later at today’s agreed price. In India it is usually taxed twice: as salary on exercise and as capital gains on sale. Employees of certified startups can defer the first bill for up to 60 months under the new Income-tax Act. Read your scheme’s vesting and exit terms, and get tax advice before you exercise.
Sources
- The Income-tax Act, 2025 (Gazette of India, 21 August 2025), Ministry of Law and Justice
- Memorandum explaining the provisions in the Finance Bill, 2026, Ministry of Finance
- Ease of Doing Business initiatives for startups (10 February 2023), PIB
- Startup India recognises 2.07 lakh ventures (13 February 2026), PIB
- Rule 12, Companies (Share Capital and Debentures) Rules, 2014, reproduced by ca2013.com
- DPIIT Startup Recognition and Tax Exemption, Startup India