Tax, investment & financial planning strategies you need to know
Stock options can be a lucrative bonus for high-achieving employees or a remuneration mainstay for senior executives. The reward depends not just on rising share prices, but also on timing and taxes. Options can be an attractive perk particularly for employees of a successful, growing company.
It’s not unusual for a company to award stock options to employees as an alternative form of remuneration, often as an annual bonus. However unlike a cash bonus, a tax deduction is available. Because of the preferential tax treatment, Stock Options attracted a lot of attention last year when the Liberal government considered placing a restriction on how they were taxed. Ultimately no change was made, to the relief of new businesses and other small companies, as well as senior executives who count on options as an integral portion of their compensation package.
What are stock options?
A stock option gives the holder the right to purchase a company’s share at a predetermined price, usually the fair market value of the share on the date the option is awarded. This is known as exercising the option, and can be done after the option has vested (typically several years after the option is awarded) and prior to its expiry date. Timing is important. Not only should you exercise options that are “in the money” (when the share price is higher than when the option was awarded), you want to do so when a good profit presents itself – and of course before it expires.
Take the example of an option awarded at $20, and the underlying share price reaches, say, $30 after the options have vested. The employee could exercise the option and pay just $20 a share, which represents a $10 gain on paper.
Of course, you have to share a piece of that profit with the tax man – not as a capital gain, but as a taxable employment benefit. In this case, assuming the shares are publicly traded, if you exercised 100 options at $20 a share, you’d pay $2,000 for shares worth $3,000 – for a $1,000 profit that is included on your tax return as employment income. However, a tax deduction is available on the exercised options, so that only one-half of the benefit is taxable. Thus your net taxable benefit in the example above would be $500. (For Quebec residents, the deduction is one-quarter of the amount, so for provincial tax purposes the net taxable benefit would be $750.)
To qualify for this deduction, generally speaking three criteria must be met:
• The options generally must be for common shares;
• The exercise price must be no less than the fair market value at the time the option is granted; and
• You must deal at arm’s length with the corporation (for example, you or your family do not control it).
If the options are for shares of a Canadian-controlled private corporation (CCPC), the taxable benefit is calculated only when the shares are sold, not when the options are exercised. A deduction reducing the benefit by one-half may be claimed, providing the shares are held for at least two years after the options are exercised, and you are at arm’s length from the CCPC. A 50% deduction also is available for Quebec purposes, but the option-issuer must be a small/medium-sized research-and-development company.
When should I exercise my stock options?
Overall, it makes sense to exercise options when you believe they are well into the money and when you aren’t willing to risk losing any on-paper profit. And, for publicly traded shares, assuming they are increasing in value, the longer you wait to exercise, the longer the tax deferral Of course, you can exercise earlier and hold the shares longer to maximize your gain – but in the case of publicly traded shares, you would have to pay the taxes when the shares are exercised.
And while stock options provide significant upside if the company is growing, there is downside risk in holding shares after you have exercised your options. In the above example, if the share price were to drop to say, $15, you’d have paid tax on the taxable benefit at the time the options were exercised, based on a share price of $30, but your investment would now be worth less. In addition, if you sold your shares, although the capital loss would be available to apply to other gains in the year, it wouldn’t be available to apply against the employment benefit from the exercised stock options. This is because the profit was taxed as employment income, not a capital gain. This would not be an issue when exercising options on CCPC shares, since the taxable benefit is only calculated when the shares are sold.
Stock options continue to be a popular form of remuneration and to continue to make the most of them, here are some additional tax planning points to consider:
• Consider exercising options (or, in the case of CCPCs, sell shares) earlier in the year to defer paying tax on the taxable benefit until you file your return the following April– keep in mind that this would have to be balanced with your share price expectations.
• The tax payable on a high-value option-related transaction may make you installable the following tax year. This would be the case if you have more than $3,000 in taxes owing (in both the current year and either of the preceding two years) in excess of the tax deducted at source on your regular employment income. Check with your employer on how your options are tax withheld and ensure you pay installments on time to avoid interest charges
• Watch the calendar to makes sure in-the-money options do not expire before exercising them.
• Be mindful of the potential for an additional capital gain where you sell shares acquired through exercised options after 30 days, this could apply in situations where you already hold the company’s shares.
• Consider contributing qualifying shares acquired through your stock option plan to your RRSP or TFSA if you have room.
• If you retain shares acquired through exercised options, make sure this position is in line with your overall asset-mix target & risk tolerance and that you are not overly concentrated in one area.
• Considering making donations in the year? If you exercise an employee stock option and donate the shares to charity you do not need to include the resulting employee benefit in your income. To be eligible they must qualify for the stock option deduction and be donated in the year and within 30 days of being exercised.
Stock options can boost your income significantly, but don’t let market-timing greed jeopardize the benefit by exercising too late. By seeking the advice of a financial professional who is familiar with employee options, including the tax element, you can make the most of this potentially lucrative employment perk.