Tax and estate issues with stock options

You just got promoted, and your compensation package includes stock options. To factor them into your plan, you need to understand how options work, how they’re taxed, and what will happen to them when you die.

Package components

There are almost as many stock option plans as companies that offer them. To understand yours, familiarize yourself with key concepts.

Options

A stock option is an agreement between you and your employer that gives you the right to purchase company stock at some future date, at a price determined at the time of the agreement.

Say the company’s trading at $20 per share when the options are granted. The agreement may say that, four years from now, you have the right to buy 100,000 shares at $20.

If the shares are trading at $35 in four years, you can make $15 per share on 100,000 shares if you exercise your options (by buying the shares) and then immediately sell the stock.

Vesting

There’s usually a waiting, or vesting, period between when the options are granted and when you’re eligible to exercise them. Michael Friedman, a partner at McMillan LLP in Toronto, points to five common vesting conditions.

1. Employment tenure

If, for instance, the options vest at a rate of 25,000 per year over four years, the agreement may say:

• after one year, you can buy 25,000 shares at $20;
• after two years, you can buy another 25,000 shares at $20;
• after three years, you can buy another 25,000 at $20;
• after four years, you can buy the final 25,000 at $20.

2. Employee performance evaluations

Companies may have elaborate evaluation matrices, and link vesting to performance.

3. Company performance

4. Performance of employee’s division within the company

5. Company’s market share versus competitors

For 3, 4 and 5, vesting occurs when company-mandated targets are achieved.

Tax consequences

When you’re granted options, there are no immediate tax implications, Friedman notes. Tax kicks in when you exercise the options, assuming you’re employed by a public company.

Friedman notes that three elements are needed to qualify for a deduction on stock option income:

• the shares have to be prescribed shares, which essentially means plain-vanilla common shares;
• there has to be an arm’s-length relationship between you and your employer firm; and
• the options cannot be in-the-money, so the amount you pay to acquire the shares after the options vest must equal the stock’s fair market value (FMV) at the time the options are granted.

For instance, if the FMV of the company’s stock is $20 when you’re offered employment, the option price in the offer of employment has to be $20 for you to qualify for the tax deduction. The deduction is meant to incentivize employees to help businesses grow and to raise stock prices.

Death, options and taxes

Multiple tax scenarios can arise on death, depending on whether you’ve exercised some, none or all your options, and how your company’s plan treats unvested options.

Some plans cancel unvested options on death, notes Bernard Pinsky, a partner at Clark Wilson LLP in Vancouver.

Better plans vest all unvested options immediately on death. About 75% of major Canadian companies fall into the latter group.

Scenario #1: Options cancelled on death

Options that don’t vest on death are cancelled and their value is nil, explains Katy Pitch, an associate with Stikeman Elliott LLP’s Tax Group in Toronto. So, from a tax perspective, there’s no benefit—or loss—reported on your terminal return.

Scenario #2: All options vested and exercised before death

Say all your options vested three years before death. You exercised all of them, but didn’t dispose of the stock. In this case there are no special rules, notes Lisa Goodfellow, a partner at Miller Thomson LLP in Toronto. The situation’s the same as for anyone who owns stock.

Scenario #3: Options automatically vest on death, all unexercised

Say all your 100,000 options were unexercised prior to death. Your plan says the options automatically vest when you die.

Your terminal return must include this deemed employment benefit, notes Friedman. The benefit is calculated by subtracting the option price from the FMV of the company’s stock immediately after death. So, if the stock’s trading at $23 immediately after death, and the option price is $20, the deemed benefit is $300,000:

$2.3 million (100,000 x $23) —

$2 million (100,000 x $20)

On an administrative basis, CRA will allow executors to apply the 110(1)(d) deduction to that $300,000. That means income tax owing on $150,000. For an executor to take advantage of the deduction, your employer must file a 110(1.1) election.

Pitch notes there are no spousal rollovers with stock options. “If you leave everything to your surviving spouse, the income inclusion [on the terminal return] would [still] occur.”

Advice for executors

If you’re an executor, and the estate you’re responsible for is for the person in Scenario #3, it’s your job to exercise the vested options—and to claim a different tax break if the FMV of the shares has declined between the time you calculate and pay the taxable benefit for the terminal return, and the time the options are exercised.

In Scenario #3, there’s a $300,000 taxable benefit, based on an option price of $20 and a FMV of $23. But, say, six months pass before you’re able, as executor, to exercise the options and sell the shares, and the FMV at that point is $21 instead of $23.

CRA offers relief under section 164(6.1) of the Income Tax Act. Since the benefit that actually goes to the deceased’s estate (based on the $21 stock price) is less than the deemed benefit taxed on the terminal return (based on the $23 price), the executor can amend the return and get a partial refund. CRA says you can do this only within one year of death; after that, there’s no relief.