Tax and estate issues with stock options

One of your best clients just got promoted, and her compensation package includes stock options. To factor them into her plan, you need to understand how options work, how they’re taxed, and what will happen to them when she dies.

Package components

There are almost as many stock option plans as companies that offer them. To understand the one your client has, familiarize yourself with key concepts.

Options

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

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

If the shares are trading at $35 in four years, she can make $15 per share on 100,000 shares if she exercises her options (by buying the shares) and then immediately sells the stock.

Vesting

There’s usually a waiting, or vesting, period between when the options are granted and when your client is 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, she can buy 25,000 shares at $20;
• after two years, she can buy another 25,000 shares at $20;
• after three years, she can buy another 25,000 at $20;
• after four years, she 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.

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Tax consequences

When your client is granted options, there are no immediate tax implications, Friedman notes. Tax kicks in when she exercises the options, assuming she’s employed by a public company (for rules on private companies, see “Private company stock options,” below).

“Tax calculation,” below, illustrates how the process would work.

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 your client and their employer firm; and
• the options cannot be in-the-money, so the amount your client pays to acquire the shares after the options vest must equal the stock’s FMV at the time the options are granted.

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

Not created equal

People tend to think stock options can make them rich. But not all plans are created equal, and some aren’t even that attractive, notes Bernard Pinsky, a partner at Clark Wilson LLP in Vancouver.

“People think more about [option] price and how many they get, and they probably don’t think much about [the plan’s] specific terms, such as what happens on death. And, probably, no one thinks they’re going to die in the next little while [so as to] make it important to them.”

He says plan documents typically aren’t overly complicated, so in most cases it isn’t necessary to get help from a lawyer. But clients have to read the plans, because there may be terms they won’t like.

“If [your client] has the ability to negotiate terms with [her] employer, one of the things [she] should negotiate is the ability to have all unvested options vest on death, with no specific limitations just because [she] passed away.”

Adds Lisa Goodfellow, a partner at Miller Thomson LLP in Toronto: “In most cases, an executive has absolutely no control over what the stock option plan says. Most company plans are written in stone, but executives with bargaining power may have an employment agreement that provides a greater benefit than what the plan offers.

“When you’re dealing with those kinds of offers, [the client] absolutely should get advice from an employment lawyer.”

Death, options and taxes

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

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

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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—to report on the client’s terminal return.

Scenario #2: All options vested and exercised before death

Say all your client’s options vested three years before death. She 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 any client who owns stock.

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

Say all your client’s 100,000 options were unexercised prior to death. Her plan says the options automatically vest when she dies.

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Her terminal return must include this deemed employment benefit, notes Friedman. Calculate the benefit 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)

Prior to 2010, CRA allowed your client’s executor to apply the 110(1)(d) deduction to that $300,000, notes Pitch. That would have meant income tax owing on $150,000. But post-2010, rule changes made it less clear the deduction could be used this way; so estates would pay tax on the full $300,000. To take advantage of the 110(1)(d) deduction, your client had possess the shares, and that would mean exercising options prior to death. [Note: CRA has issued a technical interpretation (after time of writing) indicating the agency will on an administrative basis allow the use of the 110(1)(d) deduction in cases where an employee dies with options that vest on death.]

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.”

Tax Calculation

Say a client exercises 25,000 options once they’ve vested. The fair market value (FMV) at the time of exercise is $27 per share; the option price is $20.

The FMV of 25,000 shares is $675,000 (25,000 × $27), and your client’s purchase price is $500,000 (25,000 × $20).

Your client’s taxable employment income for the year she exercised the options will include $175,000:

$675,000 – $500,000 = $175,000

The client doesn’t have to sell the shares to trigger tax. Exercising an option by purchasing the shares creates a taxable benefit.

Instead of paying tax on $175,000, Section 110(1)(d) of the Income Tax Act says your client can claim a deduction so she only pays tax on half that amount.

The deduction has a capital-gain-like result, but the benefit is not a capital gain; it’s employment income. So, capital losses on other positions cannot offset tax triggered by exercising stock options.

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Advice for executors

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

The client in Scenario #3 has a $300,000 taxable benefit, based on an option price of $20 and a FMV of $23. But, say, six months pass before the executor is able 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 only do this within one year of death; after that, there’s no relief.

Getting technical

When a client exercises options and has to report the benefit on her tax return, she has to subtract the amount she pays for the shares from the amount she would have paid if she bought the stock at FMV the day the options were exercised.

But CRA rules also say the client needs to subtract any amount she paid to acquire the options in the first place.

“Paying to acquire options is less common,” notes Michael Friedman, a partner at McMillan LLP in Toronto. An example would be where employees of a private corporation are eager to obtain equity ownership. “The employer says, ‘I’ll grant it to you, but in exchange for that right, which could prove very valuable, I want you to give me something.’ ”

Use ’em or lose ’em

“Ensure the executor knows the plan exists,” says Friedman. “You don’t want him or her to discover it several years later.”

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It’s not just a matter of losing the 164(6.1) credit, Pinsky explains: “TSX Venture Exchange rules say that if someone that has options passes away, those options have to be exercised in one year, or they expire.”

Executors should exercise the deceased’s options within a year after death.

That can mean the estate would forfeit hundreds of thousands, even millions.

The TSX doesn’t have this rule, but many TSX-listed companies have their own rules limiting the post-death exercise period, notes Friedman. “Frequently, when an employee passes away, the employer is sensitive to the fact that the estate has to be administered, but they don’t want to have to deal with the estate for years and years.”

He urges clients to inform executors whom they should speak with at their companies for plan details and instructions on how to exercise options that vest on death. “That way, they’re not running around trying to find someone” to help them settle the estate.

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Private company stock options

Tax rules for stock options on Canadian-Controlled Private Corporations (CCPCs) are even more favourable than for public companies, notes Michael Friedman, a partner at McMillan LLP. With public company options, there’s a taxable benefit when your client exercises them. Not so for CCPCs: tax is deferred until your client sells the shares. The exception is death; in that case, the benefit must be recognized on the terminal return.

Another key difference: a client can’t qualify for the 110(1)(d) deduction on public company options if the options are in-the-money. With CCPCs, “you can get the 50% deduction on options that are in-the-money, as long as the shares have been held for two years.”

Dean DiSpalatro is a Toronto-based financial writer.