Stock options in volatile times

If some of your clients have stock options as part of their employment package, they should be aware of how these options are taxed, and the risks associated with this type of compensation.

While there are no tax consequences when stock options are granted, a taxable benefit is triggered at the time the options are exercised.

This benefit is equal to the difference between the market value of the stock and the option price. It is considered a taxable employment benefit, and thus must be included in the employee’s income in the year that the option is exercised. The employee can claim a tax deduction equal to one-half of the benefit (as long as the shares are common shares, and the exercise price at the time the options were granted was equal to the fair market value of the shares).

Let’s look at an example. Floyd is granted an option by his employer to purchase 1,000 common shares in the corporation for $10,000, its current fair market value. The options are worth $30,000 when he exercises the option.

The amount of the stock option benefit will be $20,000 ($30,000-$10,000). The $20,000 benefit will be added to Floyd’s adjusted cost base of the shares, which will become $30,000.

Floyd will be entitled to deduct one-half of the benefit in computing his taxable income. Thus, Floyd will only include $10,000 in his taxable income. The company will file a T4 slip that shows the full employment income ($20,000) and the 50% deduction ($10,000). (This stock option benefit calculated above can be deferred, within certain limits, as discussed below).

Even though the stock option profit is treated like a capital gain at 50% inclusion, the net amount is taxed as high marginal rate income. So an employee pays income tax on the “deemed” profit, as calculated on exercise date, regardless of whether or not he actually realized a profit (even where the employee decides to hang on to the shares as an investment and commitment to the company).

How the tax deferral works

As you would expect, many of your clients would find it difficult to pay tax on non-cash compensation. Prior to 2000, because of the negative tax impact brought about by exercising options and holding the shares, employees were effectively forced into selling their shares immediately (i.e. on exercise date) to avoid adverse consequences. This practice did nothing to encourage employees to hold onto company shares.

Current tax law allows the employment benefit to be deferred until the employee sells the shares (or until death). The deferral typically applies where the employer is a Canadian Controlled Private Corporation (CCPC) or a public corporation listed on a prescribed stock exchange.

In the case of a CCPC, there is no maximum limit on the deferral. In the case of a public corporation, there is an annual $100,000 limit in respect of options that can be granted to an employee and be eligible for a deferral. This deferral amount is based on the fair market value of the shares at the time the option is granted.

Let’s consider another example. In January 2006, Carol received 10,000 qualifying shares at an option price of $25 per share, equal to the fair market value at the time of grant. Of the 10,000 options, 5,000 were vested in January 2007 and the remaining 5,000 in January 2008. On December 1, 2008, Carol exercised all options. The fair market value of the shares on that date was $60. In 2009, Carol sells all 10,000 shares at a fair market value of $65 per share.

You calculate the 2008 tax by doing the following.

1. Calculate the number of shares that can be tax-deferred.

The $100,000 maximum deferral is based on the $25 fair market value. Therefore, the income benefit that Carol can defer in our example is based on 4,000 shares per vested year ($100,000 deferral /$25 grant price).

2. Calculate the income deferral.

Income Deferral = (Number of shares * benefit per share)

2007 deferral = $140,000 (4,000 shares * $35 ($60-$25))

2008 deferral = $140,000 (4,000 shares * $35 ($60-$25))

Total deferral = $280,000

3. Calculate the gross income benefit (before deferral) for 2008.

2007 options = $175,000 (5,000 x $35 ($60-$25)

2008 options = $175,000 (5,000 x $35 ($60-$25))

Gross income before deferral = $350,000.

4. Calculate the net tax liability for 2008.

Total income before deferral = $350,000, less deferral of $280,000 = $70,000.

Total income reported in 2008 = $70,000

Of this $70,000, $35,000 (50%) is taxable at Carol’s 2008 marginal tax rate.

Once this is complete, you’ll have to calculate 2009 tax. Because Carol sells the shares in 2009, she will now realize two distinct tax liabilities: tax on the $280,000 option benefit that was deferred from 2008; and the gain on the shares from 2008 to 2009 ($65-$60 x 10,000 shares = $50,000).

So the total income that Carol must report is:

• employment benefit:$280,000 – $140,000 (50% stock option deduction) = $140,000 employment income.

• capital gain: 10,000 shares x $5 ($65-$60) = 50,000 x 50% inclusion rate = $25,000 taxable capital gain.

What happens if the shares decrease in value after exercising?

If your client’s shares increase in value after exercise date, she will have a capital gain, as we saw in the above example.

The real problem, however, is if the shares decrease in value after exercise date. Using the previous example, let’s say that, as a result of the current volatility and fallout of the markets, Carol needs cash and has to sell the 10,000 shares at $30. In this case, she has a capital loss of $30,000, 50% of which can be used against capital gains only. It is important to explain to your clients that the employment benefit is not a capital gain, and it cannot be reduced, even if the shares go down in value. The calculation of the amount of taxes owing from the employment benefit is based on the at the time the options are exercised, not when the stock is sold.

Therefore, continuing with our example, Carol will still have to pay tax on the $140,000 employment benefit even though the shares have decreased in value. Your clients need to understand that stock options can create a large tax liability, and proper planning is critical.

Clients who exercised options around the peak of the market in 2008 and have held on to the shares could find themselves in a difficult financial position today. For some of these clients, it likely never occurred to them that they could ultimately owe so much in tax.

Many consider the stock option tax an unfair tax on unrealized gains. The tax on unrealized gains in a downward market is the unintended consequence of a tax law that was initially designed to encourage and reward risk investment in Canada. When options are exercised and sold, tax is payable on the realized gain (classified as employment income but calculated at the capital gains tax rate). Fair enough. But when options are exercised and held, they are deemed to have been disposed, creating a deferred tax liability on the gain between option price and current market price. That gain, in reality, is unrealized because the owner has only received an “on-paper” gain, while being liable in “real-time” cash.

This very effect was devastating to those who experienced the crash of 2000-2001. Shares of companies such as JDS, Nortel and many others dropped more than 90%. Because the unrealized “on-paper” gain could not be offset by the capital loss, employees were left with the decision to liquidate assets in order to pay the tax, or continue to defer the tax and hope for a miracle. Some chose to defer the tax liability to their estate, and purchased life insurance to offset the tax at death.

In an ideal world, likely the one envisaged by the CRA, shares can only increase steadily in value over time.

However as we know, the whipsawing markets we have experienced since mid-2008 have driven down the value of all stocks. Investors who exercised stock options last year may easily feel embittered by the punitive tax measure, which can destroy the value of the highly-touted employee stock option.

Careful planning in each client situation is needed to ensure clients don’t experience a nasty surprise after selling their company shares.

Sandy Cardy is senior vice-president, tax and estate planning, at Mackenzie Financial.

(02/02/09)