The Taxation of Employee Stock Options
Employers offer a variety of different forms of stock incentive compensation. An understanding of the relevant tax rules is essential in designing incentive plans that meet the needs of both employer and employee. This article will consider the most common type of incentive plan – employee stock options.
Employee stock options are popular because they meet a number of business objectives. In particular, they help employers to recruit, retain and motivate employees, without impacting cash flow.
Most of the tax rules governing employee stock options are found in section 7 of the Income Tax Act. A stock option is defined as an agreement to sell or issue shares. It is important to note that section 7 only applies to stock options issued to employees. Therefore, these rules do not apply to option issued to contractors or other non-employees. Corporate directors and officers are considered to be employees for the purposes of these rules.
The following is a summary of the basic tax rules regarding employee stock options:
- The grant of a stock option to an employee is not taxable to the employee, nor is it deductible by the employer
- The employee is taxable when the option is exercised
- The tax is paid on the “tax benefit” of the option, which is the value of the shares at time of exercise less the amount paid by the employee for the shares
- The “tax benefit” is taxable as employment income to the employee
- The shares acquired by the employee are generally capital property
- The full amount of the “tax benefit” is added to the employee’s tax cost of the shares
- Option issued to employee on Jan. 1, 2014 to purchase 100 shares of Employerco for $0.50 per share.
- Value of Employerco shares at Jan. 1, 2014 is $1.00 per share.
- Employee is not taxed on grant of option, despite option being in the money.
- Employee exercises option on Jan 1, 2015.
- Value of Employerco shares at Jan 1, 2015 is $2.00 per share.
- Tax Benefit is $150 ($2 less $.50 x 100 shares)
- Employee includes $150 in 2015 employment income.
- Employee now owns 100 shares with a tax cost of $2 per share.
- Employee then sells the shares on Jan 1, 2017 for $3 per share.
- Employee realizes a 2017 capital gain of $100 ($3 less $2 x 100 shares)
There are two important exceptions to the above rules.
First, if the exercise price of the option is not less than the fair market value of the shares at the date the option is granted, the employee generally taxed on only one-half of the “tax benefit”. This only applies to employees who are arm’s length to the company issuing the option and the option must be for ordinary common shares.
Thus, in the above example, if we assume that the strike price is $1.00 instead of $0.50, the employee would include $50 in 2015 employment income, not $150. The 2017 capital gain would be unchanged.
Second, if the option is issued by a Canadian-controlled Private Corporation (CCPC) to an arm’s length employee, then there is additional favourable treatment. The “tax benefit”, although measured at the time of exercise, is not taxable to the employee until the shares are disposed of.
In addition, even if the fair market value test above is not met, the employee will only be taxed on one-half of the “tax benefit”, provided that the employee holds the shares for at least two years. This deferral continues even if the issuer loses its status as a CCPC.
Thus, in the above example, if we assume that the Employerco is a CCPC and that the strike price is $0.50, then the employee would include $75 in 2017 employment income, instead of $150 in 2015. The 2017 capital gain would be unchanged.
Employee stock options are the most popular form of employee stock incentive.
However, there are several others. In future articles, we will consider other stock incentive plans that may be of interest.
Invitation for Discussion
It is worthwhile to have a discussion with a tax lawyer on any transaction or life event that may involve a significant amount of tax. By being proactive, you can enjoy the tax savings that you are entitled to. Feel free to contact any member of our Tax & Estate Planning group at Nerland Lindsey LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.