It’s common for start-up and growing businesses to allocate a percentage of the company’s equity to stock options. The options are used to attract and incentivize key employees who are given the opportunity to share in the growing value of the business. However, many employees do not consider the tax implications of granting and exercising options. Getting familiar with the applicable tax consequences can help reduce the amount owing to Canada Revenue Agency (CRA) and avoid one particularly costly scenario.
Using a simple example to illustrate: ABC Co. was incorporated as a Canadian controlled private company (CCPC) that issued common shares to its founders for a nominal amount, say $0.01/share. The founders work hard to grow the business and increase value. In year two after incorporation, to incentivize an expanding team, ABC Co. grants stock options to key employees, including a signing bonus to newly hired CFO, John. Like the shares issued to the founders on incorporation, John’s options are granted with an exercise price of $0.01 per share. At the time of the grant, the fair market value (FMV) of the company’s shares has grown to $1.00/share. Because the FMV of the shares is greater than the acquisition price ($0.99 per share greater, in this case), the options are referred to as “in the money”. Seems like a good deal for John who proceeds to exercise options to acquire 100,000 common shares of ABC Co. for $1,000.
What is the Tax Treatment?
The difference between the exercise price of the options and the FMV of the shares when issued is treated as a taxable employment benefit by CRA. However, for CCPCs (and certain other qualifying companies), that benefit is deferred until the shares are sold by the employee. There are some advantages to owning the shares for at least two years. First, the employee is entitled to a 50% deduction in the employment benefit (so, only half of the difference between the exercise price and FMV is taxable). And second, the employee’s lifetime capital gains exemption (CGE), to the extent available, may be used to reduce or eliminate the tax payable on any capital gain on the shares (as of 2022, up to $913,630 in capital gains on qualifying shares can be sheltered from tax).
So, What if the Shares Go Up?
We are now in year three, John has been with the company for one year, and things are going well — the shares of ABC Co. have increased again in value to $2.00 per share. John decides to move on from ABC Co. and sell his 100,000 shares in the process. The sale price is $200,000, the current FMV.
What is owed to CRA? Well, the employment benefit is the difference between the purchase price of the shares (one penny per share) and the FMV of the shares at the time the options were exercised (one dollar per share). In other words, $99,000 is included in John’s taxable income in year three. John is also taxed on the capital gain, meaning 50% of the difference between the FMV when John acquired the shares ($100,000) and the sale price ($200,000) is included in John’s taxable income in year three. In total, John will have to pay tax on $149,000 when selling the shares for $200,000.
John would benefit from holding on to the shares for two full years. If he sells in year four instead of year three, he is entitled to a 50% deduction in the employment benefit and, assuming the shares qualify, can use any available CGE. He can reduce the taxable employment benefit to $49,500 and potentially avoid paying any tax on the capital gain. In other words, John only pays tax on $49,500 included in income when selling the shares for $200,000. Note that these deductions only apply when shares, not options, have been owned for two years.
And, What if the Shares Go Down?
What happens if the value of the shares has gone down or ABC Co. fails altogether (as is the case with many early stage companies)? Let’s say John exercised his options in year two when the shares had a FMV of $100,000 but then subsequently sells the shares in year three following a drop in the FMV to $50,000. The full amount of the $99,000 taxable employment benefit is still included in John’s income for the year. And, in the event of a bankruptcy? John is deemed to have sold the valueless shares and is still stuck paying tax on the employment benefit.
What About a Wait and See Approach:
So, why not just wait to exercise options until you’re certain of a return on the shares (for example, an exit on the sale of the company) if doing so will avoid the tax risk associated with a drop in share value? Back to John: We are in year five and ABC Co., after several years of rapid growth, is the target of a buyout by a larger competitor. John, playing it safe, has not exercised his stock options, but will exercise them as part of the share sale. The purchase price for his portion of the shares is $500,000. The difference between his exercise price ($1,000) and FMV ($500,000) is $499,000, 50% of which is a taxable employment benefit. John will pay tax on $249,500. As there is no capital gain, there is no available capital gains deduction. Had John “bet” on ABC Co.’s success and exercised the options when granted in year two, and assuming he had sufficient CGE, he would pay tax on only $49,500.
The difference in tax liability can be substantial. As a new employee of an early stage business, who is offered options with a below-FMV exercise price as part of a compensation package, there is a strong case for exercising those options as early as possible in order to (i) minimize the gap between the exercise price and FMV of the shares (thereby minimizing the deferred employment benefit) and (ii) start the clock on the two year hold period for the shares (of course, in almost all cases an employee will have to wait to exercise options until they have vested in accordance with a vesting schedule established in the grant). Where there is already some growth in the business, there is also a case for a “wait and see” approach for the more risk adverse, especially where the company’s prospects are particularly uncertain. Tax advice and a valuation of the shares are essential for the decision.
A few additional points: Where the exercise price is equal to the FMV of the shares at the time of issuing the options, the employee may be entitled to the 50% employment benefit deduction immediately. Also, the deferral only applies to employees. It does not apply to independent contractors and consultants, including advisors, who are granted options for their services. And lastly, while outside the scope of this article, it may be possible in some situations to successfully claim an allowable business investment loss to offset the tax liability in the event of a drop in share value. This should be considered with tax advice.
The above is a general summary only and is not intended to address all variations of potential tax consequences that can arise in different scenarios.