Part 2: Taxation of Employee Stock Options; how to pay less tax, and tax traps to be aware of.
In part one, we looked at two different types of options. There are many more types and we’ll cover a few of those in part 3 of this series, but until then, we’ll assume that we’re dealing with public ‘out of the money’ (OTM) Employee stock options or private turned public companies, meaning the rules for CCPCs apply.
Review: the difference between the strike price and the market value of the shares when exercised is considered a taxable benefit in the year the options are exercised. Using the example of Dave from part 1, exercising his options when SPOH shares are trading at $75 and a strike price of $10, Dave is deemed to have received a taxable employment benefit of $65,000. If he continues to hold SPOH shares in hopes that the share price will continue its upward momentum, but instead the share price falls to $50, Dave will still have to include the $32,500 ($65,000*50%) as a taxable benefit for that year and when he sells the shares at $50, he will have a capital loss of $15 per share or $15,000, but he can only use this to offset capital gains, not ordinary income. In this scenario, Dave paid tax on $7,500 that he never benefited from.
If the shares decrease in value and Dave moves the $50,000 of SPOH shares into a registered account (RRSP or TFSA), he will not be able to claim a capital loss. This important, because he can lock in the capital loss by selling the shares before moving them to a registered account. This problem is not unique to stock options. Once this transaction is complete, he can re-purchase the same shares 30 days later to avoid triggering superficial loss rules, which would negate his ability to use the capital loss.
Withholding Tax: Usually, employers will hold back some tax from the exercised stock options to ensure that some of the tax owed to the CRA is collected right away. Think of it like remitting a portion of tax every pay period. Because Dave’s tax payable will be roughly $11,000 (assuming an average tax rate of 37%) SPOH might give him a choice to cash in some of his shares to cover the tax or he can pay the $11,000 in cash from his own savings and keep the all his SPOH shares. Assuming Dave pays the tax and options cost with cash and keeps the $75,000 of shares, he could then make an In-Kind contribution to his RRSP of $75,000, assuming he has the room to do so, which would lower his income for taxes purposes from $92,500 to $17,500. Remember, Dave’s salary was $60,000 which he has likely been taxed on throughout the year. When he files, he should receive a large refund of the difference that he would have paid if his salary was only $17,500 instead of $60,000, which is roughly $10,700 in income tax difference, added to the $11,000 of withholding tax he paid when he exercised the options. His total refund should be close to $21,700.
Note: Dave would likely want to spread out his RRSP contributions to future years when his earnings and marginal tax rate are higher to receive a larger refund.
In part one, we looked at how options for CCPCs are taxed. Unlike with public ESOs, Options from CCPC are only taxed when the shares are sold, meaning the employee can essentially choose their income every year if they have a lot of vested options by selling a predetermined number of shares to generate additional taxable income. The only difference is that no tax is withheld on the transaction. Although the tax is deferred until the sale, the income included will be determined by the share price on the exercise date, not the sale date, which is relevant if the stock options are exercised prior to the shares losing value. Again, if this happens, the shares should be sold to crystallize the loss if they are being moved into a registered account.
If you make regular charitable contributions, you can use another strategy to reduce taxes and keep more because our tax system is designed to benefit individuals who donate appreciated financial securities like stocks. Instead of making charitable contributions from your income which you’ve already paid tax on, when you donate a security with an unrealized capital gain, not only do you avoid paying capital gains tax, you receive a charitable credit for the full amount of the donation which can lead to significant tax savings. Here’s how: Mike makes regular donations of $1,500 to his Church every month. At the end of the year when he files his taxes, he receives a tax credit for about 40% of his contributions (($1,500 x 12) x 40% = $7,200)), but he donated this $18,000 from after tax earnings. His average tax rate on that $18,000 is 40% meaning he already paid tax of $7,200. If instead, Mike donates $18,000 worth of his vested employee stock options of GCG Corp. with a cost base of $5,000, he receives the 40% tax credit of $7,200 just like the first scenario, but avoids paying income tax on the $13,000 gain. Mike can use the $18,000 that he normally would have donated to buy more shares of GCG. These shares will have a cost base of $18,000 instead of $5,000. Using this strategy Mike has eliminated the unrealized capital gain and kept his GCG shares. The strategy described above saves Mike $1,950 in taxes or 10.83% of his total donation. $1,950 of tax savings per year translates to $97,721 of tax savings over 25 years of charitable giving, assuming 5% earnings on your savings. For people who give to charity, this amount can also be donated to have an even greater impact. If you plan to implement this strategy, the donation must happen within 30 days of exercising the stock options.
In part 3, we’ll introduce advanced strategies to protect your employee stock options without detonating a tax bomb to do so.
Reference:
