Pity the Paper Millionaire?

Loosely based on a number of all too true stories

About a year ago, I was talking with a 30-year-old friend of mine employed at a publicly traded high tech corporation (a multi-millionaire, at least on paper) about the "miracle" of stock options. He was explaining to me how, almost overnight, his net worth had grown from nearly nothing into millions of dollars. Not only that, he told me that everyone in his company was sharing in the wealth. Just then, Mary, a member of the cleaning staff walked into my friend's office. After Mary left, my friend told me that she, too, was a millionaire.

Of course, that was last year.

My friend's wealth has suffered considerably over the past year, but he said things could have been even worse if he hadn't sought out expert advice prior to exercising and selling his stock options. Unfortunately, Mary wasn't so fortunate.

According to my friend, before the bubble burst last spring, Mary's options were set to expire so she exercised them for shares of her employer. Mary could have chosen to have her employer sell the shares on her behalf, but since the market was so "hot", she decided to hold on to them.

A short time after exercising her stock options, the stock price of her employer's shares was trading significantly lower. However, since at that point in the spring it seemed that the market and her employer's share price were just having a temporary setback, Mary continued to hold on to the shares. Of course, it wasn't temporary at all and, by the time the share price had fallen by nearly 75%, Mary decided that she'd better sell.

Even with all of the paper losses she had suffered, Mary still considered herself to have been very fortunate because she received more than $250,000 as net proceeds of the sale. Mary used the proceeds to make a down payment on a small house, make new investments in the market (oh no!) and prudently kept the rest so that she would be able to pay her taxes (those of you who know something about the taxation of stock options already know that poor Mary couldn't possibly have held enough back for taxes).

This February, when she received her T4 slip, the employment income section indicated that she had earned over $1 million of income in the prior year (Mary's salary was only $20,000). Believing the amount on the T4 slip to be incorrect, Mary spoke to a number of people in her employer's payroll department. They explained to her that when she exercised the stock options she triggered an employment benefit equal to the difference between the fair market value of the shares she received at the time the options were exercised and the amount she paid for the options (in Mary's case, about $1 million). On the bright side they told her, since the stock option rules were designed to treat the taxation of stock options in a manner "similar to" capital gains, she could claim a deduction of of the benefit.. (This deduction is only available in connection with the exercise of qualifying stock options. If Mary had exercised the stock options before February 28, 2000 the deduction would have only been of the benefit. On the other hand, if she had been able to exercise her stock options after October 17, 2000, she could have claimed a deduction of 1/2 of the benefit.)

When Mary went to have her return prepared in early March (Mary always liked to file early) the preparer told her she owed over $300,000 in taxes to the federal and provincial governments. Mary told the preparer that he must be mistaken since once the losses she had incurred on the sale of her employer's stock were offset against the employment benefit, she calculated that she only owed about $75,000 in taxes.

The tax preparer sat Mary down and explained to her that the losses could not be offset against the employment benefit. He explained that only capital gains can be used to offset capital losses. Though the exercise of the options gave rise to an employment benefit that was taxed at rates equivalent to what Mary would have paid if she had earned capital gains, the employment benefit was not a capital gain. As a result, Mary would not be able to deduct the capital losses in the current year, though she would be able to carry them forward to offset them against future capital gains (if any) that she might realize during her lifetime.

Regardless of whether Mary sells her new home and uses up all of her savings, she still will not be able to fund her tax liability. Given her $20,000 annual salary and the low likelihood that she will ever be able to climb out from under her tax debts, Mary has been advised to file for bankruptcy. To add insult to injury, if Mary files for bankruptcy, all of her capital losses will be lost.

How did Mary get into this mess?

Arguably, Mary would have been able to avoid this problem if she had sold some or all of her employer's shares at the time she exercised her stock options. Of course, if she had reinvested the proceeds in the market last year, she may well have suffered considerable losses that she still could not offset against her stock option employment benefit. Alternatively, Mary might have been able to defer some or all of the employment benefit if she hadn't sold her employer's shares.. (After February 27, 2000, proposed legislation may permit employees who acquire public company shares as a result of exercising qualifying stock options having an exercise price of up to $100,000 to defer the employment benefit until the shares are sold. However, the proposed legislation may encourage employees to make poor investment decisions in a falling market. For example, in order to avoid paying tax on the deferred employment benefit, an employee may continue to hold a marginal stock until it becomes worthless, rather than sell it. ) As a result, Mary bears considerable responsibility for her own choices. However, due to her lack of sophistication it seems unfair for her to bear all of the blame.

What about the responsibility of Mary's employer? Mary's employer took the usual steps to educate its employees about its stock option plan (literature, Q&A sessions, etc.). It also advised all of its employees to seek professional advice prior to exercising any stock options.

Mary's employer certainly did enough to satisfy its legal obligations to its employees. But as stock option plans spread from the exclusive province of senior management to all employees, including unsophisticated and vulnerable employees such as Mary, more could arguably have been done to protect the new investors. However, given that there had not been a bear market for many years, it is possible that many employers did not fully appreciate the impact that the differences between the tax treatment of the employment benefits associated with stock options and that of ordinary capital gains would have on employees such as Mary.

What about the Canadian income tax system itself? Why does it maintain the distinction? Although only the Department of Finance can say for sure, one reason appears to be that, since employee stock option plans relate to employment, benefits from such plans are likely considered to be just another means of compensating employees that should be treated no differently from more traditional forms of compensation such as wages, commissions or bonuses. As such, there is a strong argument that stock option plan benefits should be taxed as ordinary employment income.. (Until 1984 all employee stock options were taxed as ordinary employment benefits.) However, it is possible that the Department of Finance has tried to provide the same effective tax treatment to stock option employment benefits as they would to capital gains in recognition of the risk element inherent in stock options,. (Employees often choose to accept lower wages in exchange for the right to participate in a stock option plan.) and in order to be competitive with the U.S. tax system.. (At least one author has demonstrated that Canadian stock options are already taxed more favourably then stock options in the United States (see Daniel Sandler, "The Tax Treatment of Employee Stock Options: Generous to a Fault", to be published in (2001) vol. 49, no. 2 CTJ).)

But if the effective taxation is the same, why go to all of the trouble of drawing the distinction? It should be remembered that stock purchase plans come in many shapes and forms. For example, some plans pay a bonus to employees that the employee must use to buy the employer's stock. Others enable employees to acquire stock by offering loans to employees which may be forgiven if the stock suffers a loss in value. In both cases, if the stock loses value it is possible that the employee could realize both an employment benefit (the bonus or the deemed benefit from the debt forgiveness) and a capital loss. A change in the rules relating to the kind of stock option plan that Mary was a member of would be unlikely to impact on these situations.

Any change that would permit taxpayers to offset employment benefits from stock options against capital losses may also be politically difficult to make given recent reductions in capital gains rates, improvements to the taxation of stock options and the perception of many Canadians that the "Dot Com" paper millionaires have already had too many breaks.

On the other hand, the alternative is to do nothing. In which case, unless Mary is able to convince the CCRA to provide her with administrative relief, she, like many other hardworking Canadians, will be faced with the sad choice of being burdened with unbearable debts or bankruptcy. Pity.

Michael Goldberg, Minden Gross Grafstein & Greenstein.

Thanks and acknowledgement are due to Daniel Sandler, also of Minden Gross Grafstein & Greenstein, for providing an advance copy of his unpublished paper and for his comments.

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