Stock-options letdown? How to salvage a bad situation
Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of '101 Tax Secrets for Canadians'.
Each year when federal budget day arrives, many Canadians sit glued to the television wondering what might be in store for them. It's something like opening the proverbial lunch bag - there's bound to be something you don't like much, and if you're lucky, you'll find something you can actually enjoy.
This year, those who watched the news of the budget unfold suffered serious lunch-bag letdown - there was a bruised apple of sorts for those who are members of a stock option plan. The news might change how you approach your stock options.
THE FIRST CHANGE
There are two key changes to talk about. The first deals with "hybrid" or "phantom" stock option plans. Such plans have been structured so that, at the time you exercise your options, you're able to take a cash payment rather than shares in your employer if you choose. These plans worked well for both the employee and employer. How so?
Well, your employer has been able to claim a deduction for the cash paid to you, just as though it were, say, a bonus. But you could also benefit. If structured properly, you'd be entitled to the stock option deduction, which would eliminate the tax on 50 per cent of the benefit received when exercising the options. Things are changing.
The 2010 federal budget proposes that the tax break will now be available to either the employer or the employee - but not both. Specifically, the 50-per-cent stock option deduction will be available to you only when your employer has elected to forgo the deduction for the cash payment made to you. If that isn't the case, your employer will get the deduction, but you won't be entitled to the 50-per-cent stock option deduction on your tax return.
THE SECOND CHANGE
It's been possible for employees who own stock options in publicly traded companies to exercise those options but defer the tax owing until the shares are actually sold. Suppose, for example, you owned options granting you the right to acquire 10,000 shares of your employer for a cost of $10,000 ($1 per share). Suppose also that the shares are worth $10 each ($100,000 in total) on the day you exercise your options. You'd face a $90,000 benefit, and if structured properly, you'd be entitled to a 50-per-cent deduction so that you'd face tax on just $45,000. The tax owing would be $20,885 if you're in the highest tax bracket in Ontario. Suppose also that you filed the necessary election to defer the tax bill until you actually sell the shares.
Picture this: You own these 10,000 shares in your employer worth $100,000 when you acquired them. Suppose that today they are worth just $15,000, although you owe the taxman $20,885. You're eventually going to have to come up with the extra cash to pay those taxes when you sell your shares. That could be a problem if the dollars are big enough.
The 2010 federal budget proposes to change things so that your employer will now be required to remit to the Canada Revenue Agency the taxes owing on the stock option benefit at the time you exercise your options. Where is your employer going to get that cash? Probably from you. And by the way, the $85,000 capital loss ($100,000 less $15,000) you incur when you do sell your shares cannot be applied to reduce your $20,885 tax bill since the stock option benefit is treated as employment income, not a capital gain.
All of these changes apply to options exercised after 4 p.m. on March 4, 2010.
THE STRATEGY
So, what does all this mean for you? Consider a couple of ideas: First, if you are a member of a phantom stock option plan and want to receive cash rather than shares, negotiate with your employer that you will receive the stock option deduction, which will require your employer to elect to forgo a deduction for the payment made to you.
Second, where possible, consider holding your stock options until you are prepared to sell off your shares immediately upon exercising the options. This will not only provide the cash necessary for your employer to remit the tax to CRA, but will allow you to avoid that situation where you incur capital losses later that cannot be applied to reduce the taxable stock option benefit you faced when exercising your options. It will also ensure that you don't have too much of your financial well-being tied to the success of one company.
