Most boot-strapped companies with limited cash funding offer stock options in place of higher salaries. This strategy works out quite well where the company is encouraging the employees to stay long term with the organization with no up front cash outflow. It’s important to understand the complex tax consequences. Unlike, Employment income which is source deducted Stock options are not actually taxed when they are handed out to employees.
In order to explain this let’s consider a small CCPC company Snowman Inc. that just hired their new employee Santa in Jan 2013. The option’s offered to Santa was to purchase 100 shares at $1 per share in four years. On Santa’s T1 personal tax return for 2013 he would not report the stock options as they have not been exercised yet so it will be a regular tax filing with employment income and any other tax slips. The reason for this is because Santa was offered a Option not a Stock of the company.
So Santa has been with Snowman Inc. for the four years now and the vesting period is up. This means Santa can exercise his options. Snowman Inc. has been producing great income returns over the past couple of years and as such have been able to secure investments where the valuation of the shares were deemed to be $10/per share. Remember, Santa had the options to exercise at $1 regardless of the price in 4 years when he bought it back in 2013. Now in 2017, Santa can turn around and buy the shares for $1 per share for a total of $100 cash which would generate a benefit of $900. In 2018 the founders announce that GrassCutters Inc. have acquired Snowman Inc. and Santa can cash out on his shares. During the take over preceding the payment per share is deemed to be $100 per share and Santa cashes out on this offer.
There will be a total of two types of taxes reported.
Taxable Benefit:
In the T1 tax return for 2017 Santa exercised his options for the $1 per share which was valued at the time for $10 per share. The difference between the exercise price and the market price is called a taxable benefit. This is because people outside the company do not have access to the same benefits. Snowman Inc will include this part of his T4 and add it as a taxable benefit of $900. Assuming he is in a tax bracket of 30%, Santa will end up paying $300 in tax for the use of his options on the shares for 2017.
Capital Gains:
As the company was sold for $100/per share and Santa’s stock options were worth $10/share the difference will result in a capital gain. This is calculated by taking the shares valuation price ($10) minus the exit sales price ($100). The great thing is that Capital Gains are taxed at 50% of the gain so that means 50% of the gain would be exempt from the capital gain tax. Unlike employment income which is taxed at 100%, capital gains are restricted to 50%. This would mean that Santa will end up paying taxes on $100*100 shares = $10,000 *50% restriction = $5000 minus the Adjusted cost base of $100) = $4900. Santa will pay additional taxes on the additional income of $4900 on his next personal tax return with a rate of 30% that would be $1,470.
Consultation:
There are many complexities with stock options and how to execute on these for your employees. It is advisable that you meet with a Tax advisor to ensure you are tax compliant but also to build the right compensation plan for key executive members. Please remember that the rules for CCPC are different than public companies. Timing is critical when you are planning the sale of stocks and your investment advisor can definitely help with this!
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- The Capex Team