At some point in your professional careers, you may find yourself contemplating issuing shares or stock options as a business owner or deciding whether to take shares or stock options from your employer as an employee.
This can be a bit of a daunting decision! Below we break down the key points of consideration to help you with your analysis.
Shares versus stock options
Often times, there are two alternative methods of compensation that can be considered for employees outside of salary and bonuses, stock-based compensation and stock option compensation.
Both methods of compensation should be considered both from a Canadian Controlled Private Corporation (CCPC) and public/non-CCPC perspective.
Whether shares are issued for free, to the employee in exchange for services rendered, or are issued at, below, or above par value, the shares will be deemed by the CRA to have been issued at the fair market value (FMV) of the company at the time of issuance.
The difference between the deemed FMV and the issued amount could be considered an income inclusion and taxed as regular employment income for the employee. For CCPCs however, this income inclusion could be deferred until the shares are sold.
If the shares were instead sold at a reasonable price which could be considered a defensible FMV, the income inclusion discussed above could be avoided.
– If the company (employer) is to remain a CCPC and the taxpayer (employee) held the shares for at least two years, the taxpayer would be eligible for the $800,000+ lifetime capital gains exemption (“LCGE”), discussed in further detail later in this article. This means that if the taxpayer were to dispose of their shares, their capital gains would be sheltered up to $800,000+.
– Eligible for a 50% deduction on gains if shares held for more than 2 years or if shares were issued at fair market value.
– If losses are suffered on disposition of the shares (i.e. if the value of the company decreased or if the company ultimately declares bankruptcy ), the taxpayer could be eligible to claim the loss as an allowable business investment loss (“ABIL”) and would be able to use 50% of the ABIL to offset against other personal income.
– There is a deferred tax liability if the shares are bought below FMV. The tax on the difference between the FMV on issuance date and the purchase price will become payable in the year that the shares were sold.
If the company or employer in question remains a CCPC and issues stock options to its employees, the tax exposure would not be immediate as there is no tax exposure to the employee in the year the option is granted.
A taxable benefit will be triggered in the year the option is exercised by the employee and is calculated as the difference between the exercise price and the FMV of the shares on the exercise date.
Because the options were issued by a CCPC, the tax related to this taxable benefit is paid in the year the shares are disposed of instead of in the year the options were exercised.
The total tax exposure in the year of disposition is made up of the taxable benefit explained above, as well as 50% of the difference between the fair market value on the exercise date and the selling price on the disposition date.
Additionally, if the shares were held for at least 2 years from the exercise date, there is a 50% deduction available on the taxable benefit triggered by the stock option exercise.
For a public company or a non-CCPC, the stock options rules differ. There is an immediate tax liability for employees in the year the options are exercised versus the tax-deferral that is permitted when the company is a CCPC and shares are held for a minimum of 2 years.
It is also important to note that the tax deferral discussed above relating to options issued by a CCPC are applicable only to employees of a CCPC and not contractors, consultants, or advisors.
– No tax liability when options are received, only when they are exercised.
– No cash outlay required from the employee until they are exercised
– Can exercise options to buy shares immediately at discounted prices without having to pay any tax until shares are sold. An early exercise avoids a higher FMV, and hence avoids a greater taxable benefit later.
– The tax liability relating to options being exercised is unavoidable given the income inclusion made up of the difference between the FMV on exercise date and the exercise price.
– If the FMV of the shares were to decrease below the exercise price subsequent to the options being exercised, the income inclusion discussed above would still be taxable.
– The lifetime capital gains exemption cannot be used unless the shares are held for 2 years after exercising.
– The tax risk increases over time since it is the difference between the FMV and exercise price at the time of exercise that sets up the contingent tax liability. So the more FMV is considered to be increasing, the greater the potential tax liability.
– From a business owner’s perspective, large stock option pools could be negatively viewed by investors because they may cause future dilution in ownership of a company.
– If options are issued while the company is a CCPC, but the employee exercises the options after the company goes public, they would be subject to public company tax rules on stock options. This means that the entire taxable benefit would be taxed in the year of the exercise date. This could be significant depending on the deemed value of the Company once it has gone public.
It is often a complicated decision making process when deciding on the right compensation mix for an employee. We would be happy to discuss if you have any questions at all on the topics above.