Stock options - How to factor taxation and risks into your financial plan
Do you have stock options issued to you as part of your employment package? If so, you should be aware of how they are taxed and the risks associated with this type of compensation.
How are they taxed?
When you exercise employee stock options, you will trigger a taxable employment benefit equal to the difference between the exercise price and the fair market value of the stock on the date of exercise.
For example, if you are issued an option to purchase shares for $5 and the shares are worth $10 on the date the option is exercised, you will trigger a taxable employment benefit equal to $5 per share. Therefore, if you purchase 10,000 shares, you will have $50,000 in taxable income which you must report.
Is there any way to decrease the amount of tax I have to pay?
There are ways in which you can receive a 50% deduction of the employment benefit (note that the deduction may be less than 50% in certain cases in Québec). This is dependent on a variety of factors, including the type of shares issued (common or preferred), the price of the shares at the time the option was issued, whether or not your employer is a Canadian-controlled private corporation and the length of time that you hold the shares.
Can I defer the tax until I sell the shares?
In certain cases, the Canada Revenue Agency allows you to defer the tax on the employment benefit until the shares are sold. If you work for a Canadian-controlled private corporation or a public company, you may be able to defer the tax on the employment benefit if certain conditions are met. If you do not work for a Canadian-controlled private corporation or a publicly traded company, no deferral will be available.
What happens if the shares increase or decrease in value after I exercise?
If the shares increase in value, you will have a capital gain. Using the example above, if you purchased shares when they were worth $10, and the shares increased in value to $16 on the date you sold them, you would have a capital gain of $6 per share. Capital gains are only 50% taxable, so only $3 per share would have to be included in your taxable income. Using our example, if you sold all 10,000 shares, you would have $30,000 of taxable income (in addition to the $50,000 in taxable income which accrued on the date you exercised the option). The real problem, however, is if the shares decrease in value. If the shares go down to $6, then you will have a capital loss of $4 per share, of which only 50% can be used against capital gains.
How should I factor stock options into my financial plan?
When investing in shares of your employer, ensure that the investment fits within your asset allocation plan. You should have a properly diversified portfolio at all times, and the shares of your employer are one more component of that.
Date reviewed: January 27, 2015
This column, written and published by Investors Group Financial Services Inc. (in Quebec – a Financial Services Firm), presents general information only and is not a solicitation to buy or sell any investments. Contact a financial advisor for specific advice about your circumstances. For more information on this topic please contact your Investors Group Consultant.