New Tax Rules for Employee Stock Options (ESOs)
Starting July 1st, certain employee stock options may be taxed differently. Here's what employees with ESO programs need to know about these changes.
Other than a salary, there are many components to an individual’s compensation, such as pension and insurance benefits, incentive bonuses and perquisites. In this article, we look at Employee Stock Options (ESOs) and the new tax rules coming into play this year.
Why have Employee Stock Options (ESOs)?
Basic ESOs aim to provide a solution to a few economic problems. ESOs help close the agency gap between management and shareholders. They do this by aligning management’s interest with those of shareholders. The goal is to have management work harder, so the company grows in value in the share price on a stock exchange. The other economic issue that ESOs attempt to address is providing a way to pay employees for companies that do not have cash available. You have a company starting up, and you need top talent. But you cannot pay for top talent. Solution, you offer them stock options to compliment the lower salary.
What is an Employee Stock Option (ESO)?
With a basic or plain ESO plan, employees given the right to buy some shares of the company stock, at a price, within a certain number of years. There are more complicated ESO plans, like Stock Option Reloads. I know, sounds like the fourth Mike Banning Movie where Gerald Butler saves the President, again. For our purposes we’ll stick with basic ESOs.
Typical example, you work for PublicCo you have vested options to buy 1,000 shares at $4.00. The stock is now trading on the market at $8.00. You decide you want to exercise your option and buy $8.00 stock for the price of $4.00, which you then sell for $8.00. If you’re options qualify under the Income Tax Act, you would get a 50% reduction on the $4.00 per share income inclusion. You get taxed on $2.00 but PublicCo does not get to deduct the other $2.00 as an expense. So, options are often said to be like capital gains.
Why did the government make changes?
The growing disparity of wealth is a concern for many Canadians. The 2017 Department of Finance’s Backgrounder showed that 2,330 of the 36,630 taxpayers that used ESOs made up for 64% of the ESOs deductions claimed that year. Which would suggest that wealthier individuals are benefiting disproportionately from ESOs.
Who do the new rules apply to and how are they different than the old?
The new rules generally apply to non-Canadian Controlled Private Corporations (non-CCPC). That includes Publicly traded companies like RBC, who earn more than $500 million in total gross revenue in a year. If your employer is a CCPC then its business as usual and you continue to get the 50% reduction on qualifying ESOs.
The rules are effective as of July 1st of this year. Any options that were already granted before that date are not subject to the new rules. If the new rules apply to, you will lose the preferential 50% reduction for tax treatment on a part of your income from qualifying ESOs. The corporation does get the deduction, so it’s taxed like regular salary. I say a part of your income, because there is an annual cap ($200,000/strike price) of options that still get the old tax treatment regardless of the size or type of company. The $200,000 treatment and vesting order is beyond our scope. But the idea of the calculation in the new rules is to try and target executives who earn seven figures in ESOs and not those in middle to upper-middle management.
Jared Burns CPA, CA is the Director of Estate and Tax Planning with Louisbourg Investments. Submit your comments to firstname.lastname@example.org.
Read more articles from Jared:
Top COVID Tax Surprises to Watch For - Part 1
Top COVID Tax Surprises to Watch For – Part II
This writing is for general information purposes only. It is not intended to provide legal, accounting, tax or financial advice. For complex matter you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments.