Oct 03, 2016
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“Most employers will not want to elect out of the deduction.”
In most cases, when an employee exercises a stock option, the difference between the price the employee pays for the shares and their market value is treated as a taxable benefit and a deduction equal to one-half of the taxable benefit is allowed. In effect the employee is taxed at the same rate as a capital gain.
Some stock option plans allow the employee to elect to receive a cash payment equal to the value of the option benefit instead of exercising the option and purchasing shares. In essence, the employee can “cash out” the options.
Prior to the March 4, 2010 Federal Budget, the tax consequences to the employee cashing out were the same as if the option had been exercised – the employee was taxed at the same rate as a capital gain. In addition, in certain circumstances, the stock option plans were structured so the employer was able to claim a deduction for the full amount of the cash payment. This result was beneficial since the employer was able to deduct an amount paid to an employee who was subject to tax at the capital gain rate.
The 2010 federal budget eliminated this beneficial treatment for “cash outs” occurring after March 3, 2010. The budget provides that employees cashing out a stock option can claim the deduction of one-half of the employment benefit only if the employer elects to forgo the deduction for the cash payment. If the employer does not make this election, it will be entitled to a corporate tax deduction for the payment but the employees must pay tax on the full value of the employment benefit.
Assuming an individual marginal tax rate of 46%, the cost to the employee of receiving the cash out will be additional tax of 23% unless the employer elects to forego the deduction of the payment. Most employers will not want to elect out of the deduction because they will lose the corporate tax savings.
If possible, it may be preferable for the employee to exercise the option and sell the shares (to generate the cash) rather than receive the payment from the employer. The employee would maintain favourable tax treatment and the employer would avoid the cash outlay.
Since the Department of Finance has not provided any grandfathering relief for stock option cash-out arrangements that were in place before March 4, 2010, employers and employees will need to reconsider the implications of any cash-out arrangements before proceeding.
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The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.