Before Exercising Your Options, Read This!

James Schofield - Apr 05, 2023
There are several rules to be aware of before exercising your stock. Here we show you what the tax implications could be...

Way before a company turns a profit, one of the only incentives it can offer to attract talented employees is ownership or equity in the enterprise. Owning a piece of the pie is attractive to talented individuals willing to see beyond a smaller income now to help grow an amazing company in the future. For the companies that do make it to the big leagues of public markets, their employees can become rich very quickly through the growth of stock options issued before the IPO. However, there are several rules to be aware of before exercising your stock options; most of these revolve around tax.

The first thing to know is that options issued pre-IPO are treated like options of a Canadian Controlled Private Company or CCPC, and as such taxes are not payable until you sell the shares, not when you exercise them. However, when the options are exercised, the price at exercise is important because when you eventually sell, it is the exercise price that will determine part of the tax payable. Here’s an example; Let’s assume you received a grant of 1000 shares of a Canadian controlled private company at a strike price of $5, and you exercise all your shares when they are trading at $50, but you don’t sell the shares until the following year for $55. Two tax events are triggered on that sale. One is that you will trigger taxes resulting from the option exercise, meaning the difference between the grant price and exercise price will go on your T4, (Box 38). Your employer will ask you if you’ve sold any shares before they prepare your T4. In the example above, your employer will add $45,000 to your income, and a corresponding 50% stock option deduction (Box 39) of your T4. like the capital gains inclusion rate. An employee who doesn’t realize they have not paid tax on exercised options, will get a nasty surprise when they file their tax return. Using the example above, the employee will also add $2,250 to their income based on capital gain payable (($55-$50) x 1000 shares)) x 0.50.

In most scenarios, the employee should sell the options immediately after exercising to avoid the possibility that the shares could decline in value between the exercise and eventual sale of the shares. Going back to the same example, if the employee exercises options at $50, and the share price immediately plummets to $20/share, they will still have an additional $45 K on their T4, even though they only netted $15 K after the share sale, and at the highest Ontario tax bracket, the tax owing is $12,044. It is possible for the tax owing to be higher than the net benefit of the option itself. Though it may be tempting to hold the shares hoping they continue to increase after you’ve exercised, as a rule, you should exercise and sell right away. For every Google, there are thousands of companies you’ve never heard of where you would have been much better off selling the shares and investing into a diversified portfolio. It is important to note that if an employee stock option drops below its market value at exercise, the capital loss cannot be used to offset income realized from the stock option benefit. Many investors may think they can make lemonade out of lemons if the value of the options declines after exercise, but accrued gains from the grant price the market value at exercise is not considered capital gains for tax purposes.

Another unique rule applicable to CCPC options is that book values of various blocks of exercised options are not blended for the purposes of calculating the adjusted cost base. Instead, they follow, first in first out, or ‘FIFO’ methodology. Again, there are tax consequences waiting for investors who don’t plan around this. If you’ve exercised several blocks of CCPC options, you should track the exercise price yourself on a separate spreadsheet. As an option holder, it may make sense to use a different account for each block of exercised options as many wealth management firms may not have to ability to track different cost bases for identical securities. For example, if you exercised 1000 options at $50 and one year later exercised another 1000 options at $40, expect that if you sell 1000 shares, expect that Box 38 of your T4 will reflect the $50 value.

We’ve seen several situations where unsuspecting investors sell options right before year-end, essentially adding income to be recognized for the current year. Alternatively, they could have waited a few more months to sell in the following calendar year, thereby delaying the tax payable for nearly 16 months from the sale date. Yes, taxes will have to be paid either way, but triggering tax at the beginning of the year, gives you several more months to tax plan around your added income. There are several strategies you may be able to utilize if you have 12 months to plan. Like most decisions in financial planning, there is no one-size-fits-all solution. Even within these general recommendations there may be certain nuances unique to your situation. If you’re not sure how to deal with your CCPC options, be sure to speak to a tax professional about your situation.