Stock options are agreements that provide one party the right—but not the obligation—to buy or sell a company’s shares at a predetermined price within a specific time frame. In the context of employee stock options, these agreements are made between an employer and an employee (or an employee of an affiliated corporation), granting the employee the opportunity to purchase company shares under specific terms.
What Are Employee Stock Options?
Employee stock options are a form of compensation included in an employer’s total rewards package. They are often used to attract and retain talent, especially when cash is limited, or to incentivize employees to align their efforts with the company’s goals. By tying potential rewards to the company’s success, both employees and shareholders benefit from stock price appreciation.
From a tax perspective, benefits derived from participation in an employee stock option plan are considered taxable income. While the mechanics of these plans are similar for public companies and Canadian-controlled private corporations (CCPCs), the timing and deductions available differ.
Security Options Benefit
No tax implications arise when stock options are initially granted. However, upon exercising these options, the difference between the fair market value (FMV) of the shares on the exercise date and the exercise price (or strike price) becomes a security options benefit, which is taxable as employment income. This amount is reported on the employee’s T4 slip.
The adjusted cost base (ACB) of the shares includes both the exercise price and the security options benefit, ensuring that this benefit is not taxed again when the shares are later sold. Any changes in the shares’ value after the exercise date are taxed as capital gains or losses.
Tax Rules for Options Granted
Employers generally cannot claim tax deductions for employee stock options. However, if an employee’s options do not qualify for the stock option deduction, the employer can deduct the stock option benefit included in the employee’s income.
Before July 1, 2021: For stock options granted before this date, the difference between the exercise price and the FMV at exercise is taxed as employment income. However, qualifying options allow employees to claim a stock option deduction, effectively taxing the benefit as a capital gain.
On or After July 1, 2021: For certain companies, options with a vesting value exceeding $200,000 per year no longer qualify for the stock option deduction. The FMV at grant determines the vesting value, and any benefit from options exceeding this cap is fully taxable as employment income. Employers must notify employees if their options do not qualify for the deduction.
What Is Vesting?
Vesting refers to the period before stock options become exercisable by the employee. Vesting schedules incentivize employees to remain with the company and can also tie options to performance milestones. Typical vesting schedules:
- Options may vest immediately or over several years.
- A common structure is a four-year vesting period with a one-year “cliff,” where no shares vest in the first year. Afterward, shares vest incrementally.
- For example, an employee awarded options for 10,000 shares might have 25% vest after one year, with the remainder vesting monthly over three years.
Taxation of Stock Options at Death
Unexercised options generally lapse upon the employee’s death, creating no tax obligation. However, if the options do not lapse, the FMV of the options immediately before death is included as income on the terminal return.
If the estate disposes of the shares, it may incur capital gains or losses. Losses can be carried back to reduce the stock option benefit on the deceased’s terminal return, subject to specific limitations.
Conclusion
Employee stock options provide employees with the right to purchase company shares at a set price and time. They are particularly popular among startups and growth-focused companies as a means to attract and retain talent while aligning employees’ compensation with the company’s success. However, understanding the tax implications and vesting terms is crucial for both employees and employers to maximize the benefits of these plans.
