Traditional stock options are more complex than RSU’s. This post is an overview to review traditional stock options. Since most of my direct experience is with employees of US-based companies, I’m going to focus on this use case. We will continue to discuss the example of Jane at XYZ company:
Jane recently joined XYZ, a publicly traded company, as a sales representative. As part of her compensation plan, Jane was offered a stock option grant of 10,000 shares. At the time of signing, XYZ stock was trading at $12/share and the strike price for her shares was set at $10/share. Jane’s options will vest in 4 equal chunks of 25% over the next 4 years. At the time she was granted the shares, there are no income tax implications for Jane. Jane’s options expire after 10 years.
Once Jane’s options vest, she has the option to exercise her shares. Jane will only do this if the price of the shares is above the strike price, or “in the money”. In this example, we will assume that this is the case. At that time, the difference between the strike price of $10/share and the market value of the shares will be treated as regular income to Jane on her tax return.
A year later in September, Jane sees that the stock price of XYZ is now at $20/share. She elects to exercise 2,500 options. Jane’s taxable income for the year will increase by $25,000 as a result of her exercising her shares. ($20 share price - $10 strike price = $10 * 2500 shares= $25,000). There is a provision in the Income Tax Act that will allow her to deduct 50% of the income inclusion, bringing it to $12,500.
Now, Jane has to decide how she’s going to complete the transaction. She has some options:
- Exercise and hold - Jane can pay for the 2500 shares out of her pocket if she has the extra cash and hold all of the stock
- Exercise and sell - Jane can buy the shares from XYZ corp out of her pocket and have the shares deposited into her brokerage account, at which point she immediately sells the shares. This is not commonly used strategy, the more common strategy to accomplish the same objective is;
- Cashless exercise - Jane can ask XYZ corp (or an agent, usually a trust company) to complete the exercise and sell all of the shares immediately, pay XYZ their portion, and pay the remaining proceeds to Jane.
- Cashless exercise and hold the remaining shares - same as above, except Jane only sells enough shares to pay back XYZ and decides to hold onto the remaining shares in the hopes they will continue to go up in value.
Jane decides to do a cashless exercise and hold onto the shares. The transaction is as follows:
- 2500 options exercised at a market value $20/share.
- Jane owes $10/share (her strike price) to XYZ corp, which is $25,000.
- The trust company sells 1250 shares at $20/share to pay XYZ corp.
- Jane is left with 1250 shares in her brokerage account at an adjusted cost base of $20/share and a total value of $25,000.
Now, let’s consider two paths:
- Stock goes up to $100/share and Jane sells - This is a good outcome. After the exercise and once the taxes have been paid and XYZ has been paid for their shares, Jane’s cost base for these shares was $20. Therefore, if Jane sells now, she will realize a capital gain of $80/share ($100 market value minus $20 cost base). 50% of that gain is taxable.
XYZ corporation has a great quarter and Jane’s shares go to $100 in December. Jane sells the shares for proceeds of $125,000.
- Jane realizes a capital gain of $100,000, half of which is taxable
- Jane is in the top marginal tax bracket, so she will owe taxes of $27,765 (53.53%* 50000)
- Jane owes tax on the exercise of the shares of $6,691.35 ($12,500 * 53.53%)
- In total, the whole stock transaction for the year nets Jane $90,543.75 after tax ($125,000 - ($27,765+$6,691.25))
- Stock goes down to $2/share and Jane sells - If Jane sells now, she will realize a capital loss of $22,500 ($2 market value minus $20 cost base * 1250 shares ). The difficulty is that Jane still owes income tax on the income inclusion described above (the difference between the strike price and the market price at the time she exercised the shares * 50%). Jane can only write off capital losses against taxable capital gains. She cannot write the loss off against the income inclusion from when she exercised her options.
XYZ corporation is hit by a terrible crisis in the quarter and Jane’s shares go from $20 down to $2 in December. Upset by these developments, Jane sells her 1250 shares for proceeds of $2,500. Though Jane hopes the whole transaction will end up being a wash, she learns that she gets no relief from the taxes she owes from the exercise of her shares.
- Jane realizes a capital loss of $22,500 ($18 loss/share * 1250 shares)
- Jane still owes tax on the exercise of the shares of $6,691.35 ($12,500 * 53.53%)
- In total, the transaction costs Jane $4,191.35 (share proceeds of $2,500 - income taxes of $6,691.35) this tax year
- Jane can carry forward the capital loss ($22,500) to be applied against capital gains in future years
Stock Options are great incentives to attract and retain talent. When the company is successful and the stock goes up in value, it can be a tremendous benefit. However, holders of options need to be mindful of the potential outcomes if they exercise their options. In the event that they end up going down in value, it can become a net cost to the employee.
The information in this material is not intended as investment, tax, or legal advice. Please consult your advisor or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.