Employee Stock Benefits and Capital Losses Don’t Mix
With stock market declines in the current troubled economy, investors are definitely feeling the negative effects on their stock portfolios. Stock based compensation may also be leaving employees in a bad situation, not only from an investment perspective but also from a tax perspective. In particular, employees who have purchased shares through an employee share purchase plan (ESPP) or who have exercised employee stock options, and who are still holding their shares, may be impacted by an unfavourable tax consequence due to the significant market declines.
When shares are purchased, stock based compensation will generally result in a benefit to the employee that is taxed as employment income, to make up the difference between the value of stock acquired and how much the employee actually paid. But later declines in the share price can lead to capital losses when shares are sold. Unfortunately, our tax system does not allow the benefits to be offset by the capital losses. This issue isn’t new. In fact, its impact was quite significant in the early part of this decade when there were significant stock market declines, particularly in the technology sector. With the economy currently in turmoil, the issue is likely significant again. To get a better understanding of the issue, let’s take a look at the tax treatment of stock based compensation in more detail.
The Tax Treatment
Employee Share Purchase Plans
Employee share purchase plans allow employees to use their after-tax earnings to purchase shares of their employer, often at a discount. Or, the employer may match funds that the employee uses to buy stock. Under either variation, the employee will be required to report a benefit — the difference between the amount paid and the fair market value of the shares at the purchase date — as employment income. These plans normally require employees to hold the shares purchased for a specified period of time before they are able to sell. Or, employees may not actually be given the share certificates until a specific time in the future. Where the value of the shares declines before a sale can be arranged, the eventual sale of those shares will result in a capital loss, which can’t be applied to reduce the employment income benefit.
Stock Options
Where an employee is granted stock options by a public company, a benefit will arise when the options are exercised to purchase the shares. The benefit will be the difference between the exercise price and the fair market value of the shares at the time the shares are exercised and it will be treated as employment income at that time. If the employee does not immediately sell the shares and the share value declines, a capital loss will arise when the shares are later sold. Again, the capital loss can’t be used to reduce the benefit.
A favourable tax rule does allow employees to claim a 50% deduction against the employment income benefit from stock options, where certain conditions are met. As a result, the amount of tax paid on the benefit may be the same as the amount paid on a capital gain — but the benefit is still treated as employment income.
Note that in certain cases, the employment income benefit may not be taxed until the shares are sold. This applies to the shares of Canadian-controlled private corporations and certain public companies where specific conditions are met. However, this does not change the tax consequences as described. Although, the benefit is not taxed until the shares are sold, the benefit will still be considered employment income and capital losses realized can’t be used to reduce this income.
What You Need to Consider
From the point in time that the shares are purchased under a stock compensation plan, it is the government’s policy that the tax consequences will be similar to those of other stock market investors. They believe that once you purchase the shares, you are in fact accepting the market risk if you choose to hold the shares. This is the same as for other investors who purchase share investments using their regular employment income in hopes of earning a return on their investment, while accepting the risk that the share price may decline. Where a capital loss arises, it can’t be used to offset income other than capital gains. Unfortunately for many individuals who hold shares of their employer through an ESPP or from exercising employee stock options, these shareholdings may be their only capital property and they may not realize capital gains on other investments. Therefore, it is important to consider the tax consequences when making investment decisions.
With stock options, if you are not ready to sell your shares, consider holding the options as long as you can — until you are ready to sell. If the options are expiring and you need to exercise them, consider selling the shares immediately after you exercise the options to avoid capital losses. However, if you don’t want to sell all of your shares immediately, consider selling at least a sufficient number of shares for proceeds to cover the tax liability on your employment benefit. Then consider your remaining holdings as an investment that could result in either a capital gain or capital loss.
If you are a member of your employer’s ESPP, it may not be possible to avoid having an employment income benefit and a capital loss when the market is declining and your plan requires you to hold the shares for a specified period after you purchase them, or the shares will not be distributed to you until later. If you find yourself in this position, your decision will ultimately be an investment decision. Hold on to the shares if you think that their value will increase, or sell the shares and realize the capital loss. If you have realized capital gains on other investments or have the future potential to do so, you can use your capital losses to offset the capital gains on those investments.
There are a number of factors to consider when it comes to your investment portfolio — including the uncertainties of when to buy and sell — particularly in a tumultuous market. It is always important to keep in mind the tax consequences of your investment decisions, as they can have an impact on your cash situation as well as your investment return. If you have questions concerning the tax treatment of your stock based compensation, contact your BDO advisor.
Next section: Coming Soon BDO Tax Bulletins — Ontario Harmonized Sales Tax
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