A strategy to eliminate tax on the exercise of your options and meet your philanthropic goals
As an employee, you may have been granted stock options by your employer. Generally, there are no tax implications when the stock options are first granted to you. However, when you decide to exercise the options, you will realize a security options benefit. Once you have exercised the options, consider donating the shares acquired as a strategy to meet your philanthropic goals and realize tax savings.
Stock option taxation
Generally, when you decide to exercise your public company employee stock options, you will realize a security options benefit. This benefit is equal to the difference between the fair market value (FMV) of the shares at the time you exercise the options and the amount you pay for the shares (the exercise price or strike price). The security options benefit is considered employment income and is taxable to you at your marginal tax rate.
You may be eligible for an offsetting security options deduction equal to 50% of your security options benefit, if certain conditions are met. For example, one of the conditions to be eligible for the security options deduction is if the exercise price was not less than the FMV of the shares at the time the options were granted. The deduction results in the security options benefit being effectively taxed at capital gains rates.
Tax benefits of donating stock option shares
There are two tax benefits you will receive when donating your publicly listed stock option shares to a qualified donee. A qualified donee is an organization that can issue official donation receipts for gifts it receives. Typically, a registered charity is a qualified donee and includes a charitable organization, a public foundation or a private foundation.
- An additional deduction
Assuming you qualify for the 50% security options deduction, you may receive an additional deduction if you donate your stock option shares. In order to qualify for the additional deduction, you will need to donate the shares acquired on the exercise of your options in the same year you exercise the options and within 30 days of exercising the options. If you exercise your stock options in December, you will not have the full 30 days to make the donation, as you must donate the shares before December 31st.
The amount of the additional deduction is equal to 50% of the lesser of two amounts:
- The security options benefit
- The FMV on the disposition minus the exercise price
If the stock option shares have remained the same or increased in value at the time of making your donation, the additional deduction effectively eliminates your security options benefit. Alternatively, if the shares have declined in value at the time of making your donation, your additional deduction is reduced proportionately. In other words, your additional deduction will be less than 50% of your security options benefit.
- A donation tax credit
In addition to eliminating or reducing your security options benefit, you will also receive a donation tax receipt equal to the FMV of the shares you donate. This allows you to claim a donation tax credit which can be used to reduce the taxes payable on your other sources of taxable income.
Cashless exercises
If you have been granted employee stock options but do not have the cash needed to pay for the shares upon exercise of the options, you can consider a cashless exercise of your options. A cashless exercise involves short selling the underlying shares as a means of acquiring the cash needed to exercise the options. Generally, short selling is a speculative practice that involves using a broker to sell shares that you do not own. Using some of the funds raised from the short sale, you exercise your stock options. The broker receives the shares from your employer and uses them to cover the short sale. The broker then pays you the difference between the cash received from the short sale and the cash used to exercise your stock options. In a cashless exercise, if you direct the broker to immediately donate all or a portion of the proceeds to a qualified donee, you may still be eligible for a portion of the additional deduction. The deduction is prorated to reflect the proportion of the proceeds that you instruct the broker to donate.
Choosing the method of donation
Assume an executive has 1,000 options expiring next month. The exercise price is $20 a share and the current FMV is $50 a share. The executive and their spouse regularly make a cash donation at year-end of $50,000. If the executive chooses to use a cashless exercise, they will only be able to donate the net cash of $30,000. In this case, the executive and their spouse will make an additional cash donation of $20,000 by year-end to meet their annual donation goal. They are wondering if there is a more tax- efficient way to execute their charitable intentions.
The following illustration compares the tax implications of three different methods in which you can make a donation of your employee stock option shares. The illustration assumes the executive is in the highest marginal tax bracket and taxed at a rate of 50%.
Based on the above illustration, exercising options and donating the shares to a registered charity is the most tax-efficient option. That said, if the executive does not have all the necessary funds to exercise their options, a cashless exercise may be better than having the options expire and not having any funds to donate.
Conclusion
If you intend to donate to charity, consider donating the shares you acquired by exercising your employee stock options. Not only is it a great way to reduce your out-of-pocket donation cost, but you also may be able to eliminate your entire tax liability on the exercise of your options.
Tamar Ribashvily, MBA & Jonathan Rotem, CFA are investment advisors of RBC Dominion Securities in Toronto and can be reached at 416-699-4626 or by email: Tamar.Ribashvily@rbc.com
RBC Dominion Securities is a member of the Canadian Investor Protection Fund.
This article may contain strategies, not all of which will apply to your particular financial circumstances. The information in this article is not intended to provide legal, tax, or insurance advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain professional advice from a qualified tax and/or legal advisor before acting on any of the information in this article.