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Be sure to handle stock options properly

I've been travelling quite a bit lately, and while I've been away, the kids have been sleeping with my wife, Carolyn. When I get home they want to continue the habit.

"Kids, when Daddy comes home from a trip, I just want a good sleep in my own bed, which means you can't sleep with us," I told them. "It's a bad habit for you to get used to sleeping in our bed when Daddy is away."

Last week, Carolyn and the kids picked me up at the airport, and they saw me standing with a hundred other people by the luggage carousel. My three-year-old son Winston came running up to me and shouted at the top of his lungs: "Daddy, this time when you were away, nobody slept with Mommy!"

You've got to take the bad with the good sometimes. The good? We've broken the sleeping habit. The bad? My wife now lives paranoid that she's going to run into one of those people who saw us at the airport that day.

Taking the bad with the good is sometimes also a fact of life as an employee with stock options. The good? Stock options are a tax-smart type of compensation. The bad? If you don't handle your options properly, you might get stung.
Exercise properly

You should understand that the benefit you receive under your stock options is taxed as employment income. Consider Glenn. He was granted options in his employer, which we'll call Widget Inc., a public company, which gave him the right to buy 10,000 shares of Widget at $10. Halfway through last year, Glenn exercised those options at a time when Widget shares were worth $15.

Since Glenn paid $10 for each share of Widget at a time they were worth $15, he triggered a $5 stock option benefit per share, for a total benefit of $50,000. Now, just one-half of that benefit will be included in Glenn's income thanks to a special 50-per-cent deduction that most stock options will qualify for. So, $25,000 will be taxed as employment income in Glenn's hands.

Here's the problem: Glenn exercised his stock options and held onto his Widget shares. While they were worth $15 when he exercised his options, those shares are worth just $9 today. If Glenn were to sell his Widget shares today, he'd have a capital loss of $6 ($15 minus $9). Remember, the $5 benefit is taxed as employment income while the $6 loss is a capital loss. Capital losses can be applied against capital gains only. So, there's no way for Glenn to offset that taxable employment benefit with the capital loss.

The moral of the story? It typically makes sense to exercise your stock options only when you're prepared to turn around and immediately sell the shares you've acquired under the option. The exception to this rule is where your options are about to expire and you have to exercise so that you don't lose the benefit of those options altogether.

If you're concerned about giving up future growth by selling the shares immediately -- don't be. In this case, you'd simply hold onto your stock options without exercising them since you'll participate in that growth while owning the options.

I should mention that the 2000 federal budget introduced new rules that will allow you to defer the taxable stock option benefit until the year you actually sell those publicly traded shares you own in your employer. This deferral has been possible for most private company shares for years. If you take my advice and simply sell your option shares as soon as you exercise, you won't need this deferral mechanism.
Hold properly

The next tip I have for you is this: Avoid holding your stock options inside your registered retirement savings plan. You see, if Glenn had transferred his stock options to his RRSP with the hope of sheltering any future gains from tax, he'd face a double-tax problem. He'd be taxed personally on the stock option benefit when exercising the option inside his RRSP, then he'd face tax on that same amount again when he later withdraws the money from his plan. I wrote about this issue back on Nov. 20, 1999. (Visit to read that article).
Keep diversified

There's a danger with stock options that all your eggs will be in one basket. That is, you could end up in a situation where most of your investments are shares in your employer, and all your income comes from that company as well. This could expose you to more risk than you may be comfortable with. It may make sense to reallocate some of that capital to other investments from time to time.
Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002 and Winning the Estate Planning Game. He is managing director, Tax Smart Services, at AIC Ltd.

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