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Those nice-to-have stock options can generate a nasty surprise

No question, there are times when you just don't get your money's worth. Just ask Martin, the man in front of me at the hotel checkout. "I hope you enjoyed your stay with us, sir" the clerk said to Martin.

"Well, I wasn't given a pillow, my wakeup call didn't come, the food was lousy, the service slow, there was too much noise, the price is too high, but, you know, I really did enjoy your ice water," Martin replied.

No sir, Martin didn't get his money's worth.

Today, many former JDS Uniphase employees are feeling the same way. You would, too, if the taxman handed you a tax bill of about $276,000 on income you feel that you never had. There's a tax lesson to be learned here. The problem

Picture this. You've just been employed by a high-tech company that is generous enough to offer its employees stock in the company at a discount. You can buy shares at $2 each, and the value of the shares increases over time to trade at $300 a share. A nice profit. So you exercise your offer and purchase 2,000 shares at $2 each.

Now, this is going to trigger some tax. You've got a $298 benefit per share ($300 less $2), for a total benefit of $596,000 (2,000 shares times $298). The total tax bill will be $276,604 for a person in the highest tax bracket in Ontario this year. (Under many stock option or purchase plans, just 50 per cent of benefits are taxable. But as a result of the provisions of the JDS plan, for example, employees weren't entitled to the 50-per-cent deduction.)

But the story's not over. You now own 2,000 shares in your employer, and those shares drop in value from $300 to just $4 over a short period of time. That's right, your 2,000 shares are now worth just $8,000. But you still owe $276,604 in tax. How are you going to pay the tax bill?

You could always sell the shares and apply the capital loss against that $596,000 of taxable income, couldn't you? Think again. That capital loss can only be applied against capital gains. The $596,000 taxable benefit is considered to be employment income and is often taxed the moment you acquire the stock at a discount, not when you sell the stock (unless your plan meets certain criteria). It's not taxed as a capital gain. You can forget about reducing your tax bill with the loss you've just incurred. Wow. Paying that $276,000 tax bill is going to be tough when you never had the cash profit in your hands. Welcome to the world of many former high-tech employees.

The solution

Former employees of JDS Uniphase and many other high-tech companies might blame the government and Canadian tax law for the tax they owe on "imaginary profits." And while I sympathize with these employees, the onus is on the employee to obtain competent financial advice when triggering a significant taxable event.

Their profits weren't just imaginary. They had the profits, but chose to keep the profits invested in risky shares. And shame on any employer who didn't properly educate employees on the tax ramifications of these stock plans. What can be learned from these mistakes?

Consider selling any shares acquired under a company stock option or purchase plan as soon as possible after acquiring them. Otherwise, you run the risk that the shares could drop in value and leave you with a tax hit, and a capital loss you can't use to offset the tax hit. As a minimum, sell enough shares acquired under the plan to pay the expected tax bill.

Consider having your employer deduct more tax from each pay to cover the expected tax bill after acquiring shares.

Employers should ensure that employees receive the correct tax information they need to make proper decisions about the shares they acquire.

Employers should avoid adding "blackout" periods to stock plans during which employees cannot sell shares after acquiring them at a discount.

Employers should ensure that the provisions of the plan will allow employees to claim the 50-per-cent deduction against the taxable benefit, and that the shares will qualify for the deferral that will allow the employee to defer tax on the benefit until the shares are actually disposed of. These provisions will soften any tax blow an employee might face.

Finally, the Department of Finance needs to consider changing our tax law to permit a capital loss on shares acquired under a stock option or purchase plan to be applied against the taxable employment benefit on those same shares. But, until this happens (and don't hold your breath), employees should beware of the tax hit that comes with acquiring shares at a discount.

Tim Cestnick, FCA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, National Tax Services, at AIC Ltd.

tcestnick@aic.com



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