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Beware options in private companies

Two weeks ago, a woman we'll call Nancy approached me with a problem. She had been an employee at a privately held company, which we'll call XYZ Inc. Last year, Nancy found a new job. Before leaving, she exercised her stock options in XYZ and acquired shares in the company for a total cost of $35,000. At the time, those XYZ shares were worth $40,000. So, Nancy made a profit of $5,000 -- not a lot, but better than a kick in the pants -- or so she thought.

Upon leaving, she had to sell those shares back to XYZ. Most privately held companies will require the same thing. Unlike a company that trades on the stock market, there's typically only one buyer for shares in a private company -- the company itself -- and most will require those shares to be redeemed when an employee departs.

When Nancy redeemed her shares in XYZ, she had to pay tax. Although her adjusted cost base (ACB) in the XYZ shares was $35,000 (her purchase price), the paid-up capital (PUC) of her shares was nominal (let's call it zero).

The PUC of shares is like a cousin to your ACB, and it's the critical number when the shares you own are redeemed by the company. You're only allowed to receive, tax free, an amount up to your PUC. The excess is taxed as a dividend.

Since Nancy's PUC was zero, her $40,000 redemption was fully taxable as a dividend. Ouch. Her tax bill on the dividend was $12,537. Had she been able to sell her shares to someone other than the company, she would have faced tax on the $5,000 profit as a capital gain, rather than tax on a $40,000 dividend. Her tax bill on that capital gain would have been $1,160.

Now, I won't get into the nitty gritty, but when Nancy redeemed her shares, she also incurred a capital loss for tax purposes of $35,000. The end result: A $12,537 tax bill and a $35,000 capital loss she can't use until she has capital gains in the future. Since she really only made a profit of $5,000 on the XYZ shares, she is actually out of pocket $7,537.

The moral

There are some things we can all learn from Nancy's misfortune. First, always get tax advice before exercising stock options. Second, stock options in a private company aren't always a good idea if your PUC is very low, unless you can sell those shares to someone other than the company later. Private companies may want to consider setting up a "market-maker" trust to buy shares in these situations.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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