When cash reserves are low but growth potential is high, startups may decide to issue stock options, sometimes in lieu of higher salaries. Yet before moving ahead with a stock option plan, it’s important to understand what you and your team are getting into from a tax perspective.

Unlike salary, which is taxed when received, generally stock options are not actually taxed when they’re handed out to employees.

Let’s consider Startup Co. that just issued their new employee Stacey the option to purchase 100 shares at $1 per share in two years.

On Stacey’s T1 personal tax return in the year she receives the stock options, she’ll report no additional income. Why? Stacey was not issued any actual company stock and was only issued an option to acquire the stock at a later date.

So when does Stacey pay any tax?

The timing and amount of Stacey’s tax payment relies on whether the company she works for is a public company or a private corporation – though more specifically, a Canadian Controlled Private Corporation (in tax terms, a CCPC). While whether Stacey’s company is a CCPC is a tax discussion in itself, many new Canadian startups do qualify so let’s keep things simple and assume it is.

The tax treatment for a CCPC stock option plan

When the 2 year waiting or vesting period is up, Stacey decides to use or exercise her options. At the time she purchases the shares, the company just finished raising another investment round where shares were valued at $10/share. Good news for Stacey – she just paid $1/share for 100 shares worth $10/share – and since she works for a CCPC, she doesn’t have to pay any tax (well – not just yet anyway).

The following year, the founders announce that StartUp Co. has been acquired and Stacey gets to cash in on her shares. The exit was successful and the new owner paid her $50/share for her stock. On Stacey’s tax return for that year, she’ll have two types of income to report:

a) Taxable benefit

Stacey used her right to purchase stock at $1/share when it was valued at $10/share. This difference between the exercise price and the fair market value of the stock is called a taxable benefit. Basically, Stacey will be taxed at her employment income rate for the $900 benefit. Her employer will include the amount on her T4 and it will be added to her total taxable salary on her personal tax return. If she’s in a tax bracket of say 30%, that’ll mean she’ll pay an extra $300 of tax that year.

b) Capital gain

While Stacey acquired her stock options when they were worth $10/share, she was bought out at $50 /share. This difference between the amount her shares were worth when she exercised her options and the sales price on the exit is a capital gain. Lucky for Stacey, capital gains are taxed at 50%, rather than 100% like employment income, so Stacey’s $4,000 gain (ie. $50 less $10 = $40/share x 100 shares) will mean she will pay tax on an additional $2,000 of income on her personal tax return in the year in which she sold the shares. At a 30% tax rate, she’ll pay $600 of tax on the gain.

Keep in mind:

While many startups in Canada will qualify as a CCPC, keep in mind that there are different rules for non-CCPCs and public companies – which would have a separate set of tax implications when issuing stock options. Even for CCPCs, the numbers aren’t always that clear as attributing a valuation for stock of a private company can be a complex calculation. Given the variables, it’s a good idea to review your stock option plan with an advisor but also ensure that both you and your team understand the tax treatment when it’s time to cash in.