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CH 3 - Part 2

Nov 15, 2024

Lecture Notes: ITA 7, Employee Stock Options

Introduction

  • Speaker: Ruthann
  • Topic: Employee Stock Options and their Income Tax Implications
  • Purpose: To isolate and explore the details of calculations related to employee stock options.

What are Stock Options?

  • A benefit provided by employers allowing employees to purchase a specified number of shares at a specified price for a specified period.
  • Example: If shares are valued at $30, options may be granted at $35.
    • Market price fluctuates while option price remains locked.
    • Benefit: If market price rises (e.g., to $40), options become advantageous.

Importance of Stock Options

  • Motivation and Retention: Encourage employees to remain with the company.
  • Tax Implications: A taxable benefit for employees, not usually a tax deduction for employers.

Relevance in Different Courses

  • 3361: Discusses recording/reporting stock options for financial statements.
  • 4471: Focuses on the motivational aspects of stock options.
  • 3362 Focus: Tax return implications of stock options.

Accounting for Stock Options

  • Complexity: Depends on whether the company is publicly traded or a CCPC and the option pricing relative to market value.
  • Public Company Scenario:
    • Fair Market Value = $40, Option Price = $45.
    • Options considered equal to or greater than market price.
    • No Immediate Action Required when options are granted.
    • Stock Option Benefit: Occurs when options are exercised.
    • Calculation: (Market Value on Exercise Date - Exercise Price) x Number of Shares.
    • Tax Considerations:
      • Employment income inclusion when options are exercised.
      • Possible 50% stock option deduction if options were above market value when granted.
    • Capital Gains: Taxable when shares are sold.

Example: Executive with Stock Options

  • Scenario: Options for 1,000 shares at $25; market price rises to $40.
  • Year of Exercise:
    • Income increase of $15/share ($15,000 total).
    • 50% stock option deduction applicable.
  • Following Year:
    • Shares sold at $50, taxable capital gain realized.

CCPCs and Stock Options

  • Differences:
    • Stock option benefits added to income when shares are sold, not when options are exercised.
    • Stock option deduction allowed if shares held for at least two years.
  • Example - Susan:
    • Year 1: Grant of options - no tax impact.
    • Year 2: Exercise of options - no tax impact.
    • Year 3: Sale of shares results in taxable income and capital gain.

Legislative Changes (2020)

  • Addressing misuse by high-income individuals to shelter income.
  • Legislation Effective: Post-July 1, 2021, limits stock option deductions for wealthy executives.
  • Limitations: Deductions apply only up to $200,000 per employer.
  • Classification: Options are categorized as qualifying or non-qualifying.

Conclusion

  • Government uses legislation to motivate companies to hire quality employees and to limit benefits when deemed unfair.

This summary captures the essence of the lecture on employee stock options, focusing on financial and tax implications, with examples and legislative updates.

Full transcript