Employers commonly structure incentive plans for key, or all, employees based on the employer’s stock, equity or shares. This is a common way for employers to motivate staff, by giving them a more or less direct stake in the employer’s own financial success. However, such plans don’t always involve the actual granting of stock options or the issuance of shares to employees. For example, the employer may be a family business and may not want to dilute control by having employees acquire shares. As a result, many different practices have been developed to mimic the effect of stock options, without actually issuing shares to employees.
For source deduction and reporting purposes, there are substantial differences between true ‘stock option’ plans versus what are commonly termed ‘phantom stock’ plans. Because of these differences, it’s important that payroll staff know how to properly classify the type of incentive plan offered by employers. For example, phantom stock plans are sometimes termed share appreciation right, restricted share unit or deferred stock unit plans. With all these different names, it’s easy to misunderstand the requirements that apply.
First, let’s make sure we all understand some of the key terms used.
While the CRA uses the term ‘security option’, to describe taxable benefits related to stock options and issued shares, the more commonly understood payroll term is ‘stock option’ benefits, even if the actual taxable benefit stems from issued shares. For this purpose, ‘stock option’ refers to the taxable benefit that may arise when employers grant stock options to employees or issue them shares. In this article, we won’t get into how to calculate the amount of any stock option taxable benefit that may apply. Here we just want to focus on when these ‘stock option’ rules apply and when they don’t.
An ‘option’ is the right to purchase a specific number of employer shares, at a price set at the time the option is granted. The assumption is that if employees contribute to the employer’s success, the value of the related shares will rise, and employees will be able to benefit by the excess of market value over the price set in the option.
A key requirement of the ‘stock option’ rules is an agreement to issue shares to employees. For example, the rules don’t apply if employees purchase employer shares on the open market or in a private sale from an existing shareholder.
There are two issues with this requirement.
First, the object of phantom stock option plans is to provide employees with the same financial gains as if shares had been issued, without employees actually being issued them. This is the key difference between ‘stock option’ and ‘phantom stock’ plans. In phantom stock plans, the employer pays a cash bonus equivalent to the amount that employees would have earned had options been granted and employees had been issued actual stock. Since there is no ‘agreement to issue shares’, the ‘stock option’ specific rules do not apply and employer payments have to be treated as would any other cash bonus. In other words, employer payments under a phantom stock plan are income taxable, CPP pensionable and EI insurable earnings. For income tax purposes, the bonus method applies and for CPP purposes, no Basic Exemption is available. No employee deduction is available to offset the amount of this taxable benefit.
Example: Under an employer’s phantom stock plan, employees are allocated share ‘units’ designed to mimic the behaviour of the company’s publicly traded shares. An employee is allocated 500 of these ‘units’. When the employee wishes to ‘cash out’ these units, the fair market value of the corresponding shares is $10. There was no cost to the employee for the ‘units’ allocated. When these units are ‘cashed out’, the employer pays the employee $5,000. The $5,000 received is a cash bonus subject to income tax, CPP and EI source deductions and reporting.
The second issue deals with the fact that not all stock options result in issued shares. This is where it is sometimes becomes difficult to differentiate between ‘stock option’ and ‘phantom stock’ benefits.
If options are not exercised, either directly by the employee or a related person, there are 3 logical possibilities:
- An employee dies before options are exercised.
- Employee options are sold on to a 3rd party.
- The employee takes a cash payment from the employer, ‘cashing out’ the options rather than receiving newly issues shares under the agreement.
For the first two of these possibilities, the ‘stock option’ taxable benefit rules always apply. However, there may be a different outcome if the ‘agreement to issue shares’ provides discretion in either issuing shares or making a cash payment in lieu. If the employer may select ‘cashing out’, this employer discretion makes any resulting payment a ‘phantom stock’ benefit. In other words, a ‘cash out’ of an otherwise valid ‘stock option’, at the employer’s discretion, makes the resulting payment the equivalent of a cash bonus, for source deduction and reporting purposes. Only, if this discretion lies with the employee, is the ‘stock option’ nature of the agreement preserved.
Alan McEwen is a Vancouver Island-based HRIS/Payroll consultant and freelance writer with over 20 years’ experience in all aspects of the industry. He can be reached at firstname.lastname@example.org, (250) 228-5280 or visit www.alanrmcewen.com for more information. This article was first posted to Canadian HR Reporter and Canadian Payroll Reporter on May 22, 2013.