Explainer: What is the stock option deduction loophole?

The stock option deduction loophole is one of the most unfair and regressive tax loopholes of all.

Stock options get treated like capital gains. That means it allows those with stock options to pay tax at half the rate everyone else pays on their employment income.

Most of the people benefitting from this loophole are already rich executives who receive stock options as a form of compensation. In fact, over 90% of the value of this $840 million tax loophole goes to the top 1%: those making over $250,000 a year. 

However, in 2021, Canada introduced a new limitation on stock options. Now, individuals can only claim stock options up to $200,000 per year from any given public corporation to be taxed at 50%. [1] 

Though this new limit will hopefully lead to more taxation of the ultra-rich, most of the individuals in the top 1% will be unaffected. This limit also does not address the larger problem that wealthy individuals can sell their shares for capital gains and pay half the tax that way. 

HOW DOES THE STOCK OPTION DEDUCTION LOOPHOLE WORK?

A stock option is a way of compensating employees without directly paying them. Essentially, instead of giving an employee a higher salary, the employer can allow an employee to buy shares of their company at a discounted price (called a strike price), compared to the price they would pay if they bought those shares on the stock market. Then, employees can hold onto the shares for a certain period of time (called the vesting period), and eventually sell them for a profit. 

The intention of a stock option is to motivate employees to take greater interest in the success of the business, and to incentivize staying longer with the company - to “vest” their shares so they can eventually sell them.

The stock option deduction has a double benefit for employees receiving stock-based compensation:

1. First, the benefit from receiving a discount on their shares is only 50% taxable.
2. Also, the profits from selling their shares is a capital gain, and therefore only 50% taxable as well.

The deduction was initially put in place to help raise money for startups, but has since been twisted to meet the desires of the ultra-rich.

WHY IS THE STOCK OPTION DEDUCTION LOOPHOLE UNFAIR?

The stock option deduction loophole is unfair because stock options are typically only offered to high level executive employees of successful corporations. The vast majority of employees in the vast majority of companies are never granted this option and pay full tax on their wages. Why should a rule exist that almost exclusively benefits those who need it least?

Also, many of these corporate executives end up getting huge portions of their income as stock options. 

• For example, in 2017, Richard Baker, the CEO of Hudson’s Bay earned $861,000 as his salary and over $16 million in additional stock options. [2]
• Or take the example of the highest paid CEO in Canada in 2018, Joseph Papa of Valeant Pharmaceuticals, who made over $83 million. His salary was just under $1.3 million… that means almost 99% of his income came from other forms of compensation like stock options!

As you can see, this loophole allows executives to earn more capital gains income than employment income. Since capital gains are only taxed at 50%, that means these rich CEOs are only paying full tax on a small portion of their income.

With such astronomical “compensation” for the people who use this loophole, the government loses out on huge revenues, which then can’t go into public services that benefit everyone.

The stock option deduction loophole is also economically damaging. It creates a lucrative incentive for those in the executive suite to put corporate profits into share buybacks, thereby boosting the value of their own compensation, instead of making real investments in the economy that would create jobs and prosperity. [3] 

Meanwhile, this loophole keeps making inequality worse by cyclically growing and keeping the wealth of corporations in the hands of the wealthiest few.

Also, there are ways to get around the new limit on stock options, such as:

• employees receiving more than $200,000 in stock options by receiving stock options from multiple companies
• stock options received from private companies like startups, or small businesses (meaning revenue below $500,000) remain exempt [4] (See Example 2 below)
• companies finding grey areas in the law, such as creating smaller subsidiaries of themselves, or changing their accounting practices so they technically qualify as small businesses or private corporations [5]

CAN WE MAKE THIS LOOPHOLE FAIR?

The stock option deduction limit introduced in 2021 would indeed have had an impact in 2020. Had the $200,000 limit been in place in 2020, 71 of the highest-paid 100 CEOs would have exceeded it. The tax savings (also known as government revenue loss), for 71 people alone in 2020, due to this one tax loophole, was $63.4 million. [6]

However, even with this new limit, the stock option deduction loophole remains unfair, not least because the vast majority of earners in the 1% will not exceed this new limit and thus remain unaffected. Furthermore, all earners of stock options will still collect their capital gains taxed at 50% when they sell their shares. Thus, there is still a high incentive to choose stock options as a prominent form of income. 

The only real way to make this loophole fairer is to eliminate the stock option deduction loophole altogether, and ensure that stock option income is taxed at the same rate as wages. 

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FURTHER EXPLANATIONS AND EXAMPLES

For those interested in how the stock option deduction loophole works, the following section details exactly how it is calculated and reported on a tax return.

WHAT IS A STOCK OPTION?

There are two types of stock options for two different scenarios.

Scenario 1: Mrs. Vesting works for a small privately owned business in her local community. She would be offered to buy Incentive Stock Options in that company. This type of stock option would go as follows:

• She would buy the shares at a discounted price and not be obligated to report anything on her tax return.
• Then, she would hold the shares for the vesting period. There is still nothing to report on her return yet.
• Finally, when the vesting period is up, she could sell her shares and report the profit as a capital gain (only 50% taxable).

Scenario 2: Mrs. Vesting gets hired at a large publicly traded corporation and they offer her a stock option as part of her compensation. This type of stock option is called a Non-statutory Stock Option (or Non-qualifies) and would go as follows:

• She would buy the shares at a discounted price and report half [7] of the benefit on her tax return (ie. if she buys 20 shares for $40 each and they are worth $50 each at the time, her benefit would be $10 per share. She only has to report half of that. So the benefit on her tax return would be $5 x 20 shares = $100).
• Then, she would hold the shares for the vesting period. 
• Finally, when the vesting period is up, she could sell her shares and report the profit as a capital gain (only 50% taxable).

WHAT ARE THE TAX IMPLICATIONS?

EXAMPLE 1: Mr. Qualifies is promoted to an executive position at Stock Options Inc. and is given two choices for his compensation package: 

• Option 1. Receive a salary of $300,000 each year for the next three years. 
• Option 2. Receive a salary of $200,000 salary with an option to buy 10,000 shares at a price of $250 per share. The market value of those shares is $270 and the vesting period is two years (he can sell in the third year). He can exercise that option immediately.

He wants to figure out which option would avoid paying more tax:

After the two year vesting period is up, the market value of the shares is now $280 per share. Ms. Strike chooses to sell her shares in the third year. Here is the tax implication:

Option 1 Totals

• Total income over three years = $900,000 
• Total tax paid ($77,181 x 3 yrs) = $231,543
• Effective tax rate (231,543 / 900,000) = 25.7%

Option 2 Totals 

• Total income over three years (not including tax benefit)[8] = $900,000
• Tax paid (77,181 + 45,049 + 88,762) = $210,992
• Effective tax rate (210,992 / 900,000) = 23.4%

If Mr. Qualifies chooses Option 2 to get stock options, in the three year period of the option, he would pay $20,551 less in taxes for the same amount of total income. 

EXAMPLE 2: If Exemption Corporation was a large public company with executives that still wanted to receive major stock options, there are a couple things they could do to work around the new rules. 

1. The executives could create a system in which they receive their options from multiple companies and thus take advantage of a limit above $200,000.
2. The company could create a new smaller entity with a level of income that would qualify to be exempt from the limit and distribute its stock options through that smaller company. 

ENDNOTES 

^{[1]  Any options beyond that limit can still be claimed, but they will be taxed fully. This however, does not apply to options issued by private companies and small businesses.} 

^{[2] Chapter 5 of Share the Wealth by Jonathan Gauvin and Angella MacEwen}

^{[3] Roger Martin, former dean of U of T’s management school and director of the Martin Prosperity Institute, wrote a book called Fixing the Game, calling to eliminate the loophole}

^{[4] Most Private Canadian Corporations and small businesses with net income less than $500,000 are exempt from the $200,000 limit.}

^{[5] https://www.taxfairness.ca/sites/default/files/resource/c4tf_submission_stock_option_deduction_sept_2019_1.pdf}

^{[6] https://www.policyalternatives.ca/sites/default/files/uploads/publications/National%20Office/2022/01/Another%20year%20in%20paradise.pdf}

^{[7]  Under paragraph 110(1)(d), the employee may deduct half of the ESO benefit when computing taxable income if: (1) the employee received common shares upon exercising the employee stock option; (2) the employee dealt at arm’s length with the employer; and (3) the ESO option price (including any amount paid to acquire the ESO) wasn’t less than the fair market value of the underlying shares at the time that the option was granted.  https://taxpage.com/articles-and-tips/employee-stock-options-tax-implications/}

^{[8] The tax benefit is not included in total income because it is not money received by the employee at the time of exercising the option. It is an implied benefit of the discount they received on buying their shares.}

^{{Photo by Ben White on Unsplash}}