Friday, December 7, 2007

Government Forgives JDS Employee Tax Bills

Here is a bonus post on some recent news. If you were looking for my promised post on trying to beat stock spreads, click here.

The Canadian government has decided to forgive the tax bills of some JDS Uniphase employees who got caught by tax rules on employee stock options. The articles I have read on this so far haven’t explained things very well. I understand what is going on because I was caught by these same tax rules.

When employees get stocks options, what they have is the right to buy a certain number of company shares at a certain price. This is different from owning stock. If employee Ed has 5000 stock options struck at $2, it means that he has the right to buy 5000 shares in his company for $2 each. When he exercises this right, the company comes up with the shares (usually by just creating new shares) and gives them to Ed in return for $10,000. At this point, Ed is holding 5000 shares in his company, and he can sell these shares if he wants to.

Back when we were in the high-tech bubble, share prices rose to crazy levels. Suppose that the shares in Ed’s company rise to $100. For $10,000, Ed can exercise his options, and then sell the resulting 5000 shares for $500,000!

But what if Ed decided to exercise his stock options and hold on to the stock for a while to see if it goes up more? By the tax rules, Ed has made a gain of $500,000 minus $10,000, even though he hasn’t sold the shares yet. This $490,000 paper gain is considered to be employment income that will be taxed at the same rate as capital gains, but is not the same as a capital gain. By the rules as they were changed in 1997, Ed won’t have to pay tax on this income until he sells the shares.

Ed‘s luck runs out, the stock drops back to $2 before he can sell. He decides to cut his losses and sell at $2 to get his $10,000 back. So now he’s even right? Not so fast. From the government’s point of view, Ed has an employment gain of $490,000 and a capital loss of $490,000. They want their taxes on the employment gain now, even though Ed never got that money. Ed can use his capital loss to offset future capital gains, but that isn’t much consolation as he loses his house to pay his tax bill now.

In my case, I did make money when my employer’s stock rose, but I’m still holding most of the last block of stock I got from exercising options. If I were to sell the rest, I would have to declare a big employment gain on money I never received. So, I sit on these shares hoping that my employer doesn’t go out of business triggering a deemed sale.

Each year where I have a capital gain on other investments, I sell a little of my former employer’s stock to create a corresponding capital loss. This effectively turns the capital gain into an employment gain. I should be finished leaking out all my shares this way in about 40 years.

As I see it, the fundamental problem is that the government treats stock option gains as employment gains rather than capital gains. What is the point of this given that they are taxed at the same rate? If both types of gains were capital gains, then Ed could offset them against each other, and his problems would be over. He wouldn’t be getting away with anything. After all, he put in $10,000 and took out $10,000; why should he pay any taxes on this? He didn’t make any money.

I wrote a letter to Paul Martin about this after he delivered his budget in 1997. I explained how an unsuspecting person could be ruined financially without even realizing the risks. Unfortunately, all I got back was an off-topic form letter. I also got a local high-tech lobby group interested, but they couldn’t get the government to make any changes.

This all sounds like tax games for the rich and famous, but these problems have affected many people of modest means who never really understood what stocks options are or how they are taxed.

For smaller amounts, none of this makes much of a difference. If you have to declare an employment gain, you end up being able to reduce your capital gains by the same amount, and the tax bill isn’t affected. The only time it makes a difference is for larger amounts that can break someone financially.

What is the point of forcing someone into bankruptcy for income he never received?

This is continued here.

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