I have been involved with many technology start-ups over the years and many of us old timers take a lot of the stuff we know about shares and options for granted. Shares and options are also an area where the rules keep changing and the implications of buying and selling effect each person differently. The tax man is always standing close by with his hand poised to enter your pocket and how much of your gain he gets, will depend directly on what you do.
“NOTE: I AM NOT A TRAINED TAX PROFESSIONAL AND I AM TRYING TO GIVE YOU TAX OR INVESTMENT ADVICE. PLEASE CONSIDER THE FOLLOWING AN HISTORICAL ACCOUNT OF MY PERSONAL JOURNEY.”
The end goal of each investor is not necessarily the same so the first step for you may be to decide what it is that you hope to accomplish. My end goal has always been to get the most return for my investment and to minimize what portion of that the tax man gets. It is against the law to not give the taxman his due, but there are options (Excuse the pun).
Shares are property in that they represent your partial ownership in a business. As a business owner you are informed with respect to the intentions of the business. This means that you are invited to the annual shareholders meeting, and you get quarterly reports. If you sell all of your shares and options, these things will go away. If your goal is to participate in the business and share in its growth, then you may never want to sell your shares.
I’m going to start my talk by talking about options. Options are a promise between the company and usually an employee. The company promises to hold a number of shares at a fixed price so that the person in question can purchase at any time. The fixed price is usually called “The Strike Price” and once the shares start trading above that price, the employee can buy and/or sell on the same day and make instant money with little to no risk. Unfortunately the tax man considers the lack of risk a way to take a bigger share of your gain. The taxman considers the difference between the price you pay and the price you sell at as income, not a capital gain, and it is taxed at your income rate. In Canada, your income rate is calculated in a graduated fashion in accordance with your overall salary.
If you buy an option from the company and hold onto it before you sell, the taxman still gets to tax you as income on the difference between the strike price and the purchase price, but any additional gain is considered “Capital Gain” and falls under different tax rules.
Citizens in Canada had and may still have a lifetime capital gain exemption which means it is possible that the capital gain may be tax fee. You need to check into the current tax rules and your personal tax situation. I made some money back in the 90’s and took advantage of my life time exemption. The government is always playing with the total amount however, so it may still be an option for me.
If the trading price of an option is lower than the strike price (Commonly referred to as “Under Water”) most people would not buy their options from the company unless they believe that the shares are about to realize a significant increase in price. If you buy a share at less than its current trading price the taxman awards you a “Capital Loss” which you can later use to offset a “Capital Gain”. Once you own the share, any gain is considered a capital gain because you are taking a risk.
You can quickly see that the stock market is a legal form of gambling and the same rules apply. “Know your limit and spend with it!”
I’m not a gambler so I am not comfortable buying (Sometimes called picking up) options that are “Under Water”. I as a general rule, only pickup options that have value. I may hold onto them for a while, but I will always sell them before they become worthless.
Now lets consider shares. Shares are property and represent the holders ownership in a company. There are special (and ever changing) rules for shareholders that apply to how the shares can be traded and what taxes are owed. There are special rules to encourage investment in Canadian corporations that allow early investors to completely avoid the taxman, for example. The rules tend to require the investor to have held the shares for a number of years before the company goes public, but these rules may apply to you! There are also rules that restrict when a person that is employed by that company can sell. This depends on the agreement between the company at the organization that represented the company when it went public.
In order to turn shares into money, you need a broker. A broker is a person that will offer your shares for sale on a stock market and buy shares on your behalf. I don’t buy and sell that often so I tend to do that through my bank. Brokers are like the tax man in that they charge for their services in the form of a commission. These commissions vary depending on the services rendered, so choose carefully.
Once you have a brokerage account setup, you need to ask your broker to transfer your shares from a holding company like “Computershare” to your account, or you need to bring your share certificates into the bank/broker. It seems to be more common these days to have the shares held by a holding company. After the shares are transferred, you have several options. In Canada, everyone has the option to open a Tax Free Savings Account (TSFA) which allows the holder to deposit a fixed amount per year that can be withdrawn at any time tax free.
There is no benefit to the TSFA if you put money in and take it out right away, in fact there is a disadvantage, because the amount you can deposit into a TSFA is regulated and limited. The TSFA is a place where you put things that you expect to increase in value so that you keep that gain away from the taxman. You can put shares in a TFSA, but the act of doing so means that the difference between your purchase price and the price on the day of the deposit is considered income and the taxman will be knocking on your door for his money on your next tax return. This sequence of events is sometimes referred to as “Triggering a tax event.”
You used to be able to put shares into an RRSP which is also regulated with respect to the amount you can contribute, and this reduces your taxable income by the amount of your contribution. This can put money back in your pocket in that all money placed in an RRSP is not taxed so you get a refund on the income tax that you most likely already paid. The rules may have changed with respect to putting stock in an RRSP because at the end of the last decade many people abused this mechanism. RRSP’s are supposed to be for your retirement, so putting money in and getting money out has consequences. RRSP’s are not supposed to be used for shorter term investments.
You can contribute to your spouses RRSP’s and this can be a way to manage expenses during years when you or your spouse are taking care of children. When you draw from an RRSP you get taxed at your tax rate for that year. If you are not working that tax rate will be low, maybe even low enough to pay no tax. Either spouse can draw from an RRSP and will be taxed at that spouses tax rate.
The last option that you have is selling the shares and getting the cash. When you sell shares you trigger a tax event. The difference between the purchase price and the selling price is “Capital Gain” because during the entire time you were taking a risk. If you have a capital gain exemption, the tax man gets nothing (But you do have to report everything on your next tax return so keep good notes and all associated paperwork). If you don’t have an exemption and you did not sell from inside a TSFA or RRSP, then you pay tax. The tax is calculated using the formula that can be found in your last years tax return form (or online). The tax on a Capital Gain is not as much as Income Tax so that is something that your should keep in mind.
The saying that “You only pay tax when you make money” used to be true, but today there are several ways to trigger a tax event where you pay tax and you haven’t actually made any money yet. In those cases you have the option to sell some shares to pay the taxes or just pay the taxes now to shelter future gains.
Investing is all about finding your comfort range for risk and not getting greedy.