[bowline_nc]

You shouldn't be in bad shape tax-wise. I don't know Canadian tax law - but in the US, you only get taxed when you sell the shares. Capital gains would not be recognized if you exercised the options and held onto the shares.

Since you have been exercising your options - you are a shareholder in the company (or a member depending on the structure) and I would imagine that the company's operating agreement would require them to disclose any funding rounds to you. I'd get a hold of that if you can.

It sounds like you're working with amateurs, so I'd pass it by a lawyer to determine the real impact on you - but I wouldn't flip out until you get the entire picture. They may be planning on diluting the hell out of you or they may just not know what the hell they're doing.

I'd say it's too early to tell.

[jlmorton]

> Capital gains would not be recognized if you exercised the options and held onto the shares.

That's not exactly accurate in the US. You need to pay income tax - not capital gains - on the spread between the strike price and the fair market value. Since the company is not publicly traded, the fair market value needs to be assessed. The IRS has rules on how to do this, but many companies use independent third party auditors to do this, though an early stage company probably would not do this.

Once an investment has been made, a fair market value has been established, and you need to report the difference between the strike price and the investment price as income when you exercise options. Capital gains applies when you later sell the stock for a gain.

Edit: Though I should point out, this is only for non-qualified stock options. If the options are tied to performance metrics, for instance, this may not apply.

Edit 2: See here for a discussion of this: http://www.investopedia.com/articles/optioninvestor/07/esoab...

[emcrazyone]

he can't pay income tax if he's never received the income.

"I will be left with a tax bill on $10,000s of additional "income" that I never received"

[davidu]

Actually, and unfortunately, in the US, that's how it works.

His paper gains are taxed. It's not quite "income" but it's taxed that way.

[limeyx]

That actually depends on if the options were ISO's (where you'd only have to account for the spread in AMT calculations) or non-Quals where yes you'd have to pay regular tax on the spread at exercise time.

If he's really a founding engineer though he should have filed an IRS 83B election and basically paid close to zero tax on all this

[davidu]

Correct.

[swalberg]

You are correct in that capital gains are only triggered at the time of sale. But that has little to do with the OP's problem which is the taxable benefit he gets when buying the shares.

As an employee, if I buy shares of a company at a discount then that discount is taxable income -- not capital gains. Buying the shares as they vest is a way to minimize this tax. The adjusted cost base of the stock is changed to become the fair market value (on which the tax has already been paid) so that when they're eventually sold, the difference between ACB and sale price is a capital gain which only pays half the tax.

In his case he could end up paying taxes at full marginal rate on an inflated amount, and if the company goes under, gets a capital loss that a) doesn't offset the taxes paid earlier and b) is not usable until he gets capital gains elsewhere.

The CRA lets you carry the taxable benefit forward until you sell the stocks. I'd suggest talking to an accountant, not a lawyer. Also see http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/...

[epa]

This is correct for Canada too - Please seek advice of a tax professional and not on the internet however:

In a private corporation where an employee is issued stock options, a taxable benefit exists ONLY when you sell the shares for a profit. Unless this is a public company or a non-Canadian controlled company, you will not face a tax liability. Just make sure both owners and any majority investor is a Canadian resident.

Now - there is another question - when you were given the options, were they in the money at the time. This is to say, were the options priced below the FMV at the time of the option being given to you? If they were not, or there was likely no way to tell at that time (they were worthless, and were priced accordingly which it appears), then you will be eligible for an additional tax credit on the gain (it is approximately 50% of the capital gain, it is substantial). Please do your own research in this regard. Also keep in mind selling shares of a QSBC (Qualified small business corporation) means you get up to $800K in TAX FREE gains, once in your life. This is called the life time capital gains exemption. Please do your research here. You likely will pay no tax at all on the capital gain.

[adekok]

> In a private corporation where an employee is issued stock options, a taxable benefit exists ONLY when you sell the shares for a profit.

I really don't think so. There are many cases in Canada of people getting screwed by buying and selling at the wrong time.

If you buy options and immediately sell them, you have the cash to pay the taxes.

If you buy and hold, you are likely to have tax owing. i.e. buy a share at $0.01, where it's FMV is $1.00. You have $9.99 of either capital gains or income, and you have to pay taxes on that.

If the shares later go to $0.00 in value, well, you might have a non-refundable tax credit. But that doesn't matter when you've paid taxes on value which is valueless.

[epa]

I don't agree. If the shares dropped to nil, you would be able to claim an ABIL (allowable business investment loss) for 100% of the drop in share price.

For example: 1) Your share is worth 0.0001. 2) The company goes bankrupt/insolvent/no longer carries on business 3) You include $10-0.0001 * 50% in your income as employment income for the benefit you recieved from options. The tax base of the shares is now $10. 4) You claim a business investment loss of $10 per share. This can be deducted against all income. This in effect negatives 2x the tax you would have had to pay.

Please keep in mind this does not apply to public companies or large non-small business companies. Only to this example he has proposed. Again i suggest approaching a tax accountant.

[andrewfong]

+1 for talking to a Canadian tax lawyer. Also, you may want to ping company counsel about why he or she advised you the FMV was so low given that there was at least one investor. Maybe there's a really simple explanation that we're not aware of. The first investor may have invested using convertible debt rather than actual shares or options. Some founders (falsely, I think, but it's debatable) believe debt has no impact on the FMV of the company.

[CPLX]

> in the US, you only get taxed when you sell the shares

That's not quite correct with regards to US tax law at least. You can get taxed on the spread between the price you pay and the "fair market value" of the shares received.

It's quite possible to get nailed with an insane tax bill in situations like this. You can end up in a situation where a company raises money at high valuations, and that spread is high, generating a tax bill of hundreds of thousands of dollars on a supposed million dollar spread, and then the company implodes and the shares are worthless, but that tax bill is still there -- leading to a horror story of being taxed on a percentage of the millions of dollars you supposedly got but never realized a dime from. This has happened to real people and is "a very bad thing" to say the least.

[dragonwriter]

> leading to a horror story of being taxed on a percentage of the millions of dollars you supposedly got but never realized a dime from.

If the shares a complete loss and liquidated that way, you also have a capital loss for the millions of dollars which can be applied against income for tax purposes; this may end up somewhat less than offsetting the tax bill depending on your other income because of tax rates; you do end up paying (for employer-provided options) the payroll tax for the spread in any case, but then, the main part of that is limited by the annual cap on SS taxes, so for most of anything in the millions, you'll only be paying, on the payroll tax side, the Medicare portion.

But, in any case, that risk (plus the long term capital gains benefit) is why, if you have confidence in the company, you exercise options as early as possible; you only delay exercise if your confidence in other uses of the money vs. the company's stock is such that the risk that you'll exercise at a point where the tax burden is higher is a cost worth paying for the other use of the money.

(Note also that if you get equity directly instead of in the form of options, you pay taxes -- payroll and income -- on the fair market value at the time you get the equity, too; which is equivalent to an option with a $0 strike price. So, its not like options that you choose whether and when to exercise are any worse in that respect.)

[geoelectric]

In the US, at least, the problem is that you realize the gain in a single tax year, but there's a limit on capital loss writeoffs so you have to spread that over a multi-year rollover. It doesn't balance.

Also, we have AMT (alternative minimum tax) which gets triggered by this kind of scenario--exercise and hold--and really ends up screwing you due to outdated but not updated calculations that assume anyone making over 150k or so is "rich".

[stygiansonic]

> If the shares a complete loss and liquidated that way, you also have a capital loss for the millions of dollars which can be applied against income for tax purposes; this may end up somewhat less than offsetting the tax bill depending on your other income because of tax rates; you do end up paying (for employer-provided options) the payroll tax for the spread in any case, but then, the main part of that is limited by the annual cap on SS taxes, so for most of anything in the millions, you'll only be paying, on the payroll tax side, the Medicare portion.

This depends on the tax jurisdiction; as the OP indicated, in Canada capital losses cannot be deducted against ordinary income, which the difference of (FMV - strike) would be assessed as. (I believe in the US, up to $3,000 of losses can be deducted against ordinary income)

[CPLX]

You can't necessarily offset the tax bill from the gains with the tax savings from the loss. That's the horrible "gotcha" scenario that makes everyone worry, and is in fact a real risk in these scenarios.

I looked around to find a overview of how this works with some case study examples, and this is the best I could come up with in 5 minutes of googling: https://www.sharespost.com/docs/the_stock_option_tax_dilemma...

[jeffbush]

I'm not sure your statement about "capital loss" is correct. I know people who have gotten burned by this. They still ended up writing a big tax check at the end of the year despite having worthless shares. The tax code is definitely not fair.

EDIT: other people have pointed out that capital loss is capped, which makes sense. So while it may be true that you can claim capital loss, my understanding has been that it never compensates for the tax you're already liable for when you exercised.

[davidu]

"but in the US, you only get taxed when you sell the shares. Capital gains would not be recognized if you exercised the options and held onto the shares."

In the US this is a completely false statement.

As the FMV increases of your exercised options, you are responsible for paying taxes at the /time of exercise/ between the strike price and the FMV of that stock.

Once you pay those taxes, you do not need to continue to pay taxes as the FMV increases. The reason you pay at exercise is because you are exercising options that are already "in the money" even though you obviously have not yet realized that actual gain since you didn't sell the stock.

Sucks, but it's the way it is.

[limeyx]

Thats only true for non-qualified options.

ISO's were specifically designed to get around this issue (but you may still get hit w/AMT on the spread)

[akgerber]

At least in the US, AMT can apply even when capital gains taxes don't. The exact conditions are very complicated.

[ksherlock]

In the .bomb era, some people exercised their options and kept their shares. When April 15th rolled, around they had a massive tax bill and now-worthless stock -- because the discount is treated as income but capital losses are limited to $3,000 a year.

[aggieben]

Yep, this is the right answer: don't panic, lawyer up.