In Canada, it is not uncommon for employers to grant stock options to employees as a form of compensation, notably in technology and startup sectors. These stock options provide employees the right to purchase company stocks at a predetermined price, often referred to as the “exercise price.”

What are the tax implications of these stock options when the employee dies while holding unexercised stock options? The tax treatment on death is complex and differs from the tax treatment during the individual’s lifetime.

During an employee’s lifetime, stock options are generally taxed when exercised. The difference between the fair market value of the shares at the time of exercise and the exercise price is considered a taxable employment benefit. This amount is added to the employee’s income in the year of exercise.

Taxation on Death

However, on death, different rules apply to ensure that outstanding stock options do not escape taxation.

If the employee dies while holding unexercised stock options and the unexercised options do not expire upon death under the option agreement, they will be deemed to have exercised the option at the value immediately after death. This will result in a taxable employment income for the deceased individual[i] to be included in the deceased’s terminal return. This may result in a significant tax liability.

To alleviate some of the tax burden, the deceased may be eligible for the stock option deduction[ii] equal to 50% of the taxable benefit. Interestingly, the two-year holding period requirement for the 50% deduction is waived on death[iii] as long as all criterias are met, notably that the employer elect not to take the deduction for the payment to the employee (see subsection 110(1.1).

The executor must act quickly to exercise and sell the shares. Otherwise, because of the deemed disposition rules resulting in deemed taxable income, the estate could be facing a cash flow problem; taxes are payable, yet no proceeds have been received.

Another reason why the executor must act promptly is because some stock option plans may require the option to be exercised within a limited time after death (e.g., 90 or 180 days). Upon learning that the deceased had stock options, the executor should seek to see the terms of the stock option plan in order to act accordingly.

[Note: If dealing with U.S. stock options (acquired while working for a U.S. employer), one cannot ignore the U.S. taxation of employee stock options and the Canada-U.S. Tax Treaty provisions. This will require cross-border tax advice.]

 [i] equal to the FMV of the shares minus the amount paid to acquire the options (see paragraph 7(1)(e)).

[ii] under subsection 110(1)(d) of the Income Tax Act.

[iii] See subparagraph 110(1)(d.1)(ii).