Shares can be offered as a performance incentive (the better you do, the more shares you are eligible to buy) or as remuneration in lieu of a higher salary.
They are particularly popular amongst start-up businesses, or businesses in a growth phase, where cash is often tight so the best way to attract and retain key talent can be to offer shares as a form of remuneration. That way, the employee can see that they are getting real value, even if they can’t immediately access it.
There’s a performance incentive too; to the extent that they deliver on their goals, they add value to the company and some of that value flows straight back to them in the form of a higher share price.
However, there are tax consequences. Typically, employees get stung for tax on the market value of those shares (less the amount they paid for them) from the date they acquired them. This is known as the “discount”.
The problem with that arrangement is that they have to pay tax on an asset that they haven’t yet realised, so cash flow can be a real concern.
This discount is included as assessable income in your tax return. The terms of when the market value is measured, and whether tax concessions may apply, vary depending on the exact nature of the employee share scheme.
Let's break it down
For example, say your employer issues you shares that are worth $100,000, but you only pay $80,000 for them. The “discount” of $20,000 is included in assessable income in the year you received the shares.
When you ultimately sell the shares, you make a capital gain which needs to be included in your tax return. Using the example above, the cost base of the shares that you acquire is $100,000.
Let’s say that sometime later, you sell the shares on the open market for $120,000. You have made a capital gain of $20,000 – if the date of sale is at least 12 months after the date you became the owner of the shares, you can discount this by 50% but if the date of sale is less than 12 months after the date of purchase, no discount is available.
The problem is that the employee often needs to sell the shares very soon after the acquisition in order to pay the initial tax bill on the discount, so in practice, very few people get to take advantage of the CGT discount.
If you sell the shares within 30 days of acquiring them, the entire profit on sale is subject to income tax. Using the example above, if you sold within 30 days, you would be subject to income tax (not CGT) on the entire profit (which is $40,000, or $120,000 less $80,000).
This might not seem attractive – you can wave goodbye to the CGT discount – but it could be advantageous if you sell the shares for less than you acquired them for as the resulting loss can be offset against any other income (whereas a capital loss can only be offset against any other capital gains).
The fine print
In some situations, tax concessions can apply. To be entitled, you must not:
- Hold over 10% ownership of the company; or
- control more than 10% voting rights in the company.
There are then a series of specific conditions depending on the precise details of the employee share scheme that the employer offers.
If available, potential tax concessions can include:
- Start-up concessions: These apply where the employer is a start-up company, and you meet the 10% ownership and voting rights test, you can reduce your taxable discount to nil, however you will be subsequently assessed under the capital gains tax provisions when your interests are sold;
- $1,000 discount on taxed-upfront schemes: This applies where your taxable income is under $180,000 and you meet the general condition on ownership and voting rights referred to above; or
- a deferred taxing point: Usually applies where there are restrictions on what you can do with the shares, meaning the taxing point is deferred until the restrictions drop away.
Employee share schemes are complex, so if you are a beneficiary of shares from your employer, the best option is to talk to a tax professional, like those at H&R Block, to understand your tax liabilities and the disclosures you need to make in your tax return.
Mark Chapman is the director of tax communications at H&R Block (NYSE:HRB). As well as operating his own private practice, Mark spent seven years as a Senior Director with the Australian Taxation Office. Mark is a Chartered Accountant, CPA and Chartered Tax Adviser and holds a Masters of Tax Law from the University of New South Wales.