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Published on
June 5, 2024
Cashless exercise, secondaries, and taxes
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The usual process of cashing out the employee stock options (ESOP) is done in two steps:
- exercising stock options, that is, buying shares in the company at predetermined conditions and price,
- selling the shares to an interested buyer at a suitable price.
Between these two steps, there can be a shorter or longer time period, depending on the shareholder’s wish or possibility of selling his shares.
The shares might not be sold right after the exercise because of restrictions in the share purchase agreement. Share purchase agreement is a legal document used to transfer ownership of a company's shares from the seller to the buyer.
Tax reasons can also delay the sale as some rules for more favourable tax treatment may require holding the shares. Such requirements might not be even related to stock options but rather an incentive to encourage long-term investments.
What is cashless exercise?
Cashless exercise in the context of employee stock options means that the exercise of options and the sale of shares take place at the same time. Often within the same transaction.
It is also called a ‘same-day sale’.
It typically happens during secondary sales, where it can even be talked about as ‘selling your options’ regardless of the fact that stock options normally cannot be directly sold, and there are still these two different steps that should be taken - exercise of options and then selling the shares.
However, sometimes, it is best to take advantage of the cashless exercise despite the tax costs because the moment is right or the price is attractive.
Here are a few things to pay attention to regarding taxation.
Cashless exercise does not mean some steps will be skipped
Even if the exercise of options and the sale of shares happen simultaneously, these two transactions should still be distinguished for legal and tax purposes.
The exercise of options and the sale of shares both have different legal and tax consequences. By exercising options, the promise of getting a share in a company becomes real—the employee becomes a shareholder with certain rights and obligations.
From the tax perspective, if the shares are offered at a discounted price compared to what they would cost in an open market, the discount is considered a receipt of benefit from the employer. In the tax world, it is called a ‘fringe benefit’ or ‘benefit in kind’.
Almost everywhere, such benefits are taxed in the same way as salaries, as they are typically part of the employee’s remuneration. So, even in the case of a ‘cashless exercise, ' the discounted price creates a benefit, and tax obligations cannot be forgotten.
Cashless exercise does mean getting actual cash
When exercising stock options, the option holder must pay a certain predetermined price to purchase the shares.
The price is usually agreed upon when options are granted. Tax rules may set price requirements, especially if tax relief is offered. Therefore, the exercise price can be zero or lower than the market value of the shares, but sometimes, it has to be equal to the market price.
Cashless exercise alleviates the issue of finding the money to pay the exercise price. In cashless exercise, you don’t have to pay the exercise price as it will be covered by your income from the sale of shares.
There are different ways to set up the cashless exercise, such as through a loan settled by the selling price or without it. The point is to ensure that the profits from the sale cover the purchase cost and also possible taxes on the share benefit.
Thus, there is no need to invest a significant amount of money indefinitely until the sale and to take the risk of the share price falling.
However, you must ensure that the purchase costs, including possible taxes at the exercise, would not exceed the proceeds from the sale.
Tax base is different for exercise and sale
The exercise of stock options is the most common point of taxation in most countries. Only a few countries allow postponing the tax until later, under specific conditions.
However, the benefit arising from stock options doesn’t immediately translate to cash gains. The tax obligations on the benefit are often referred to as ‘dry taxes’ due to the absence of available liquidity for payment.
The taxable benefit is determined by the difference between the market value of the shares and the discounted price offered by the employer. The benefit is typically calculated based on the fair market value of the shares, from which the exercise price or any related expenses can be deducted.
When the exercise price matches the market value, there is no taxable benefit and no taxes due. However, the larger the difference between these values, the higher the taxable benefit and the subsequent tax liabilities.
Tax obligations upon exercise typically mirror those on regular salaries, including income tax and social security contributions.
The sale of shares, if profitable, creates a capital gain.
The tax base for capital gains tax is the difference between the purchase price and the sale price of the shares.
So, knowing and being able to prove the purchase price of the shares is essential for tax calculations. This price is usually set in the grant agreement but may be adjusted for additional expenses, such as reimbursement of employer tax obligations if this is the case.
Some countries’ tax rules allow for favourable treatment if the exercise price is not too low or at least equal to the market price at grant (Belgium, Ireland, the UK).
If the exercise price is zero, there is no purchase price. In such cases, the entire sales price is taxed as a capital gain.
Many countries also allow transaction fees or other related expenses to be deducted from the sale price to reduce the taxable amount. Thus, keeping track of and documenting all fees paid or deducted from the gain is important.
Fortunately, double taxation is not normally an issue with social security contributions, as these are very rarely applied to capital gains.
Tax rates vary for benefits and capital gains
While the benefit from exercising the options is usually taxed at the same rates as employment income, the capital gains from the sale of shares are often taxed at a separate rate.
The recent report from the OECD on taxation of labour vs capital income shows that in most countries, one or more of the following is true:
- income sale of shares is taxed at one single rate (flat rate) compared to income from employment, which is taxed at progressive rates (like in Latvia)
- income from capital gains is taxed at more favourable progressive rates than wage income (like in Lithuania)
- taxpayers can choose their tax rate for capital gains - either a flat tax rate or their respective progressive rate, whichever is more favourable (like in France)
- long-term capital gains are taxed at more favourable tax rates compared to wage income (like in Slovakia)
- some countries don’t tax capital gains from the sale of shares (like in Belgium)
- almost all countries do not tax capital gains with social security contributions, unlike employment income.
Tax Foundation has a list of tax rates on capital gains here.
Tax is paid twice but normally not on the same income
Some countries give tax reliefs for the employee share plans so that the tax obligation occurs only once. Typically the tax is postponed until the sale of shares. Conditions may include obligation to notify tax authorities of the option plan or certain holding period of the options (e.g in Estonia, it is three years).
However, many countries do tax income from stock options twice – first, at exercise and then again, at sale. But countries’ tax laws are typically designed in a way that double taxation of the same income does not occur.
To be able to avoid double taxation, the benefit that is already taxed at exercise should be taken into account when taxing the proceeds of sale.
For example, an employee had an option to buy 1000 shares in a company at the price of 5 euros each. The market value of the shares at the time of exercise is 8 euros per share. So the employee's benefit is 3000 euros (8000 - 5000), and it is taxed, let’s say, at a rate of 25% as income from employment.
We can imagine that the buyer of shares is ready to offer a slightly higher price, for example, 9 euros per share. In such a case, the employee will get 9000 euros for the sale of shares. As the exercise price was 5 euros per share, his purchase price was 5000 euros. A simple computation of the capital gains would result in 4000 euros being taxed with a capital gains tax of 15%.
But we know that part of this gain, the 3000 euros was already taxed as a benefit from exercise. The fair tax rules will take this amount into account, so that the taxable capital gain will be 1000 euros – the difference between the sales price of 9000 euros, the exercise price of 5000 euros, and the taxed benefit of 3000 euros.
In practice, the price offered for the sale of shares may sometimes be lower than the market value. This is particularly evident in cashless sales, where the purchase and sale happen simultaneously. In such case, it is important to note that there might not be any taxable capital gain.
In the same example, if the sale price of the shares were 7000 euros instead of 9000 euros, the would not be any gain to tax.
So, it is important to check the rules for calculation of the capital gain in a particular country and to make sure that the previously taxed amounts can be taken into account.
Losses from the sale of shares may be deductible
At the exercise, if the price is higher than the share's market value, there is no benefit from the exercise. No taxes must be paid, but the exercise of options into shares may not be reasonable, especially when the sales price of the cashless exercise is also lower than the exercise price.
At sale, however, if the sales price of shares is lower than the purchase price, the shareholder suffers a loss, which may be used to reduce the tax from other gains.
Some countries allow the loss to be deducted from the gains of other share transactions. If there are no other gains in the same tax year, some countries allow this loss to be carried forward to the next year or even further.
Thus, even if the cashless exercise does not promise the expected gain, there is a silver lining to this cloud, which could be checked with local tax advisors as this is a legal way of reducing the tax bill.
The content provided by our team in Salto X can assist you in making informed decisions regarding employee incentives. However, it is important to note that our guidance and support should not be construed as legal, tax, accounting or financial advice as this requires more information on your personal circumstances.
