The federal budget has key changes that will impact ownership and disposition of employer stock options.

For those of you with clients who participate in public company employer stock option plans or whose investment portfolios currently include shares acquired under such plans, last month’s federal budget included some important changes that may affect strategies relating to ownership and disposition of such shares.

First let’s look at clients considering exercising their employer stock options. Since 2000, people have been able to elect to defer taxation of the stock option employment benefit—arising from the exercise of employer stock options—until the shares were sold. Although an attractive opportunity for many, it also carried risk. If the shares declined in value after exercise, the employee was left with a capital loss that could not offset the employment income inclusion. In some cases, the related tax liability was greater than net sale proceeds.

Well, that won’t be a problem any longer since the ability to defer tax on stock option benefits has been eliminated for options exercised after 4 p.m. on budget day (March 4, 2010).

Further, to ensure tax on stock option benefits is collected on a timely basis, beginning 2011, employers will have to withhold and remit tax on the net stock option benefit at the time the options are exercised. This would likely mean employees will, at minimum, sell sufficient shares upon exercise to cover the tax on the employment benefit that arises upon exercise.

But for clients who have previously made a deferral election and continue to own option shares that have declined significantly in value, the budget provides some relief. The deferral continues to apply until the shares are sold but there is a special election available in the year of sale – for sales before 2015 – that will limit the related tax liability to the proceeds on sale.

Under this election, your client pays a special tax equal to the proceeds on sale; the employment income benefit is eliminated; and a taxable capital gain, equal to the lesser of one-half of the employment benefit and the capital loss, is included in income. The election only makes sense if the tax liability in relation to the sale of the option shares is greater than the sale proceeds, and your client can’t benefit from what would otherwise be the capital loss on the sale by applying it against taxable capital gains.

Say your client, Romeo, deferred an $80,000 employment income benefit ($110,000 FMV at exercise less $30,000 exercise price) in relation to employer company shares that he still owns. The shares are now worth $10,000. If he makes the election on the sale of the shares, he will pay the special tax of $10,000; there will be no income inclusion in relation to the employment income benefit; and he’ll have an allowable capital loss of $10,000 ($50,000 in relation to the disposition less $40,000 taxable capital gain resulting from the election).

Without the election, he’d have $18,000 of tax to pay in relation to the employment income inclusion ($80,000 employment benefit less $40,000 deduction x 45% tax) and $50,000 allowable capital loss.

If he had other taxable capital gains in the year of sale – say $50,000 under the election – he’d be able to save an additional $4,500 by using the allowable capital loss, resulting in a net tax liability of $5,500. However, without the election, he’d save $22,500 ($50,000 x 45%), resulting in a net tax savings of $4,500.

And to provide the same opportunity to individuals who suffered significant economic loss from the sale of tax-deferred stock option shares before 2010, a retroactive election is available, but it must be made by the filing due date for 2010 returns.

Before deciding to take advantage of this new election, it’s critical your clients determine if the capital loss on the disposition of the shares can be used currently or within a year or two. There is no benefit in paying the reduced special tax if the total cost in the near term ends up being higher.

Gena katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge