Granting Share Options to employees is a great way to incentivise and retain key people in a business and provides a practical alternative to making an outright award of shares. Doing this is not a new concept, and these schemes have been around for years.
But with the rapid rise in employers providing Restricted Stock Units (RSUs) over the last decade as an alternative, are Options still relevant? And, if you pardon the pun, are they sometimes the better option?
We have covered RSUs in various articles and so in this article, we will focus mainly on Share Options.
Why not issue shares?
When a company issues shares to an employee, the employee is deemed to receive a reward equal to the market value of the shares. For mature businesses, this can create a significant tax liability for the employee as well as an employer’s national insurance liability for the business. For growing businesses, it may be possible to argue a low market value of those shares, but that not only comes with risk, it also does not create an incentivised environment for the employee – they have just been awarded something without potentially having to do much for it.
This is where options come in. They offer the chance of becoming a shareholder without the up-front costs.
What is a Share Option?
A Share Option provides the employee with the opportunity/right to purchase shares in the future. When the Options are Granted, a set price for the future purchase will be agreed upon – the Strike Price. The main incentive is, therefore, that by the time the Options are Exercised, the market value of the shares that they acquire under their option is greater than the strike price. This provides the employee with a discount and the employer with a way of providing an equity interest in the business in the future without actually giving away an interest immediately.
Most option schemes come with additional conditions for the employee to be able to exercise their option and acquire shares. Usually, they include one or more of the below:
- They can only be exercised when the company is sold or listed on a market;
- The employee must meet certain performance conditions; and/or
- A period of time must have elapsed since the options were granted for the employee to be able to exercise the option.
Importantly, employees who hold Options have no voting rights or rights to a dividend – they will only become eligible if and when they exercise their options and obtain the shares. And perhaps not even then. Many businesses create a separate class of shares for the employee to have options over that do not include a right to vote or a dividend. In essence, the employee will only benefit if and when the company is sold or there is a share buyback scheme at some time in the future.
How are Options Taxed?
For tax purposes, there are broadly two categories of share options: Approved and Unapproved schemes. The term ‘approved’ simply means that the option scheme meets the criteria laid down by HMRC for the employee and employer to obtain particular tax benefits.
Importantly, in both cases, no income tax or NIC is due on the grant of an option. This means that neither the employee nor the employer can be liable to tax until the Options are actually Exercised.
Unapproved Options
When an unapproved option is exercised, income tax will be payable on the difference between the strike price and the market value of those shares at that time. The difference can sometimes be very large, especially if the company has grown significantly between the grant and exercise of the option or if the strike price has been set much lower than the market value at the time of the grant.
Whilst it is true that many options will give the power to exercise the option to the option holder, therefore giving them the benefit of controlling the timing of the exercise, some do not and simply trigger at a point in time or when certain conditions are met. As the tax must be paid in cash, the employee must settle this out of personal funds. Often, this is achieved by the employer withholding a certain number of shares, which it sells on the market to generate the revenue to pay the tax on behalf of the employee under PAYE. This is not often possible for businesses that are not listed. So, for SMEs and start-ups, unapproved options may not be appropriate – but what of approved schemes?
Approved Options
The main benefit of approved schemes over unapproved schemes is that no income tax or NIC liability arises when the option is exercised, as long as the strike price is at least equal to the market value of the shares under the option at the time the option was granted.
A quick example for a 40% taxpayer illustrates the benefits of an approved scheme. Let’s say they are issued an option with a strike price of £500 (which is the market value of the shares at the time of grant). Five years later, the employee exercises their option and pays the strike price. At the time the options are exercised, the shares under the option are now worth £20,000. Under an approved scheme, the employee will have an income tax liability of £7,800 (40% of £19,500), plus a potential NIC liability if certain conditions are met. If the option was an approved option, there would be no tax to pay at all!
Of course, the Government are not going to let the employee earn this value for free – they are not that generous. But the increase in value will never be taxed to income tax – instead it will be chargeable to capital gains tax when the shares are eventually sold. Where capital gains rates are lower than income tax rates, this is a massive benefit.
Enterprise Management Incentive Schemes
Easily the most common approved options scheme, the Enterprise Management Incentive (EMI) allows the employee to be granted up to £250,000 worth of options over a three-year period, again subject to various conditions. Further tax incentives apply to EMI, for example, the ability to claim Business Asset Disposal Relief (BADR) if the options have been held for at least 2 years, which can reduce the tax payable on sale to just 10% on the first £1 million of lifetime qualifying gains.
Capital Gains Tax
In both cases, if the shares are sold in future, Capital Gains Tax (CGT) may be due, or potentially income tax in some circumstances.
For more information on employment related securities and section 431 election, click here.
Who is liable to the tax?
If no ready market exists, the employee will be responsible for paying the tax under self-assessment following the end of the tax year, and they will have to ensure that they have the cash to pay this personally.
National Insurance
If there is a ready market for the shares, i.e. they are Readily Convertible Assets (RCAs), the employer will be liable to collect that tax and NIC under PAYE at the time the shares are granted. They may offer a sell to cover scheme which releases the cash value of some of the shares to pay the taxes due.
Restricted Stock Units (RSUs)
RSUs fall somewhere between Options and Outright Share Awards. Because these usually come with restrictions (hence the name), income tax does not arise until the point the restrictions lift and the shares vest. Unlike an Option, though, there is no flexibility over the timing on the employees’ part – there will be a vesting schedule, and the units will vest in accordance with that, whether it is at the most tax-efficient time or not. You can read more about RSUs here or watch our RSUs video here.
So why issue Options?
Options are a great way of incentivising employees to perform in the way a business wants them to. But it is not just about the employer – both win! The employee gets rewarded with a share of the business they have helped build, and the employer gets a highly motivated employee that helps drive the growth of the business. The question is what type of option to use or whether an RSU is more practical.
What next?
To discuss how Share Options might work for you, please contact the Gravita Tax Consultancy team here for more detailed advice.
