Canadian Startup Stock Options: US Tax for US Residents

How does the US tax stock options from a Canadian startup?

A US resident is taxed on options from a Canadian corporation under the same US rules as options from a US company. The company's country does not change the answer; the option type and your working relationship do. Most Canadian startup options are nonqualified stock options (NSOs): nothing is taxed at grant or vesting, and the spread at exercise (share value minus exercise price) is ordinary income (Publication 525; 26 CFR 1.83-7).

The general ISO and NSO rules are in exercising startup stock options. A Canadian option is not simple when:

• You worked in Canada between grant and exercise. Both countries may tax part of the same spread.
• The company calls them ISOs. A plan written for Canadian rules may not meet section 422, and the label alone does not make them ISOs.
• You work through an employer of record or as a contractor. ISO treatment generally needs direct employment, and nobody may report the income to you.
• You hold the shares after exercise. Shares of a foreign corporation can bring Form 8938 and PFIC questions.

Gather: the plan document, your grant letter (option type, grant date, exercise price, vesting), your employment, contractor or employer-of-record agreement, each exercise confirmation with the share value used, the exchange rate for each date, any Canadian tax slip, and a count of days you worked in each country from grant to exercise.

Can a Canadian company grant ISOs, or are they NSOs?

A Canadian corporation can grant incentive stock options (ISOs): the ISO regulations define "corporation" to include a foreign corporation (26 CFR 1.421-1(i)). The options are ISOs only if the plan and each grant meet every condition of section 422. Miss one and they are NSOs.

Stricter price and term limits apply to large shareholders. ISOs that first become exercisable in one calendar year above US$100,000 of share value (measured at grant) are treated as NSOs. If the grant letter does not say "incentive stock option", ask the company before treating the options as ISOs.

Does it matter if I work through an employer of record or as a contractor?

Yes. An ISO must be granted to an employee of the issuing corporation or a related corporation, and employment is tested under the federal income tax withholding rules (26 CFR 1.421-1(h)). A contractor is generally not the Canadian startup's employee, so a contractor's options are NSOs. A worker hired through an employer of record is on someone else's payroll, but can still be the startup's common-law employee if the startup controls how the work is done (26 CFR 31.3401(c)-1).

Whether someone is an employee depends on the facts of the working relationship, not only the contract. Treat employer-of-record options as NSOs unless the company has a written analysis concluding otherwise.

The relationship also decides how the NSO spread is taxed:

When are Canadian startup options taxed: at grant, at vesting or at exercise?

NSOs in a private startup are taxed at exercise. An option that is not traded on an established market has no readily ascertainable value, so it is not taxed at grant or at vesting (26 CFR 1.83-7). At exercise, the spread is income in that tax year.

Two refinements apply:

• Unvested shares. If you exercise early and the shares are still subject to vesting, the income is generally measured when the shares vest, unless you file an 83(b) election.
• Discounted price. An NSO granted with an exercise price below the share value at grant is deferred compensation under section 409A, unless an exception applies. The spread can then be taxed before exercise, plus an additional 20% tax and interest (26 CFR 1.409A-1(b)(5); 26 U.S.C. 409A(a)(1)). Ask how the company set the price; a Canadian valuation may not follow the US rules.
• Currency. Report in US dollars. Translate Canadian-dollar amounts at the exchange rate on the date of each event (IRS currency rules).

ISOs are not taxed at exercise for regular tax, though the spread enters the AMT calculation.

Can I file an 83(b) on Canadian startup options?

No, not on the option itself. Section 83 does not apply to the grant of an option without a readily ascertainable value (26 U.S.C. 83(e)), so there is nothing to elect on at grant.

An 83(b) election is available for shares you receive by exercising early while they are still unvested. You file it within 30 days of the exercise, and the same rule applies whether the issuer is Canadian or American. A different election, under section 83(i), lets an eligible employee defer NSO income for up to 5 years, but only if the company's plan grants options to at least four in five of its US employees on the same terms (26 U.S.C. 83(i)). The timing, cost and risks are in early exercise of startup stock options.

Can exercising Canadian startup options trigger AMT?

Only ISOs create the stock option AMT adjustment. When you exercise an ISO and keep the shares past year end, the spread is added to income on Form 6251 line 2i, even though regular tax ignores it (Form 6251 instructions; Publication 525).

NSO spread is already ordinary income for regular tax, so an NSO exercise does not create that adjustment. Because most Canadian startup options are NSOs, settle the option type first. If they are true ISOs, see AMT on incentive stock options for how much you can exercise before AMT starts.

Does Canada tax or withhold when I exercise?

A US resident who never worked in Canada generally owes Canada nothing on the exercise. Canada taxes a non-resident's employment income only for duties performed in Canada (Income Tax Act, section 115(1)(a)(i)), and the CRA lists security option benefits as part of that Canadian-source employment income (T4058).

If you worked in Canada for part of the period, the Canada–US treaty splits the spread. Each country, as the source country, may tax the share of the income equal to the days your principal place of employment was there, out of the days you were employed between grant and exercise (Treasury technical explanation, General Note paragraph 6). The US, as your country of residence, taxes the full spread and gives a foreign tax credit for the Canadian tax on the Canadian share.

Three traps:

• Different years. For options from a Canadian-controlled private corporation, Canada includes the benefit when you sell the shares, not when you acquire them (CRA). The US taxes NSOs at exercise, so the credit may have to be matched across years.
• Different periods. The US's own sourcing rule generally looks at grant to vesting, not grant to exercise (26 CFR 1.861-4). Check which period applies before you compute the credit.
• Wrong withholding. Canadian tax withheld when none was owed is not creditable in the US (26 CFR 1.901-2(e)(5)). You recover it from the CRA with a Canadian return.

The day-count method and the move year are covered in stock awards and pay after a move.

Who reports the income, W-2, 1099 or nobody, and how do I pay the tax?

An employee should get a Form W-2 showing the NSO spread in boxes 1, 3 and 5 and in box 12 with code V (Publication 525). Social Security and Medicare cover work done in the US whatever the country of the employee or the employer (26 U.S.C. 3121(b)), so a Canadian employer of a US-based employee is not outside the US payroll rules. Employers may withhold income tax on the spread at a flat 22% (Publication 15), which can fall short of your actual rate.

A contractor may receive a Form 1099-NEC or no form at all. Either way, the spread is income: the Form 1040 instructions require you to report earnings even when no Form W-2 arrives.

When too little is withheld, pay the difference through estimated tax payments. They are generally required if you expect to owe US$1,000 or more after withholding and credits. Payment dates and penalties are in exercising startup stock options.

Once I own the shares, do I file Form 8938 or Form 8621?

Possibly both. Shares of a Canadian corporation held directly, not in an account at a US financial institution, are a specified foreign financial asset for Form 8938 (Form 8938 instructions). A US resident files Form 8938 when total foreign assets exceed these thresholds:

The same instructions list options with a foreign issuer among reportable assets but do not address unexercised employee options directly; ask whether yours count. The FBAR covers accounts, such as a securities account at a Canadian broker (31 CFR 1010.350), not shares registered with the company. Thresholds and penalties are in foreign account reporting.

Form 8621 applies if the company is a passive foreign investment company (PFIC). A foreign corporation is a PFIC in a year when 75% or more of its gross income is passive, or at least 50% of its assets produce passive income (Form 8621 instructions). Interest is passive income (26 U.S.C. 954(c)), so a pre-revenue startup living on interest from raised cash can meet the income test. A start-up year exception may apply (26 U.S.C. 1298(b)(2)), and section 1298(a)(4) allows regulations to treat an option holder as owning the shares. Ask the company each year whether it has tested its PFIC status. No annual Form 8621 is needed for a year in which all your PFIC stock is worth US$25,000 or less (US$50,000 on a joint return) at year end and you sold none and received no excess distribution.

How is a sale taxed, and does QSBS apply?

For NSO shares, your basis is the exercise price plus the spread already taxed, and the holding period starts when the shares are vested and transferred to you (26 CFR 1.83-4). The gain above that basis is a capital gain, long-term after more than a year. If the company is a PFIC, the gain can instead fall under the PFIC excess-distribution rules, unless you made a qualified electing fund election on Form 8621, which needs an annual statement from the company (Form 8621 instructions).

QSBS does not apply. Section 1202 requires shares of a domestic C corporation (26 U.S.C. 1202(d)). If the startup later moves under a Delaware parent, the question changes; see moving a Canadian startup under a Delaware parent.

Example

All figures are illustrative and in US dollars.

Seattle engineer hired directly

A Vancouver startup hires an engineer living in Seattle and grants 20,000 options at $0.50. The plan was never approved by shareholders, so the options are NSOs. The engineer exercises when shares are worth $3. The $50,000 spread is US wage income in the exercise year, and Canada has no claim because no work was done in Canada. No AMT adjustment arises.

Same grant through an employer of record

The same engineer works through an employer of record instead. The options are still NSOs because the plan was never approved, and the engineer may not count as the startup's employee either. The $50,000 is still taxable at exercise. If neither company reports the spread, the engineer still reports it and makes an estimated payment.

One year in Toronto, then Austin

An employee is granted NSOs on January 1 while working in Toronto. The options vest two years later, on December 31 of the second year, and the employee exercises that day. The spread is $40,000.

• Year 1: works in Toronto. Nothing is taxed in either country.
• Year 2: moves and works in Austin all year, then exercises on December 31. Half the days from grant to exercise were in Canada, so Canada may tax $20,000. The US taxes all $40,000 and allows a foreign tax credit for the Canadian tax on that $20,000, within the credit limits.
• If the startup is a Canadian-controlled private corporation: Canada taxes its $20,000 share in the year the shares are sold instead, so the credit is matched to a later year.

Different for you?

• You live and work in Canada: see stock options for employees in Canada.
• You moved between the countries while the options vested: see stock awards and pay after a move and get cross-border tax help, because both countries may tax the same spread in different years.
• Your options really are ISOs: check AMT on incentive stock options before you exercise.
• You are leaving the company: see exercising stock options when you leave a startup.
• The company may be a PFIC, or you missed Form 8938 or Form 8621: get cross-border tax help; see foreign account reporting.
• You may move states before a sale: see moving to another state before selling startup shares.