What happens when an employee exercises their options?
When an employee chooses to exercise their options, they must inform the company in writing and pay the exercise price as stated on their option agreement. Shares are then issued at Companies House and the employee becomes a shareholder of the company.
Options granted to employees must be available to be exercised by the employee within ten years to qualify for the tax benefits made available under the EMI scheme. Options may remain exercisable after this time, but the tax benefits will no longer apply.
In most cases the exercise price paid by the employee is the same as the market value agreed with HMRC at the time the option was granted. In these cases there will be no income tax liability upon exercise. However, in cases where the options were granted at a discount and the exercise price was less than the market value, there is income tax liability on the employee at the time of exercise.
If an option is disqualified, any increase in market value of the shares that has occurred between the date when the options were granted and the date of the disqualification remains exempt from income tax.
National Insurance Contributions are payable if exercising the options results in an income tax liability and the shares can be classified as readily convertible assets (ie. if they can be sold on a stock exchange or other arrangements exist that would enable the employee to sell the shares for cash).
If the employee sells the shares to a third party, they will have to pay capital gains tax on any gains made: ie. on the difference between the sale value and the amount they initially paid for the shares at exercise. But if at least 12 months have passed (or 24 months if the options were granted during or after April 2019) between the date of grant and the onward sale of the shares, any capital gains will be taxed at a discounted rate of only 10% because the employee will qualify for Entrepreneurs Relief.