Limited Company: Investment Options

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'Share options' are not shares, but the right to purchase shares at a future date, at a predetermined price. Share options work as a reward for founders and employees if there is an increase in the Companys share value. In the context of contractors who setup Limited Companies, share options can be a source of wealth creation. In this article of "Path of Education for New Contractors", we look specifically at share options for Directors of Limited Companies in detail.

Director share options in detail

At the time of setting up, a Limited Company has to issue a number of shares to the Directors. Along with shares, a Company can issue share options. These are not actually shares, but a contract to purchase shares at a predetermined price within a set period. When exercised, share options get converted into normal shares. A Company can restrict the exercising of options only upon fulfilling to certain conditions; for example, the share price has to go above a certain value.

Example 1: As a Director of a Limited Company, you may issue 1,000 shares of £1 each. Along with the shares, you may issue share options of 2,000 additional shares if the Companys share price goes above £3. The share options will have an expiry date of let's say 31st March, 2018. Suppose by 2016, if the Company's share price exceeds £3, you can then exercise the option to get 2,000 additional shares at the original price of £1. However, if not exercised by the expiry date, the share options will expire.

Advantages of share options:

No cost: Directors do not have to incur any cost to issue share options. If they want to issue shares in the beginning, they will have to invest capital. As you can see in the above example, if you had to issue 2,000 shares instead of share options, this would have required an additional investment of £2,000.

Reward for risk: For Directors, share options can be a reward for the risk of setting up a Limited Company. In the early stage, the Directors may not even be able to offer themselves a high salary. Share options allow the Directors to grow their wealth if the Company starts growing.

Savings of Tax and National Insurance: If share options are provided under certain tax-friendly schemes, the Company doesn't have to worry about income tax and National Insurance contributions. In addition, Directors don't have to pay tax and National Insurance on share options. Continuing with the above example, the Directors don't have to pay any tax or National Insurance on the issue of 2,000 additional shares.

Methods of Awarding Director Share Options:

Broadly, share options can be awarded in two ways:

Approved
Unapproved

Approved schemes are approved by HMRC and provide tax savings both to the Company and to the Director. Unapproved schemes do not provide any tax savings.

Approved Schemes:

Within approved schemes, there are two major methods for awarding Director share options:

Enterprise Management Incentive (EMI) Options
Company share option plan (CSOP)

Enterprise Management Incentive (EMI) Options:

EMIs are the most beneficial in terms of tax benefits, among the various methods of issuing share options. However, there are certain criteria for a Company to be able to issue EMIs.

Criteria for Companies to issue EMIs:

The Company should not be dealing in certain businesses, which are ineligible for issuing EMIs. Some of these businesses include land, financial trading, leasing, development of property, and shipbuilding, amongst others.
At the time of issuing of share options, the value of Companys gross assets should not be more than £30 million.
The Company should be an independent Company and not be a subsidiary of another Company.
The Company should not have more than 250 employees.
The Company cannot award share options worth more than £3 million in total or £120,000 per employee.
All employees, including Executive Directors of Companies, can be issued EMIs.
EMIs cannot be issued to employees who own more than 30% of ordinary share capital, either directly or indirectly through spouse, children, parent and other close relatives.
You can issue EMIs only to employees who spend minimum 25 hours a week working on the Companys business.

Tax treatment of EMIs:

Neither the Company nor Director have to pay any income tax or National Insurance contribution when EMIs are issued.
Also, there is no tax or National Insurance at the time of exercising the EMIs as long as they are not exercised below market price.
When shares are sold after 12 months, the capital gains tax on EMIs is lower than other methods of issuing share options.

For Companies that qualify for EMI, this is the best method of awarding Director share options. If not, Companies can choose another approved method - Company Share Option Plans (CSOPs).

Company Share Option Plans (CSOPs):

Similar to EMIs, CSOPs can be offered to a few staff in a Company. Listed below are some key requirements for issuing CSOPs.

Before the implementation of CSOPs, Companies should get approval from HMRC.
Companies should be independent or not controlled by another Company.
Only Executive Directors who work for a minimum of 25 hours every week for the Company are eligible for CSOPs.

Tax treatment of CSOPs:

If options are exercised after 3 years of awarding them, there will be no income tax or National Insurance contributions on the profit between the issue price and the exercise price (market price).
Individuals cannot hold share options worth more than £30,000. Any options above £30,000 won't qualify for tax benefits.
Whenever you sell the shares acquired under CSOP, you will have to pay normal capital gains tax, as opposed to EMIs which charge a lower capital gains tax.

Apart from EMIs and CSOPs, there are two other HMRC-approved schemes for awarding share options -- known as Save As You Earn (SAYE) scheme and Share Incentive Plan (SIP). These schemes are suitable if a Company is awarding share options to all employees and not specifically to Directors. SAYE and SIP are beyond the scope of this article, but you can find more information on the HMRC website.

Unapproved Schemes:

When Companies cannot use approved schemes, shares options are awarded under unapproved schemes.

Tax treatment for unapproved schemes:

There is no tax upon the grant of unapproved options.
Unlike approved schemes, when options are exercised you need to pay income tax on the difference between the exercise price and the market value of shares.
When shares are sold, you have to pay normal capital gains tax.

Conclusion:

The article covers broad guidelines regarding Director share options. Before issuing share options, you should consult a professional in order to understand more about the legal and tax implications. Tempo can provide you with professional advice on how to deal with Director share options in the most tax-efficient way.

Contractor Calculators

You may also find the following contractor calculators useful for your salary and tax calculations.

If you are looking for accounting support with your new limited company or if you need support setting up your accounts as a contractor, iCalculator recommends Tempo, a solid, dependable company that the team at iCalculator have known and worked with since 2009.

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