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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.
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.
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.
Broadly, share options can be awarded in two ways:
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.
Within approved schemes, there are two major methods for awarding Director share 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.
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).
Similar to EMIs, CSOPs can be offered to a few staff in a Company. Listed below are some key requirements for issuing CSOPs.
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.
When Companies cannot use approved schemes, shares options are awarded under unapproved schemes.
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. Account Direct can provide you with professional advice on how to deal with Director share options in the most tax-efficient way.
You may also find the following contractor calculators useful for your salary and tax calculations.