Also in this Issue:
-Stock Options: The Basics
-A Brief Guide to Stock Option
Taxation and a Few Illustrations
-Tips and Traps for Options in
Real Estate Contracts
GIFTS OF STOCK OPTIONS FOR ESTATE PLANNING PURPOSES
by Thomas J. Stikker stikker@ddrs.com
Stock options (the right to buy stock at a specified price), received as compensation from a corporate employer, are frequently a significant asset of a client's estate. Estate planning involving lifetime gifts of such options can often offer such clients significant wealth transfer opportunities with favorable tax results.
Check the Plan. Stock options received by corporate employees generally are either incentive stock options (ISOs) or nonqualified options (NSOs). Lifetime gifts of ISOs are not possible since such options cannot be transferred to a third party by an employee during his or her lifetime. Certain NSOs, however, can be gifted by an employee provided that the employer's stock option plan allows it. Many corporate employers have adopted plans permitting such gifts.
Gift Tax. If permissible under the relevant stock option plan, a gift of stock options by an employee during his or her lifetime can shift all post-gift appreciation in the value of the options to the recipients of the gift. Any gift tax due will be based on the value of the options at the time of the gift, as determined under procedures approved by the IRS. Thus, if the options appreciate in value after the gift is made (because, for example, the value of the employer's stock increases over the exercise price of the stock specified in the option), that appreciation is enjoyed by the recipients of the gift without being subject to gift or estate tax.
Income Tax. Furthermore, in certain cases, additional value can be transferred to the recipients of the gift by way of income tax savings. In many situations, until the recipients of the gifted option actually exercise it, the donor does not realize any income from the original grant of the option. That is, the donor frequently will be subject to income tax on the option only after he or she has given it away and the recipients then exercise it by acquiring the stock at the exercise price. At that time, the donor, not the recipients, of the option will realize taxable income on the difference between the exercise price and the fair market value of the stock at the time the option was exercised by the recipients. The donor then will pay the income tax resulting from the recipients' exercise of the option. The donor's estate subject to estate tax at his or her later death will be reduced by the amount of income tax paid as a result of the recipients' exercise of the gifted option. This strategy often is attractive to clients who are trying to shift as much wealth as possible to their children or other family members at the lowest possible tax cost.
Trust Planning. Gifts of stock options may also be combined with other estate planning techniques to leverage the overall wealth transfer advantages. For example, it may be possible to transfer such options to an "intentionally defective grantor trust" for the benefit of family members. Such a trust remains income taxable to the donor, so that he or she not only pays the income tax attributable to the exercise of the option, but also pays any capital gains tax resulting from any subsequent sale of the stock acquired on exercise of the option. If the trust is properly structured, however, the gift of the option will be complete at the time the option is transferred to the trust, so that the value of the gift for gift tax purposes will be fixed at that time, and the value of the trust property will not be included in the donor's estate for estate tax purposes when he or she dies later.
Limited Partnerships. It also may be possible to transfer stock options to a family limited partnership and then make gifts of interests in the partnership to family members. The value of the gifts of partnership interests for gift tax purposes may be able to be discounted significantly. Since the IRS has taken the position that the value of a stock option itself cannot be discounted when given away, using a family limited partnership as the gifting vehicle may result in substantial leveraging of the gift which would not otherwise be possible.
Problems with the IRS. There still exists substantial uncertainty about the income, gift and estate tax ramifications of lifetime gifts of stock options. It has only been in the last several years that the IRS has offered any guidance about the tax treatment of such a strategy. Many questions remain open at this point. For example, the IRS has taken the position that if a stock option can only be exercised after the employee performs additional services for the employer, any gift of the option by the employee is not complete until the option is no longer conditional on the provision of such services. If correct, this position results in all appreciation in the value of the option between (i) the date of the transfer of the option to the recipients, and (ii) the date the option is no longer conditional, being subject to gift tax. Many commentators believe the IRS position in this regard is incorrect and poorly reasoned. Moreover, it seems at odds with another IRS position that gifts of options which expire because the employee resigns or is terminated are complete at the time of the option transfer because any later termination of the employee's employment is "an act of independent significance." Nevertheless, many clients may not want to risk a dispute with the Service over a gift of unvested stock options which only can be exercised after the employee satisfies a precondition relating to his or her employment.
Lifetime gifts of certain vested stock options, on the other hand, remain a viable estate planning strategy. Such gifts are particularly attractive if done early and in such a manner so as to shift as much appreciation in the value of the options as possible to the recipients, with the donor paying the income tax attributable to the exercise of the option, and possibly even the capital gain tax on the subsequent sale of the stock acquired on exercise of the option.
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