Take Stock of Estate Planning Strategies for Options

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1 Take Stock of Estate Planning Strategies for Options Publication: Practical Tax Strategies Stock options are no longer a perquisite reserved solely for corporate management and key employees. From closely held technology companies to Fortune 500 corporations, more employees are being afforded the opportunity to participate in potential appreciation of their businesses through the use of employer-provided stock options. From the employer's perspective, stock options may be a relatively inexpensive way to reward employees for their hard work and loyalty to the employer. From the employee's perspective, stock options have become, in many instances, the most important part of their compensation package. Despite the significant and growing attention employees devote to stock options, they spend very little time considering what might happen to their stock options in the event of their death. Estate planners must take into account their clients' stock options when formulating and implementing estate plans. Stock options present special income tax problems that must be dealt with in an estate plan. Options are not often transferable (except on the optionee's death) and when they are transferable, care must be taken to address the peculiar attributes of these options. Background A stock option gives the option grantee (for our purposes, the employee) a legally enforceable right against the option grantor (the employer) to purchase stock at some time in the future at a specified price (the "strike price").

2 If the grantee, however, does not want to exercise the option and purchase or sell the property, the grantor has no legally enforceable right against the grantee to require the grantee to do so. Options come in two basic flavors: Call options. Put options. A call option gives the option grantee a legally enforceable right against the grantor to purchase property. If the property subject to the call option has a value greater than the option price plus whatever consideration the grantee paid for the option (if any), the grantee typically will want to exercise the call option and purchase the property. Not surprisingly, if the value of the property subject to the call option, however, is below the option price, the grantee generally will not exercise the option. A put option, on the other hand, gives the grantee a legally enforceable right against the grantor to sell the property. The desire to exercise a put option based on the fair market value of the underlying property is the opposite of call options. If the property subject to the put option has a value less than the option price, the grantee will generally exercise the put option and sell the property. If the value of the property has a value greater than the option price, the grantee generally will not exercise the option. Two types of employee stock options receive special treatment under the Code: Incentive stock options (ISOs). Nonstatutory options granted under employee stock purchase plans (NQSOs, also referred to as nonqualified stock options). Both ISOs and NQSOs have significant tax advantages, but there are many differences between them. ISOs Under an ISO, the employer grants the employee an option to purchase stock at some time in the future at a specified price. As the value of the stock increases relative to the option price, the employee has the potential to recognize the appreciation in the option stock's value over the option price with preferential tax consequences. Income taxation. The income tax consequences of ISOs are deceptively simple and could lull the employee into a false sense of security. In general, the employee does not recognize taxable compensation income at the time the option is granted, becomes vested, or even exercised.1 On exercise of the option, the employee, however, has to

3 take into consideration the spread between the option price and the stock's fair market value as an "item of adjustment" for purposes of the alternative minimum tax (AMT). An employee who is subject to AMT in the year the ISO is exercised, however, may be entitled to a tax credit against the employee's regular income tax in some later year when not subject to AMT. Thus, unless the employee incurs AMT, the employee has a taxable event only on the later sale or disposition of the option stock, using the original option strike price as the employee's basis for determining gain. In addition, subject to the holding requirements discussed below, the employee recognizes long-term capital gain on such sale or disposition. For the ultimate sale of the stock to be treated as a sale of a long-term capital asset, (1) the employee must hold the stock for at least one year after the date the stock was transferred to the employee and (2) the disposition cannot be before two years after the date the option was granted.2 If the employee engages in a "disqualifying disposition" of the stock (i.e., a disposition that violates either the one- or two-year rules), the employee recognizes ordinary income (i.e., compensation) in the year of disposition to the extent of the lesser of: The fair market value of the stock on the date of exercise minus the strike price. The amount realized on the disposition minus the strike price. The grant of an ISO by the employer typically does not create any tax consequences for the employer because the employer does not receive a tax deduction when it grants the option or when the option is exercised by the employee.3 If the employee, however, violates the one- or two-year rules in a disqualifying disposition, the employer may deduct the amount of ordinary income recognized by the employee attributable to the disqualifying disposition.4 Example. Corporation C adopts an ISO plan on 1/1/00 granting each employee the option to purchase 100 shares of C stock for $100 per share (the stock's fair market value on 1/1/00) prior to 12/31/05. Ellen, an employee of C, exercises her option to acquire 100 shares of C stock on 7/1/00 when each share of C stock has a value of $110. On 7/1/05, Ellen sells all of the stock acquired through the exercise of the ISO to Paul for $150 per share. Ellen does not recognize any income (assuming AMT will not be triggered) on the grant or exercise of the option. When Ellen sells the 100 shares to Paul on 7/1/05, she realizes and recognizes $50 of long-term capital gain per share. C is unable to take a corresponding deduction.

4 If instead Ellen sold all of the C stock on 11/15/01 to Paul for $115 per share, she still would not recognize any income (assuming AMT would not be triggered) on the grant or exercise of the option. Ellen, however, would have violated the two-year rule because she sold the stock before two years after the date the option was granted. She would have ordinary income of $15 per share. C would be able to take a corresponding deduction. If Ellen acquired the C stock for $110 on 7/1/01 and sold it on 3/31/02 to Paul for $115 per share, the tax consequences would be the same as in the immediately preceding paragraph because Ellen would have violated the one-year rule. ISO requirements Very strict rules must be complied with to qualify for the beneficial ISO tax treatment. For an option to qualify as an ISO, the recipient must be an employee of the granting corporation (or a related corporation) at all times beginning on the date of the option grant until three months from the date of exercise (the three-month period is extended to 12 months if the employee stopped working because of a disability).5 Consequently, the employee must exercise any outstanding ISOs within three months after leaving the employment of the granting employer. If an option recipient holds a stock option at his or her death, it can qualify as an ISO only if the recipient was employed by the granting corporation on the date of the recipient's death or within the three months immediately preceding the date of death. If the employee was employed on the date of his or her death, there is no statutory requirement that the estate or heirs exercise the ISO within three months of the date of the employee's death. nnisos must also meet the statutory requirements under Sections 422(b) and (d). Some of these requisites are: The option must not be transferable by the employee other than by will or the laws of descent and distribution and must be exercisable during the employee's lifetime only by the employee. The ISO agreement should give the ISO employee the ability to specifically designate the employee's beneficiary. The absence of any such provision or any specific designation would prevent the option from being an ISO. In

5 addition, in the event the employee becomes disabled, the legal representatives of the employee should be able to exercise the option on the employee's behalf.6 The employee's estate is also permitted to exercise the ISO. The option price must not be less than the fair market value of the stock at the time the option is granted. For purposes of the ISO pricing rules, the employer must make a good faith attempt to determine the fair market value of the underlying ISO stock. Various valuation rules exist with respect to publicly traded and closely held stock. Restrictions that are placed on the underlying ISO stock are not to be considered when determining the fair market value of the ISO stock, except when the restriction is one which, by its terms, will never lapse (i.e., restrictions under applicable securities law). The employee, at the time the option is granted, must not own stock possessing more than 10% of the total combined voting power of all classes of the employer, its parent, or subsidiary, unless at the time the option is granted, the option price is at least 110% of the fair market value of the stock subject to the option and the option, by its terms, is not exercisable after the expiration of five years from the date the option is granted.7 The value of shares of employer stock that can be exercised for the first time by an employee in any calendar year under an ISO cannot exceed $100,000, based on the fair market value of the stock at the date of the ISO's grant.8 Consequently, if the employer grants 5,000 immediately exercisable options to an employee on December 31, when the stock price is $25 per share, only the first 4,000 ($100,000 divided by $25) shares of stock can qualify as ISO stock; the remaining 1,000 shares of stock cannot qualify for ISO tax treatment. As discussed above, an employee generally incurs favorable tax results when selling stock acquired through the exercise of an ISO unless the employee violates the one- or two-year rule. This is an especially important consideration for an estate planner to take into account to prevent the inadvertent--and usually avoidable-- triggering of ordinary compensation income by implementing a plan that will not cause a disqualifying disposition. In general, a "disposition" of ISO stock is defined as any sale, exchange, gift or transfer of legal title, subject to the following exceptions under Section 424(c):

6 A transfer from a decedent, who held ISO stock, to an estate or a transfer by bequest or inheritance. An exchange of the ISO stock in a nonrecognition transaction, such as a tax-free reorganization or stock-for-stock exchange. A pledge or hypothecation of the ISO stock (but if the stock is actually transferred to another pursuant to such pledge or hypothecation, the transfer is considered a disposition; therefore, ISO stock should not be used as security). Any transfer of ISO stock between spouses or incident to a divorce (and the spouse who receives the stock steps into the shoes of the original employee). The exercise of an option by an individual if such option is taken in the name of the individual and another person jointly with the right of survivorship, or is subsequently transferred into such joint ownership. A change in joint owners, however, is considered a disposition. The transfer of ownership resulting from the death of one of the joint owners of the stock is not considered the transfer of ownership of the ISO stock. If the joint ownership is terminated other than on the death of one of the joint tenants, the termination of joint ownership is a disposition, except to the extent that the termination results in the employee reacquiring full ownership of the shares. A transfer of ISO stock by an insolvent individual to a trustee in bankruptcy, a receiver, or any other similar fiduciary in any proceeding under the Bankruptcy Code or any other similar insolvency proceeding. Despite the laundry list of exceptions to the definition of "disposition," the estate planner must note that there are no exceptions for gifts of ISO stock. Thus, a gift of ISO stock triggers capital gain (or potentially ordinary income if a disqualifying disposition occurs under Section 422(a)(1)). This may make ISO stock unattractive for gifts from one generation to the next. NQSOs Stock options that do not meet the requirements for ISOs are nonqualified stock options and are governed by Section 83. Because NQSOs do not have to meet the requirements for ISOs, employers and employees are

7 afforded much greater flexibility in implementing an NQSO plan. Income taxation. The tax consequences of NQSO grants are not as straightforward as with ISOs. They too include tax traps. The first question to answer in determining the tax treatment of an NQSO is whether the NQSO has a "readily ascertainable market value" (RAMV). An option generally would have an RAMV only if either: The option itself is traded on an exchange. The option is immediately (a) exercisable, (b) transferable, (c) not subject to any restrictions that have a significant effect on the option's value (i.e., forfeitability) and (d) the fair market value of the "option privilege" can be readily determined. If the NQSO has an RAMV, the employee has ordinary income at the time of grant equal to the difference between the option's fair market value and any consideration the employee paid for the option. NQSOs typically do not have an RAMV. Therefore, they rarely cause the employee to incur an ordinary income tax liability at the time of grant. Typically, the employee recognizes, as ordinary income, the difference between the strike price and the fair market value of the stock when the option is exercised. This result may be disadvantageous to an employee who desires immediate taxation of the option to ensure that any future appreciation will be taxed as a capital gain. The employer is entitled to a deduction equal to the spread in the year the employee recognizes the income. If stock acquired through exercise of an option is subject to a substantial risk of forfeiture (i.e. subject to a vesting schedule), income taxation is deferred until the risk of forfeiture is removed or lapses. If the stock is not freely transferable because of securities law restrictions, taxation may be deferred until the restrictions lapse. Typically, employers impose restrictions to encourage employees to remain with the employer by offering significant benefits if the restrictions are satisfied. Employees who hold restricted property (such as restricted stock received through the exercise of an option) have the ability to close the compensation element in a restricted property transaction at the time the property is transferred (e.g., when stock is acquired on the exercise of an option), thus giving employees the opportunity to limit their ordinary income from the transaction by making a Section 83(b) election.

8 The Section 83(b) election is not available when the option is granted because an option is not a transfer of property. The Section 83(b) election may be made on the exercise of an option to acquire stock that is subject to substantial risks of forfeiture. If the Section 83(b) election is made, the employee is required to recognize as ordinary income any difference on the date the property is transferred between the fair market value and the amount paid for the property. A "painless" election can be made to close the compensation element in a restricted property transaction, even if there is no difference between the fair market value and the amount paid for the property.9 Thus, any appreciation in the property (i.e., the restricted stock) after the date of exercise is converted into potential capital gain income. If on the date of exercise the fair market value of the stock is the amount paid for it pursuant to the exercise of the option, and the employee makes a Section 83(b) election, the employee will not recognize any ordinary (or capital gain) income. Any realized gain on the ultimate sale of the stock will then receive capital gain treatment. If the stock is subject to any type of restriction, the estate planner should inform the client of the availability of the Section 83(b) election if one can still be timely made. Example. Corporation C adopts an NQSO plan on 1/1/00 granting each employee the option to purchase 100 shares of C stock for $1 per share (the fair market value of C's stock) prior to 12/31/05. On the date of grant, the option does not have an RAMV. Edward, an employee of C, exercises his option to acquire 100 shares of C stock on 7/1/01, when each share of C stock has a value of $110. The NQSO plan provides that in the event an employee ceases to be employed within three years after exercising the option, C will repurchase the stock for $1 per share. Edward does not recognize ordinary income on the grant of the option because the option does not have an RAMV or on exercise of the option because the stock is subject to a substantial risk of forfeiture. If, however, on the exercise of the option, Edward makes a timely Section 83(b) election, he will recognize $109 per share of ordinary income. If Edward sells the stock for more than $110 per share (after having held it for longer than one year), he will recognize capital gain. If the fair market value of each share of stock on 7/1/01 is $1 (instead of $110) per share, Edward can make a "painless" Section 83(b) election because he would not recognize any ordinary income. If Edward sells the

9 stock for more than $1 per share (after holding it longer than one year), he will recognize only long-term capital gain. Unless Edward makes the Section 83(b) election, the compensation element of this transaction will remain open despite the fair market value of the stock being equal to the strike price. PLANNING TIP: The Section 83(b) election can convert what would otherwise be ordinary income into lower-taxed capital gain. The election must take the form of a written statement signed by the employee. It should be filed with the IRS office at which the employee regularly files the employee's tax returns not later than 30 days after the date of the transfer. The written statement must also be included with the employee's income tax return for the year of the transfer. Reg (e) provides that the written statement must include: The taxpayer's name, address, and identification number. A description of the property that is the subject of the election. The date of the transfer and the calendar year involved. The nature of the restrictions attached to the property. The fair market value of the property. The amount paid (if any) for the property. A statement that copies of the election have been filed with the employer and, if necessary, with the transferee of the property. Gift-giving strategies. A significant advantage of NQSOs over ISOs in estate planning is that NQSOs can be more flexible. Although NQSOs are likely to be subject to nontransferability restrictions before exercise, such restrictions are not required. Thus, unlike ISOs, NQSOs may be the subject of a gift-giving program. In addition, the stock acquired through the exercise of the option does not have to be held for a specified period of time (unlike the special one- and two-year rules for ISOs) to preserve capital gain treatment on the spread at disposition. (Of course, the general more-than-one-year holding period requirement must be met for long-term capital gain treatment.) Thus, the stock acquired through the exercise of an NQSO can also become the subject of a gift-giving program. Unlike ISOs, NQSOs do not have any statutory restrictions, but the NQSO plan must permit or be amended to permit the options to be transferred to family members. The employee may then be able to transfer an NQSO to the employee's children (or in trust for them) when the gift tax value of the NQSO is substantially lower (see "Valuation of options," below) and, for a low gift tax transfer cost, remove substantial potential

10 appreciation in the underlying stock from the employee's estate. Caveat. An employee who makes a gift of an NQSO does not shift the compensation income from the exercise of the NQSO to the transferee, even though it would be the transferee who ultimately exercises and gets the benefit of the NQSO. This liability, however, would reduce the employee's estate. In any event, the employee must recognize that he or she will bear this tax burden and, therefore, must plan for this "phantom income" on the exercise by the donee. Gifts of options to charities may result in favorable tax benefit/detriment timing in that the donor can get a charitable deduction in the year of gift, but may have the income recognition event in a later year when the options are exercised. The income tax liability will also help to reduce the donor's estate. Rev. Rul Until the issuance of Rev. Rul ,10 many issues regarding the tax treatment of stock options were uncertain. One such issue was the effective date of an NQSO gift. According to Rev. Rul , the gift of a compensatory NQSO that is conditioned on the additional services of the employee is a completed gift under Section 2511 on the later of: The transfer. The time when the donee's right to exercise the option is no longer conditioned on the performance of services by the transferor. According to this Ruling, the rights the employee possesses in the NQSO do not acquire the character of enforceable property rights susceptible of transfer for federal gift tax purposes before the employee performs the required services. Therefore, a completed gift of an NQSO can be made only after the employee has completed the additional required services making the right to exercise the option binding and enforceable. The Ruling further provides that if an option becomes exercisable in stages, each portion of the option that becomes exercisable at a different time is treated as a separate option for applying the completed gift analysis. The implication of Rev. Rul is that the gift of an unvested NQSO must be valued on the date the vesting occurs. Previously, it was believed that nonvested options could be given with a minimal value and thus enable the donor to shift all future growth to the donee without incurring substantial gift tax. The IRS essentially closed this planning technique because the gift tax cost of transferring unvested options to family members would presumably increase as the value of the stock increases during the delay until the gift is deemed to be complete.

11 Thus, a valuation expert may have more difficulty justifying a lower valuation since less of an argument could be made with regard to the future value of the company's stock, volatility of the marketplace, or the level of interest rates. Therefore, from an estate-planning perspective, it may be impractical to use unvested stock options in a gift-giving program. Valuation of Options The IRS has provided much needed guidance with regard to the valuation of options. Rev. Rul and Rev. Proc provide a safe-harbor method for valuing nonpublicly traded "compensatory stock options" (i.e., stock options granted in connection with the performance of services, including ISOs) for stock that, on the valuation date, is publicly traded on an established securities market. Taxpayers relying on this Procedure may use a recognized option pricing model, such as the Black-Scholes model. If the model is properly applied and certain procedural requirements are met, the IRS will accept the value for gift, estate, and generation-skipping tax purposes. Rev. Proc indicates that no discount can be applied to the valuation produced by the option pricing model. Retaining an experienced valuation expert is essential to support any type of gift-giving program, especially when the property being valued is a stock option. The valuation expert must ensure that the option pricing model takes into account, as of the valuation date, the following six factors: 1. The strike price of the option. 2. The expected life of the option. 3. The current trading price of the option.nn 4. The expected volatility of the underlying stock. 5. The expected dividends on the underlying stock. 6. The risk-free interest rate over the remaining option term. Effect of employee's death The death of the employee to whom stock options were granted has tax implications for both NQSOs and ISOs.

12 NQSOs. An NQSO generally provides that the option will pass to the estate or heirs of the employee after the employee's death (or any manner the employee and employer contractually agree on) and that the transferee may exercise the option under terms similar to those governing exercise of the option by the employee. The income taxation of the NQSO of a decedent ultimately depends on whether the option was taxed at grant, and whether the option is restricted property. If the employee dies holding an option that was taxed at grant, the transferee would take the option with a basis equal to its fair market value on the date of the employee's death. Because the compensation income was taxed to the employee, no income in respect of a decedent (IRD) is inherent in the option. If the transferee exercises the option, the stock received on exercise apparently must be held for the requisite long-term holding period before it is eligible for long-term capital gain treatment. If the employee dies holding an option that was not taxed at grant, the compensation element remains open. When the transferee engages in a transaction with respect to the option that would close the compensation element in the hands of the employee (i.e., exercise or disposition), compensation income is produced for the transferee. The transferee is deemed to step into the employee's shoes for purposes of taxing the compensation income inherent in the option. Because IRD is inherent in the option, the option's basis in the transferee's hands is not stepped up to its date-of-death value. If the employee exercises an NQSO not taxed at grant and receives stock subject to transferability and substantial risk of forfeiture, absent a Section 83(b) election, the compensation element in the transaction remains open until those restrictions lapse. Depending on the terms of the NQSO plan, the stock may: Pass to the estate or heirs free of restrictions. Be forfeited as a result of the employee's death. Pass into the hands of the estate or the heirs subject to the same restrictions. If the estate or heirs remain subject to the same restrictions, the tax consequences are the same as the option not taxed at grant. If the restrictions lapse because of the employee's death, the lapse will generate compensation income to the transferee. If the stock is forfeited because of the employee's death, the rules governing the forfeiture of restricted property to the employee should govern this forfeiture. Any gain should be IRD to the estate or the heirs to whom the proceeds flow. If the forfeiture produces a loss, the

13 ordinary loss generated should be available to the decedent's estate or heirs to whom any proceeds of the forfeiture flow. ISOs. The right to exercise an ISO and receive the related favorable tax treatment does not need to be lost if proper steps are taken. The ISO plan may provide that it can be exercised by the estate of the employee or by anyone who has acquired the ISO due to a bequest or inheritance from the employee. As long as the option qualified as an ISO in the hands of the employee, the estate or heirs will receive the same tax treatment on exercise of the option. If the estate or heirs, however, make a disqualifying distribution of the ISO stock, they will recognize taxable income. Additional estate planning considerations The potential need to exercise ISOs and NQSOs (and the corresponding triggering of a taxable event), or sell any option stock, can exacerbate an estate's liquidity problems. Therefore, the increased use of both NQSOs and ISOs requires the estate planner to carefully review the terms of the option grants with a view towards the liquidity needs of an estate. Life insurance might be considered to provide family members with reasonable liquidity to maximize the use of the options. Unexercised options can be bequeathed to a named beneficiary, but the estate planner should review the option grant to see if it provides for automatic transfer at death to particular employee beneficiaries (or provides for the filing of a beneficiary designation with the employer). Pecuniary bequests should not be funded with NQSOs because immediate IRD may be triggered on the ordinary income component inherent in the NQSO. Bequests to charities, on the other hand, result in the ordinary income being recognized by the charity (a tax-exempt entity).13 Thus, NQSOs are especially good candidates for charitable bequests. The required holding period and the employment requirements are waived for stock acquired pursuant to an exercise of an ISO by the decedent's successors.14 The holding period waiver, however, does not affect the characterization of gain from a later sale of the stock as long-or short-term capital gain. The holding period for long-term capital gain purposes begins on the date the option is exercised.15 The employment requirement waiver does not apply if the decedent was not employed by the employer at the employee's death or within the previous three months. The estate planner should ensure that the executor and trustee (as well as the agent under any power of attorney) has sufficient authority and funds to exercise the ISOs and NQSOs. The liquidity concerns involved with NQSOs are somewhat greater than with ISOs because an NQSO triggers tax when exercised, as

14 contrasted with an ISO, which is not taxable until the stock is sold. The fiduciaries should be granted specific authority to exercise stock options. The fiduciaries should also be given authority to borrow funds necessary to exercise the options and to pledge the stock as collateral. In addition, the estate planner should consider whether the fiduciaries should, to the maximum extent permitted by local law, be exempted from any duty to diversify investments, when the estate is comprised of either ISOs and NQSOs. Fiduciaries may be restricted by Regulation U of the Securities and Exchange Act of 1934, as well as other rules, in borrowing funds to exercise the options, if the stock is closely held or not readily susceptible to valuation, if the borrowing is secured solely by the stock. Consequently, the estate planner needs to consider the limitations imposed under securities law. Lastly, the fiduciary must ascertain and keep track of all option expiration dates. The expiration of an unexercised option could result in serious fiduciary liability. Conclusion Estate planners are now more likely to encounter clients who own or will own stock options. Recent IRS rulings--by clarifying how gifts of options will be treated and valued--present more opportunities to transfer the unrealized appreciation inherent in these options out of a client's estate. A comprehensive understanding of how ISOs and NQSOs operate are essential tools for estate planners who must practice in the "new economy." ******************* 1 Section 421(a). 2 Section 422(a)(1). 3 Section 422(a)(2). 4 Section 421(b). 5 Section 422(a)(2). 6 Rev. Rul , CB

15 See Section 422(c)(5). 8 Section 422(d). 9 See Alves, 734 F.2d AFTR2d (CA-9, 1984) IRB CB CB See Ltr. Rul Section 421(c)(1)(A). 15 Section 1223(6). Headquarters Plaza, One Speedwell Avenue, Morristown, New Jersey t: f: Suite 1010, 50 West State Street, Trenton, New Jersey t: f: Fifth Avenue, New York, New York t: f: