August 1999

ESTATES AND TRUSTS

NONQUALIFIED STOCK OPTIONS

By Robert S. Barnett, Esq., CPA, counsel to Capell & Vishnick

Stock options are an important form of executive compensation and allow financial participation in the growth of the company. Option plans generally fall into two categories. Incentive, or qualified, stock options are governed by IRC section 422 and are generally not transferable other than by will. Nonqualified stock options, on the other hand, may be transferable depending upon the provisions of the underlying plan. This discussion will first address the general tax treatment of nonqualified options and then the valuation issues and application of IRC chapter 14.

Transfer of options may play an important role in planning by reducing the size of the executive's estate and providing for asset appreciation outside of the estate. Many corporate plans prohibit executives from gifting stock options.

Taxation

The following example, based on a private letter ruling [PLR 9350016 (September 16, 1993); see also PLR 9616035, (January 23, 1996)], sets the stage for discussion of the taxation of nonqualified options.

Example. Employee E is currently employed by ABC Company. E, his children, and a cousin own 45% of the issued and outstanding stock of ABC, which is a publicly traded corporation. ABC adopted a stock option plan allowing directors, officers, and employees to purchase stock in the company at a price equal to the fair market value on the date of the grant. The plan has recently been amended to take advantage of the new securities law rules and provides that the option holder may transfer the option to certain of the holder's descendants or to a trust for their benefit. E desires to transfer options in the company to a trust for the benefit of his children.

The tax effects of such a transfer are governed by IRC section 83 and may be summarized generally as follows:

* The transfer of the stock options to the trust will be a completed gift for tax purposes if several conditions are met. E must not retain any power over the disposition of the trust property. Provided the trustee of the trust exercises the option rights and is not subject to control by E, the gift will be treated as a completed gift when E transfers the options to the trust. In this example, the options are not subject to a risk of forfeiture and are not conditional upon continued employment. If such conditions were present as "golden handcuffs" (i.e., the option is subject to a substantial risk of forfeiture), Rev. Rul. 98-21, 1998-18 I.R.B. 7 states that there is no enforceable property right for Federal gift tax purposes until the options become vested. Therefore, the gift becomes complete for gift and valuation purposes only when the conditions are met. Any increase in value of the option during this period will result in increased gift tax.

* The assets of the trust are not included in E's estate upon his death, since E has not retained dominion and control over the property and is not the trustee of the holding discretionary power that might result in the estate inclusion.

* The exercise of the stock options by the trustee will result in E receiving taxable compensation income under IRC section 83. ABC will receive a corresponding deduction under IRC section 162. If E is not then living, E's estate will similarly be deemed to receive the taxable income. This deemed receipt of compensation income may cause liquidity problems and must be properly planned.

Under IRC section 83(e)(3), E is not taxed upon receipt of an option without a readily ascertainable fair market value. The regulations generally provide that such options will have a readily ascertainable fair market value only if they are traded on an established exchange. In the example above, the option is not traded, and therefore the tax event does not occur upon grant but rather upon exercise. Great care must be taken to exercise the option prior to the death of the employee. Otherwise, the income tax liability might not be allowed as a deduction to E's estate. The exercise of an option after the transferor's death would likely trigger income for the estate.

* The transfer of stock options to the family members will not be subject to IRC sections 2701­2703, which were designed to eliminate the estate freeze techniques allowable under prior law. The aforementioned private letter rulings have concluded that the option holder has a potential equity interest in the corporation. Therefore, the transfer of the options is not subject to IRC section 2701.

Valuation

IRC section 2701 provides special valuation rules that determine the dollar value of a gift when an individual transfers an equity interest in a corporation (or partnership) to a member of the individual's family. In computing the value of a gift under IRC section 2701(a)(3), the value of any applicable retained interest is disregarded, unless the right consists of the receipt of qualified payments. IRC section 2701 applies if the transferor or an applicable family member holds an "applicable retained interest" immediately after the transfer. An applicable retained interest is defined by Treasury Regulations section 25.2701-2(b)(1) as any equity interest in a "controlled entity," which could be a corporation or partnership, with respect to which there is either an "extraordinary payment right" or a "distribution right." In the case of corporations, control has been defined as the holding of at least 50% by either vote or value of the stock of the corporation.

Under the facts of the earlier example, E proposed to transfer stock options to or for the benefit of family members. Until the options are exercised, however, the holder of the options has no right to receive dividends and no right to vote shares of the corporation. The holder has only the right to purchase an equity interest represented by the shares of stock. Upon purchasing the shares, the holder would then obtain an equity interest. The previously cited private letter rulings state that the option holder does not have an equity interest until the option is exercised and stock is received. This result may be different if the option price is less than the stock price on the date of grant.

IRC section 2703 provides that the value of the gift will be determined without regard to any option, agreement, or other right to acquire or use property at a price less than the fair market value of the property. Similarly, any restriction on the right to sell or use such property will also be disregarded. Exceptions are provided where the rights or restrictions 1) represent bona fide business arrangements, 2) are not used as a device to transfer property for less than adequate and full consideration, and 3) are comparable at the time of drafting to similar arrangements entered into in arms-length transactions. According to Treasury Regulations section 25.703-1(b)(3), a right or restriction is considered to meet each of the three requirements if more than 50% of the property subject to such restriction is owned by persons that are not members of the transferor's family.

Under the facts of our example, the property whose value is at issue is the gift value of the options themselves. E owned less than 50% of the options; the remainder was issued to other key employees. Due to the fact that more than 50% of the property is owned by individuals that are not members of E's family, the special valuation rules of IRC section 2703 will not apply.

In valuing the gift options, E might wish to consider appropriate discounts for lack of marketability and transferability, forfeiture vesting provisions, and other restrictions under the option plan. Several evaluation methods might be appropriate, including the Black Scholes method for valuing options. The Black Scholes economic valuation model was developed in the 1970s and is a complex formula used to determine valuation of short-term publicly traded options. Option holders have the benefit of participating in the upside potential of the underlying stock without omitting or risking their resources. The formula attempts to define the intrinsic value of the option by weighing various factors such as price, duration, dividends, interest rates, and stock volatility.

The IRS has recently issued safe harbor provisions in revenue procedure 98-34, 1998-17 I.R.B. 15 that apply to the valuation of non­publicly traded compensatory stock options where the underlying stock is publicly traded. The revenue procedure outlines the various factors that must be considered in valuing the options, including those features generally taken into consideration under SFAS No. 123. However, under the IRS safe harbor, no discount can be applied to the valuation produced by the option pricing model.

Employers should carefully consider the effects of this change in implementing and administering stock option plans. Many employers are amending plans to provide for transferability of options to family members and family trusts in order to facilitate estate planning for key executives and other employees. Significant estate tax benefits can be achieved if options are gifted soon after grant. This will help ensure the smallest gift tax value and, therefore, the largest appreciation passing outside of the estate. *

Editors:
Lawrence M. Lipoff, CPA
Rogoff & Company, P.C.

Alan D. Kahn, CPA
The AJK Financial Group

Contributing Editors:
Barry C. Picker, CPA

Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Peter Brizard, CPA

Ellen G. Gordon, CPA
Lopez Edwards Frank & Company LLP

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