Retirement Benefits Planning Update etirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.
Gifts of Nonqualified Stock Options
A corporate employer will often grant options to its executives to purchase shares of the corporation's stock as part of its executive compensation package. Under a stock option arrangement, the employee has the opportunity to purchase company stock at a price specified in the option agreement (the "strike price"). The strike price is usually (but not always) the fair market value of the stock at the time the option is granted. When the employee exercises the option at a future date and pays the strike price, the employee will receive shares that have appreciated while the option was outstanding; the amount of appreciation is the compensation benefit to the employee. Three recent developments relate to the now-popular technique of making gifts of non-qualified stock options.
Income Taxation of Nonqualified Stock Options
Compensatory stock options may be divided into two categories for income tax purposes_incentive stock options (ISOs) and nonqualified stock options (NSOs). The fair market value of an NSO is not included in the recipient employee's taxable income at the time the option is granted because, under Treas. Reg. 1.83-7(b), such options have no readily ascertainable value for income tax purposes at the time of grant. Accordingly, a recipient employee cannot make an election under Code . 83(b) to include the value of NSOs in income at the time of grant and instead recognizes income when the option is exercised (or transferred in an arm's length transaction). At that later time, the "spread" (the difference between the strike price and the fair market value of the stock at the time of exercise) is included in the employee's ordinary income.
Gifts of NSOs
A gift of an NSO is attractive for at least two reasons. First, if the gift of the option occurs near the time of the grant of the option and the value of the option for gift tax purposes reflects the underlying stock value at that time, a substantial economic value can be transferred at a reasonably low gift tax value (assuming the underlying stock appreciates significantly in value). The second benefit of an NSO gift is that the liability for the income tax payable when the NSO is exercised remains the obligation of the donor. Thus, the full amount of the spread will be ultimately received by the donee (on the later sale of the stock) with the donee's income tax cost being equal to only the tax at capital gain rates on the increase, if any, in the stock's value after its receipt by the donee.
The IRS has ruled privately that the gift of an NSO does not trigger income recognition when the gift is made. PLR 9722022. Neverthe- less, questions about the gift tax implications of gifts of NSOs have remained. Three recent developments may affect the continuing use of the NSO gift technique.
In 1992 the Securities & Exchange Commission (SEC) promulgated revised rules that effectively permitted the transfer of an NSO to be made under . 16 of the Securities Act of 1933 without violating the short swing profit rules. Under these rules, sales and purchases (of stock options and/or option stock received on exercise) by certain corporate employees generally are "matched" if they occur within six months of one another and any profit realized is subject to recovery by the employer. The inclusion of provisions in NSO plans that allow donees to exercise gifted options has been hampered, however, by the unavailability of the streamlined form of SEC registration for plans that permitted nonexecutives to exercise NSOs. In March 1998 the SEC issued proposed regulations to amend Form S-8 (Registration Statement under the Securities Act of 1933) to facilitate the adoption of plans that contemplate the exercise of stock options by family members who are given NSOs by an employee.
Gifts Restricted to Vested NSOs In Revenue Ruling 98-21, 1998- 18 IRB 1, the IRS ruled that until an employee had performed all services required as a precondition to exercising the option, an NSO was not yet a binding and enforceable property right that could be transferred for gift tax purposes. Although a willing buyer would pay less for an NSO that is not yet exercisable (so that the value of the option should be subject to discount for gift tax purposes), it is not clear that the ruling's conclusion is correct. Under a traditional gift tax analysis, a completed transfer of the option occurred because the donee had the right to enforce the transfer against the donor. The need for the donor to continue employment for the option to become fully exercisable and bind the employer would seem to be of independent significance (typically not viewed as creating or defeating a property right for gift and estate tax purposes).
Valuation of Gifted NSOs
In Revenue Procedure 98-34, 1998-17 IRB 1, the IRS describes a "safe harbor" method of valuing compensatory stock options to purchase publicly traded stock for gift, estate and generation-skipping transfer tax purposes. Contrary to the approach taken in the income tax regulations under Code . 83 (which makes it virtually impossible to value an NSO), this revenue procedure recognizes the use of accepted formula appraisal approaches (such as the Black-Scholes model or binomial model), provided that the employer company is subject to Financial Accounting Standard 123 (Accounting for Stock-Based Compensation). In addition to considering the strike price and the value of the underlying stock, these formulas account for several other factors (such as the option's expected life, the stock's volatility, expected dividends and the risk free interest rate over the option term) that affect an option's value.
The Procedure imposes restrictions, however, on the valuation assumptions that can be made in two respects. First, no discount to the formula value may be taken. Thus, no discount can be taken for the lack of the transferability of the option itself (or of the stock received on the option's exercise) or for the possibility that the option may terminate within a window period after termination of employment. Second, if any of seven factors identified in the ruling exist on the valuation date, the option's expected life for purposes of the formula may be required to be the maximum remaining term of the option as of the valuation date (rather than the expected life reasonably determined in a manner calculated to reduce the option's value).
Because one of the employer objectives of a compensatory stock option plan is to provide an economic motivation for the executive to continue employment, the graduated vesting of the right to exercise the granted option is a typical stock option plan feature. Before Revenue Ruling 98-21, the IRS' position had not been formally published. Now, however, advisors are on notice that the IRS will treat a gift of a nonvested NSO as occurring at the time of the full vesting of the right to exercise the option so as to cause the gift value to include the spread at that time.
Before Revenue Ruling 98-34, the IRS had not published guidance indicating that the formula approach to valuing NSOs would be recognized. Now it is clear that a fully vested NSO with respect to publicly traded securities can be valued for gift tax purposes (even though apparently it still cannot be valued for income tax purposes). The ruling's express exclusion of discounts as a trade-off for safe harbor treatment does not explicitly question the legitimacy of the basis for discounting the formula value of NSOs but may prompt donors to seek formal appraisals in anticipation that discounts claimed may be challenged. Retirement Benefits Planning Editor_Harvey B. Wallace II, Joslyn Keydel & Wallace, 211 West Fort St., Suite 2211, Detroit, MI 48226-3270.
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