Consider your options: Income and estate planning with stock options

Real Property, Probate and Trust Journal, Summer 2002 by Markstein, Daniel H III

Editors' Synopsis: This Article examines new estate planning opportunities that have recently arisen with respect to stock options and discusses issues surrounding the grant, exercise, and transfer of the stock options. The Article focuses primarily on gifts of stock options, and specifically on the income, gift, and estate tax issues that pertain to making a gift of stock options. Finally, the Article examines various methods of valuing options for transfer tax purposes.

I. INTRODUCTION

The granting of stock options is one of the most popular forms of deferred compensation used by corporations today. By granting stock options, a company gives its key employees and directors an incentive to contribute to the growth in its value over a reasonably long term. From the standpoint of the grantee, receiving an option is a way to share in the growth potential of the company without putting any personal resources at risk.

Recent developments in the rules promulgated by the Securities and Exchange Commission ("SEC") have made possible new estate planning opportunities with regard to stock options. On May 30, 1996, the SEC adopted long-awaited changes to Rule 16b-3, promulgated under section 16(b) of the Securities Exchange Act of 1934.1 Section 16(b) of the Securities Exchange Act of 1934 provides that "insiders"-those who are ten percent owners or officers or directors-must disgorge any profits made from short-swing trading, which is defined as acquiring and then selling, or selling and then acquiring, the corporation's securities for a profit within a period of six months.2

securities (including options) of the issuer, but required that options granted to section 16 insiders be nontransferable to qualify for the exemption. As revised, Rule 16b-3 does not require that such options be nontransferable, so transferable options now may be granted by a company to its officers or other insiders while still complying with Rule 16b-3. Furthermore, the transfer of an option by gift to a family member or to a trust for the benefit of family members is exempt from section 16(b) liability under the Rule 16b-5 exemption for gifts.3 In effect, Rule 16b-5 exempts all transfers of stock by bona fide gift or devise from the short-- swing profits prohibition.

However, a securities law problem with transferable options remained. Form S-8, the registration form under the Securities Act of 1933 used by issuers to register shares of company stock underlying stock options, was available only for securities offered to employees and consultants. Therefore, a donee exercising a transferred option was in the position of either having to purchase in a private placement (with a resulting one-year holding period) or causing a violation of section 5 of the Securities Act (the registration requirement) by the issuer of the security. Effective April 7, 1999, the SEC adopted amendments to Form S-8, as well as Rules 401 and 405 under the Securities Act of 1933 and Regulations S-B and S-K, to make Form S-8 available to family members of employees. Form S-8, as amended, is available only if the option is transferred by gift or domestic relations order. Of course, the issuer must decide whether to permit options to be transferred to persons or entities falling within the definition of the term "family member."

appreciate. If the underlying stock substantially appreciates in value after the gift, the initial grantee will have transferred substantial value at limited gift tax cost.

Since the enactment of the Tax Reform Act of 1986, an effective transfer tax strategy has been to make a completed gift of property to a grantor trust.4 In such transaction, the transfer of property to the trust is a completed gift for transfer tax purposes, but the grantor remains the deemed owner of the property for income tax purposes. Consequently, while the grantor is taxable on the income of the trust, beneficiaries of the trust enjoy all of the economic benefits of the trust property free of any income tax, and the payment of the income tax by the grantor does not appear to be an additional gift to the beneficiaries of the trust. Section 83 of the Internal Revenue Code ("Code") offers the same opportunity with respect to the transfers of restricted property or stock options. Opportunities clearly are greater when stock prices are artificially depressed or well below historical highs if the company's fundamental business, prospects, or both are good.

technique.5 A revenue procedure also issued in 1998 provides guidance on the valuation of some stock options for transfer tax purposes.6

A discussion of the important income and estate planning opportunities available and issues that arise regarding the grant, exercise, and transfer of stock options follows. It will focus primarily on gifts of stock options. For income tax purposes, the question is whether the donor must recognize income at the date of the gift, as opposed to the date of exercise of the options by the donee, under section 83. The gift tax issues involved in such transfers include whether there is a completed gift at the date of transfer and whether the payment of the income tax by the donor when income is recognized is an additional gift. The estate tax issue is whether the transferred option will be includible in the gross estate of the optionee-- donor. Finally, various methods of valuing options for transfer tax purposes will be examined.