Gifting compensatory stock options.

Taxpayers fortunate enough to have been granted compensatory stock options have a unique opportunity to use these options to transfer the anticipated appreciation to future generations at little or no gift/estate tax cost. Unfortunately, a recent IRS ruling casts a cloud over the ability of taxpayers whose compensatory options are not yet exercisable (i.e., not vested) to make a gift of their options at a minimal transfer tax cost.

Income Tax Consequences

The income tax consequences of nonqualified options that do not have a readily ascertainable fair market value (FMV) at the time of grant are generally set forth in Regs. Sec. 1.421-7. Unless the specific nonqualified option is actively traded on an established market, it will almost always be considered as not having a readily ascertainable FMV for income tax purposes. The grant of such a nonqualified option does not cause income recognition. If the option is exercised by the grantee or otherwise disposed of in an arm's-length transaction, the grantee will have ordinary compensation income in the following amount:

1. If the option is exercised, the excess of the FMV of the stock received over the exercise price; or

2. If the option is transferred in an arm's-length transaction, the amount or FMV of the consideration received.

In the case of exercise, the grantee's holding period for the stock received begins on the date of exercise; the stock's basis is its FMV at that date.

If the option is transferred in a transaction not regarded as arm's-length, no income is recognized until the transferee either exercises the option or disposes of it in an arm's-length transaction. At that point, the transferor (the service provider) is deemed to recognize taxable income. If the transferee exercises the option, the transferor's taxable income would be the excess of the FMV of the stock received over the exercise price. The transferee does not incur an income tax liability as a result of exercise, even though the transferee's basis in the stock would be its FMV at the time of exercise. The transferee's holding period for the stock commences on the option's exercise date. Similarly, if the transferee disposes of the option in an arm's-length transaction, the transferor (service provider) would recognize taxable income equal to the amount or FMV of the consideration received by the transferee.

Gift Tax Consequences

The gift of nonqualified, compensatory stock options to children and grandchildren, either outright or in trust, constitutes an attractive estate planning technique. Prior to Rev. Rul. 98-21, most tax practitioners believedthat such gifts had the following favorable consequences:

1. The transfer of the options to family members did not cause the recognition of taxable income. The transfer via gift is a non-arm's-length transfer governed by the above income tax rules. This result is not challenged under Rev. Rul. 98-21.

2. If the family member to whom the options are transferred subsequently exercises the options, the transferor (or, if the transferor is not then living, his estate) will be deemed to receive taxable income as described above. Rev. Rul. 98-21 does not challenge this either. The payment of income tax by the transferor does not constitute a taxable gift, even though the economic value inures to the transferee's benefit. This income tax payment reduces the amount of the transferor's estate eventually subject to estate tax. It appears that the Service is not challenging this result.

3. The transfer of the options to a family member constitutes a completed gift for gift tax purposes. The option's value at the date of the gift needs to be determined, even though the options are not deemed to have a readily ascertainable value for income tax purposes. This gift tax value is determined using a generally recognizable option-pricing model (e.g., the Black-Scholes option-pricing formula). The special valuation rules applicable in the case of transfers of certain interests in corporations would not apply. The transferor may be able to avoid current gift tax liability by using available annual per-donee exclusions and the unified credit. Once the gift is complete, no additional gift tax liability would arise on exercise (or disposition) of the options by the transferee; neither the stock options nor the stock obtained on exercise would be includable in the transferor's estate.

In Rev. Rul. 98-21, the IRS attacked the gift tax consequences noted above in the third item. In this ruling, Company granted to A nonstatutory, compensatory options to purchase shares of Company common stock. However, A could exercise the options only after he performs additional services. All options granted under the plan expire 10 years from the grant date. The exercise price per share is the FMV on the grant date. The plan permits the transfer of the options to a member of the optionee's family (or to a trust for the benefit of family members). A transferred his options to his children as a gift. As a result of this transfer, after A performs the required additional services (and before the expiration date), the children can determine whether and when to exercise the options, and on exercise they will be obligated to pay the exercise price.

The Service recognized that for gift tax purposes, the term "property" is extremely broad and includes "every species of right or interest protected by law and having an exchangeable value." However, a gift is complete only when the donor has so parted with dominion and control over the property as to divest himself of the power to change its disposition. Thus, the IRS concluded:

In the present case, Company grants to A a nonstatutory option conditioned on the performance of additional services by A. If A fails to perform the services, the option cannot be exercised. Therefore, before A performs the services, the rights that A possesses in the stock option have not acquired the character of enforceable property rights susceptible of transfer for federal gift tax purposes. A can make a gift of the stock option to B [his children] for federal gift tax purposes only after A has completed the additional required services because only upon completion of the services does the right to exercise the option become binding and enforceable.

Of course, by the time A completes the additional services, it is likely that Company's stock price will have risen, causing the amount of the gift to be substantial.

In support of its conclusion, the Service cited two authorities involving promises to make transfers if the intended transferee would either get married or graduate from college. These authorities held that there was no completed gift until the transferee performed additional services, at which time the promise would become legally enforceable. However, in the case of a compensatory stock option, the legal rights are created between the employer and employee at the time of grant, rather than between the donor and donee.

The possibility that the employee will terminate employment before the options vest is a factor to be considered in valuing the options, but it should not preclude the gift from being complete. There are several authorities recognizing that the possibility an employee will terminate employment because of retirement, disability, voluntary resignation, etc., should be considered an act of independent significance (i.e., a condition subsequent), so that such a possibility is not a power to change the disposition of the transferred property. For example, in Rev. Rul. 72-307, the IRS held that the power to cancel a group-term life insurance policy solely by terminating employment was not an incident of ownership causing the policy to be included in the insured's gross estate; Rev. Rul. 84-130 and Estate of Smead, 78 TC 43 (1982), reached similar conclusions. Moreover, the Service has recognized that a completed gift can occur despite the fact that the property right is subject to a contingency such that the donee may not obtain possession or enjoyment of the property; see Rev. Rul. 79-238, in which a contractual arrangement by which one sibling promised to transfer property to another sibling's children in the event the latter sibling predeceased the life tenant or a trust was held to be a completed gift at the time the contract was entered into.

In a compensatory option situation, the grant of an option gives the employee the legally enforceable right to exercise it at his discretion, if the employee does what he is normally expected to do--i.e., remain with the employer for a specified period of time. The ability to exercise usually matures by the mere passage of time, because it would be against the employee's self-interest to voluntarily terminate his employment. (Other causes of termination are generally beyond the employee's control.) Certainly the employee, the employer and the investment community believe that the employee is being given a property right at the time of grant. Thus, economic compulsion, normal expectations, the employee's self-interest and the existence of a legally enforceable option (even though not presently exercisable) should enable an employee to make a completed gift of a nonqualified, compensatory option without being taxed at a future date on the future value of the gift.

The IRS's issuance of Rev. Rul. 98 21 casts substantial doubt on the ability of a taxpayer to make a completed gift of compensatory options that are not presently exercisable. The inability to be certain of the gift tax consequences of such a gift will undoubtedly deter many taxpayers from using this technique. Moreover, it remains to be seen whether or not the Service will apply its theory to gifts made prior to the issuance of the ruling.