How to value gifts of employee stock options.

For employees fortunate enough to possess stock options, the IRS has cracked down on the transfer tax benefits of gifts of such options. Rev. Rul. 98-21 provides that a completed gift exists when the options vest, even if not exercisable; Rev. Proc. 98-34 explains how to value the gift. This article uses detailed examples to analyze both pronouncements.

The Service has launched a two-pronged attack on a popular transfer tax planning technique--gifts of employee stock options (ESOs). A tax benefit exists because most ESOs granted by publicly traded companies have been valued for gift tax purposes at relatively small amounts (frequently, zero). Two recent IRS pronouncements, Rev. Rul. 98-21(1) and Rev. Proc. 98-34,(2) are designed to curtail this advantage. This article describes the tax planning technique involving gifts of ESOs and discusses the implications of the IRS pronouncements.

Gifts of ESOs

An opportunity to generate significant transfer tax savings was created in 1996 by a change in the securities laws that allowed recipients of ESOs to transfer them to family members or to trusts for their benefit. This ability created the need to value ESOs for gift tax purposes. However, very little IRS guidance existed; the only pronouncement was a 45-year-old ruling(3) holding that the value of a stock option for estate tax purposes was the difference between the fair market value (FMV) of the employer's stock and the option's exercise price. This difference is known as the option's "intrinsic value."(4) Intrinsic value considers the value of an option only if it is exercised immediately; it disregards the portion of the option's value attributable to the potential future appreciation of the underlying stock.

Example 1: T, an executive of publicly traded Z Corp., was granted 500,000 ESOs on June 1, 1997. The options grant T the right to purchase 500,000 shares of Z for $10 per share at any time from June 1, 1998 until June 1, 2007. The options are not generally transferable, but may be transferred to an immediate family member or to a trust for his benefit. The option contract further provides that, if T's employment with g terminates within the first year after the options are granted for any reason other than death or disability, the options will be forfeited. At the date the options were granted, the FMV of Z's stock was $10 per share. One year later, T's rights to the options became fully vested; on that date, Z shares were worth $12 each.

If T remains with Z and holds his options until their June 1, 2007 expiration date, when Z stock has risen to $40 per share, the options would be worth $15,000,000 (($40 - $10) X 500,000); T would certainly exercise them. If T is in the 39.6% Federal income tax bracket at that time, he will pay $5,940,000 in Federal income tax; his wealth will increase by a net amount of $9,060,000.

However, if T transferred his options to his daughter, G, on the grant date, the intrinsic value of the options would have been zero, because the stock's FMV would have equaled the ESO's exercise price. Based on then-existing IRS guidance, the intrinsic value would have been the value used for gift tax purposes; thus, no gift tax would have been due. If the options are exercised in 2007, G will pay the $5,000,000 ($10 x 500,000) exercise price and receive $20,000,000 of stock ($40 x 500,000). The $15,000,000 of income from the exercise of tile options would still be included in T's gross income,(5) so he would still be liable for the $5,940,000 income tax. However, as a result of the 1997 gift, $15,000,000 of wealth will have been transferred from T to G tax-free.

The IRS's Response

Due to the clear advantages, many taxpayers have used gifts of ESOs as a leveraged wealth transfer technique. In response, the IRS has issued two pronouncements that will reduce taxpayers' ability to use ESOs to make wealth transfers without incurring transfer tax. The Service's two-pronged approach attacks when the gift of ESOs is deemed to have occurred and how the value is computed.

When a Gift of ESOs Is Completed

Rev. Rul. 98-21 deals exclusively with gifts of ESOs and clarifies when such gifts are deemed completed if the options are conditioned on the performance of services by the donor-employee. The ruling states that, before the employee performs the services, the options do not comprise a set of enforceable rights that can be transferred as a gift for Federal gift tax purposes; a gift occurs only after the services have been performed and the option contract has become binding. Therefore, according to Rev. Rul. 98-21, the gift is completed on the later of the date (1) of the transfer or (2) that all of the services have been performed.

In Example 1, above, the options granted on June 1, 1997 were conditioned on T's continued employment with Z until June 1, 1998. Rev. Rul. 98-21 would have applied to this transfer; thus, the gift of the options to G would not be deemed completed on June 1, 1997. Instead, the valuation date used for gift tax purposes is June 1, 1998, the date when the options became fully vested; at that date, Z stock had risen from $10 to $12 per share. Thus, the intrinsic value of the options was $2 per share ($1 million for 500,000 options). The one-year delay in the valuation date caused T's transfer to G to become a $1 million taxable gift.

The Rev. Proc. 98-34 Safe Harbor

Rev. Proc. 98-34 outlines a safe-harbor method for valuing ESOs for gift, estate or generation-skipping transfer tax purposes. The procedure applies only to nonpublicly traded options on publicly traded stock. The valuation method suggested in Rev. Proc. 98-34 is based on the Black-Scholes option pricing model,(6) which takes into account both an option's intrinsic value and the value derived from the potential appreciation of the underlying stock. By endorsing the Black-Scholes model as a safe-harbor valuation method, the IRS appears to be distancing itself from its prior acceptance of intrinsic value as an appropriate valuation technique.

To comply with the safe harbor, the option value must be computed based on the following factors:

1. The ESO's exercise price,

2. The underlying stock's current price.

3. The underlying stock's expected volatility.

4. The underlying stock's expected, dividend yield.

5. The risk-free interest rate over the remaining ESO term.

6. The ESO's expected life.

The first two factors in the valuation model can be quickly determined. The ESO's exercise price can be found in the employee's ESO contract. Because Rev. Proc. 98-34 applies only to ESOs on publicly traded stock, the underlying stock's current trading price should be readily available.

The third factor, volatility, is a measure of the tendency of a stock price to change. Although expected volatility can be difficult to estimate, Rev. Proc. 98-34 simplifies the process. The estimate of volatility must be identical to that used for financial accounting purposes as disclosed in the issuing corporation's financial statements. Because generally accepted accounting principles require all publicly traded corporations issuing ESOs to disclose their estimates of volatility in their financial statements,(7) this amount should be easy to obtain.

The same is true for the underlying stock's expected dividend yield. Dividend yield is the company's expected annual dividend payout divided by the stock's average price. This should be taken from the company's financial statements; it is a required financial statement disclosure.

The risk-free interest rate is the yield on a zero-coupon Treasury bond with a remaining term equal to the option's expected life. The rate should be computed as of the valuation date for transfer tax purposes. The risk-free interest rate can be obtained from the financial section of most business publications.

The final factor is the option's expected life. Rev. Proc. 98-34 specifies that taxpayers should use one of two alternative estimates of expected life: the maximum remaining term (MRT) or the computed expected life (CEL) The choice is an important one for the taxpayer. MRT is longer than CEL; an ESO's value is always larger when a longer life is used. A longer life increases the probability that the value of the underlying stock will eventually exceed the option's exercise price and, therefore, increase the option's value.

Use of MRT: Taxpayers may always determine the option's value using MRT, defined as the number of years (rounded down to the nearest 1/10th) from the valuation date until the option's expiration date. Rev. Proc. 98-34 provides that the taxpayer must use MRT if any of the following conditions exists:

1. The option transferor (or decedent) was not the person to whom the ESO was granted.

2. The option transferor is not an employee or director of the company on the valuation date.

3. The option does not terminate within six months of termination of employment (or service as a director) with the company.

4. The terms of the option permit it to be transferred to persons other than family members or charitable organizations.

5. The option's exercise price is not fixed as of the valuation date. For example, this condition is met if the company has adjusted the exercise price in the three-year period ending on the valuation date.

6. The option being valued has terms and conditions such that if all options granted in the company's fiscal year that includes the valuation date had the same terms and conditions, the weighted-average expected life for the year would have been more than 120% of the weighted-average expected life annually reported for the year.

7. The company is not required by FAS 123 to disclose an expected life of the options granted in the company's fiscal year that includes the valuation date.

Conditions 2, 3, 5 and 6 are waived in the case of the employee's death; condition 3 is also waived in the case of the employee's disability.

If none of the preceding seven conditions exists, taxpayers may substitute use of CEL for MRT. CEL approximates the length of time from the valuation date until the option is likely to be exercised. In contrast, MRT is the full period from the valuation date until the option expires.

Use of CEL: CEL is determined by dividing the weighted-average expected life of the company's options (as disclosed in the company's financial statements) for the fiscal period containing the valuation date by the number of years (rounded up to the nearest 1/10th) from the date the option was granted until its expiration date. This ratio is multiplied by the MRT (rounded down to the nearest 1/10th of a year).The ratio used to calculate CEL is always less than 100%; thus, CEL is always less than MRT.

One problem inherent in the implementation of Rev. Proc. 98-34 is the availability of information needed to use the Black-Scholes model. Some of the factors needed to compute an option's value (e.g., volatility and dividend yield) are obtained from the issuing company's financial statements for the fiscal year that includes the valuation date. These statements may not have been issued before the due date of the estate or gift tax return. Thus, the taxpayer may have to file his gift tax return on extension if he wants to rely on Rev. Proc. 98-34.

Examples

Examples 2-5, below, have the same facts as Example 1, above, unless otherwise indicated. In addition, from Z's financial statements, the expected volatility and dividend yield of Z's stock were 35% and 3%, respectively. Examples 2-5 illustrate how the determination of the value of ESOs varies according to the choices made by the employer and employee. (The calculations are shown in Tables 1 and 2 on p. 853 and explained below under "The Spreadsheet Approach.")

Example 2: Use of MRT at vesting date

Option's exercise price                                  $10
Underlying stock's current price                         $12
Underlying stock's expected volatility                   35%
Underlying stock's expected dividend yield                3%
Risk-free interest rate over the remaining
 option term                                            5.7%
Option's expected life (MRT)                         9 years
Option's value                                         $4.84
Number of shares under option                        500,000
Told value of options                             $2,420,000

Example 3: Use of CEL at vesting date

Option's exercise price                                  $10
Underlying stock's current price                         $12
Underlying stock's expected volatility                   35%
Underlying stock's expected dividend yield                3%
Risk-free interest rate over the
 remaining option term                                 5.56%
Option's expected life (CEL)                       5.4 years
Option's value                                         $4.38
Number of shares under option                        500,000
Total value of options                            $2,190,000

Example 4: Use of MRT at grant date

Option's exercise price                                  $10
Underlying stock's current price                         $10
Underlying stock's expected volatility                   35%
Underlying stock's expected dividend yield                3%
Risk-free interest rate over the
 remaining option term                                 6.82%
Option's expected life (MRT)                        10 years
Option's value                                         $3.93
Number of shares under option                        500,000
Total value of options                            $1,965,000

Example 5: Use of CEL at grant date

Option's exercise price                                  $10
Underlying stock's current price                         $10
Underlying stock's expected volatility                   35%
Underlying stock's expected dividend yield                3%
Risk-free interest rate over the
 remaining option term                                 6.57%
Option's expected life (CEL)                         6 years
Option's value                                         $3.38
Number of shores under option                        500,000
Total value of options                            $1,690,000
Table 1: Spreadsheet for Computing Option Values

              A                                         B

1     Option's exercise price
2     Underlying stock's current price
3     Underlying stock's expected
       volatility
4     Underlying stock's expected
       dividend yield
5     Risk-free interest rate over the
       remaining option term
6     Option's expected life (MRT or CEL)
7     Option's value
8     Number of shares under option
9     Total value d options
10    Intermediate computations:
11                                           =C3^2*C6
12                                           =LN($C2/$C1)+$C5*$C6
                                             -SC4*$C6+$B11/2)/
                                              SQRT($B11)
13                                           =NORMSDIST(B12)

              A                                     C

1     Option's exercise price                Enter value here
2     Underlying stock's current price
       Enter value here
3     Underlying stock's expected
       volatility                            Enter value here
4     Underlying stock's expected
       dividend yield                        Enter value here
5     Risk-free interest rate over the
       remaining option term                 Enter value here
6     Option's expected life (MRT or CEL)    Enter value here
7     Option's value                         =C2*B13/EXP(C6*C4)
                                             -C1*C13/EXP(C5*C6)
8     Number of shares under option          Enter value here
9     Total value d options                  =C8*ROUND(C7,2)
10    Intermediate computations:
11
12                                           =(LN($C2/$C1)+$C5*$C6
                                             $C4*$C6$B11/2)/
                                              SQRT($B11)
13                                           =NORMSDIST(C12)

Table 2: Alternative Intermediate Calculations if Spreadsheet Function "NORMSDIST" Not Available

           A                       B

10    Intermediate
      computations:
11                           =C3^2*C6
12                           =(LN($C2/$C1)+$C5*$C6
                             $C4*$C6+$B11/2)/SQRT($B11)

13                           =ABS(B12)
14                           =EXP(B13^2/2)/2.506628
15                           =1/(1 +B13*0.2316419)
16                           =0.31938153*B15
                             -0.356563782*B15^2
                             +1.781477937*B15^3
                             1.821255978*B15^4
                             +1.330274429*B15^5
                             =IF(B12>0,1-B14*B16,B14*B16)

          A                           C

10    Intermediate
      computations:
11
12                           =(LN($C2/SC1)+$C5*$C6
                             $C4*$C6$B11/2)/SQRT($B11)
13                           =ABS(C12)
14                           =EXP(C13^2/2)/2.506628
15                           =1/(1 +C13*0.2316419)
16                           =0.31938153*C15
                             -0.356563782*C15^2
                             +1.781477937*C15^3
                             -1.821255978*C15^4
                             +1.330274429*C15^5 17
                             =IF(C12>0,1-C14*C16,C14*C16)

Example 2--Use of MRT at vesting date: Based on the terms of the option contract, T is required by Rev. Rul. 98-21 to use June 1, 1998 as the gift's valuation date. In addition, because the options do not automatically expire six months after termination of employment, MRT must be used. Because the options will expire on June 1, 2007, nine years after the June 1, 1998 valuation date, the MRT is nine years. The risk-free interest rate is determined from the average yield on Treasury zero-coupon bonds maturing in May 2007, the date closest to the options' expiration date; this rate was 5.7% on June 1, 1998.

Based on the above information, the value of each option determined using the Black-Scholes option pricing model is $4.84, as shown in the Example 2 box at right. The total value for all 500,000 options is $2,420,000. This is considerably more than the options' $1,000,000 intrinsic value on June 1, 1998. Rev. Proc. 98-34 explicitly recognizes that the option's value includes not only its value if exercised immediately; but also the potential for the underlying stock price to increase over the option's remaining life.

Example 3--Use of CEL at vesting date: It would be simple for Z to adjust its ESO contracts to allow its employees to use CEL; a provision would have to be added that the options will expire six months after termination of employment for a reason other than death or disability. If Z adds this provision, the value of options determined under Rev. Proc. 98-34 can be substantially reduced.

To calculate CEL, T would have to obtain the weighted-average expected life of Z options granted in the fiscal year that includes the valuation date. The weighted-average expected life is required to be disclosed in the company's financial statements. For the year ended Dec. 31, 1998, Z reported a weighted-average expected life of options granted in that year of six years. The ratio used to calculate CEL is the weighted-average expected life divided by the period from the grant date until the expiration date; this is six years divided by 10 years, or 60%. This ratio is multiplied by the MRT (nine years) to arrive at a CEL of 5.4 years.

With the change in the estimate of expected life, the appropriate risk-free interest rate will also change. The new risk-free interest rate is the average yield on Treasury zero-coupon bonds maturing in November 2003, approximately 5.4 years from the June 1, 1998 valuation date; this rate was 5.56% on June 1, 1998. As is typically the case, this shorter-term interest rate is slightly lower than the nine-year rate of 5.7%. Both the shorter expected life and the lower interest rate will reduce the options' computed value.

As shown in the Example 3 box on p. 852, the value of each option using CEL and the lower risk-free interest rate is $4.38. This results in a total value for all 500,000 options of $2,190,000, an approximate 9.5% decrease from the $2,420,000 value obtained in Example 2. T's substantial tax savings result from a relatively modest adjustment in Z's ESO contract.

Example 4--Use Of MRT at grant date: If Z were to remove from its ESO contract the condition that options are forfeited unless the employee remains with the company for a year following the grant date, T would not be required by Rev. Rul. 98-21 to delay the valuation date of the options for gift tax purposes; rather, the transfer of options from T to G will be treated as an immediate gift. Although many employers may be reluctant to make this type of change in their ESO contracts, they may find that the tax benefits for their executives outweigh the costs.

As a result of removing this requirement, the value of the ESOs is substantially reduced. The Example 4 box on p. 852 shows the value of the options determined as of the June 1,1997 grant date, using a 10-year MRT and a risk-free interest rate of 6.82%. Because the options are treated as a gift to G on the day they were granted by Z, the exercise price and the current stock price are equal. The value of the options is $3.93 per share ($1,965,000 in total), $455,000 lower than the $2,420,000 value determined in Example 2. The gift tax will be paid a year earlier, but the amount will be substantially smaller.

Example 5--Use of CEL at grant date: If Z made both of the modifications to its ESO contracts mentioned in Examples 3 and 4, T would reap the double benefit of computing the value of his gift as of the grant date and being permitted to use CEL. The Example 5 box on p. 852 shows the value of T's options using a CEL of six years and associated risk-free interest rate of 6.57%. The value of the options is $3.38 per share ($1,690,000 in total).

The Spreadsheet Approach

The option values presented in Examples 2-5 were calculated using common spreadsheet software. The formulas necessary to value ESOs using a spreadsheet are provided in Table 1 on p. 853.(8) The formulas shown are for a Microsoft Excel spreadsheet, but can be adapted to other spreadsheet software with minor modifications.

Construction of the spreadsheet should begin with rows one through nine. For column C, the values in rows one through six and row eight will be entered based on the specific options being valued. The formulas shown for cells C7, C9, and B11 through B13 should be entered as shown in the table. Cells B12 and B13 can then be copied to cells C12 and C13. Finally, in cell C12, the + sign in front of "$B11/2" should be changed to a - sign.

The formulas in row 13 use the spreadsheet function "NORMSDIST." This function is the standard normal cumulative distribution function, which is used in the Black-Scholes option pricing model. The function is not available on older versions of most spreadsheet software. Table 2 on p. 853 contains substitute formulas for the intermediate calculations that can be used with any spreadsheet package. The formulas in rows 13 through 17 perform the same calculation that the NORMSDIST function does automatically. If the Table 2 formulas are used, the formula for cell C7 should be modified by changing "B13" and "C13" to "B17" and "C17."

Once the spreadsheet has been constructed, the formulas will not change. The spreadsheet can be used to compute option values by entering the appropriate amounts for the factors in cells C 1 through C6 and the number of shares under option in cell C8.

Other Implications

With Rev. Rul. 98-21 and Rev. Proc. 98-34, the IRS has defined the top of the range of values that a transfer of options can assume. Table 3, above, shows the range of values under consideration for T's gift of ESOs. Rev. Rul. 98-21 affects the determination of value by delaying the valuation date for options with contingencies as long as possible. Because stock prices tend to rise over time, the application of Rev. Rul. 98-21 will result in most options with vesting restrictions having positive intrinsic values on their valuation dates. In Table 3, this effectively moves the valuation of T's options from the right column to the left.

Table 3: Comparison Option Values Using Alternative Valuation Dates and Methods

                                 Valuation date

                        Vesting date         Grant date

Black-Scholes model     Example 2            Example 4
using MRT               $4.84 per share      $3.93 per share
                        $2,420,000           $1,965,000

Black-Scholes model     Example 3            Example 5
using CEL               $4.38 per share      $3.38 per share
                        $2,190,000           $1,690,000

Intrinsic value         Example 1            Example 1
                        $2.00 per share      $0 per share
                        $1,000,000           $0

Rev. Proc. 98-34 affects the determination of an option's value by endorsing a valuation method that explicitly considers the value of potential future appreciation of the underlying stock. Taxpayers may choose not to adopt the procedure's safe-harbor provisions, but it is clear that the IRS will use the upper-end amount provided by Rev. Proc. 98-34 as a benchmark against which the taxpayers' determinations will be evaluated. In Table 3, the effect of Rev. Proc. 98-34 will be to move the valuation of T's options away from the pure intrinsic value and closer to an amount based on the Black-Scholes model. The combined effect of the two pronouncements on Examples 1-5 is to take a girl: that would have been valued at zero, and value it at up to $2,420,000.

The safe-harbor provisions do not allow taxpayers to include in the determination of an ESO's value discounts for lack of marketability or for restrictions on rights. Because such restrictions can substantially reduce the value of ESOs, many taxpayers will probably continue to claim the discounts and fall outside the safe harbors. Taxpayers who choose this approach should obtain an independent appraisal of the ESOs' value. To be defensible, the appraisal will have to rake into consideration the six factors used in the Black-Scholes model and cannot ignore the value of the potential future appreciation of the underlying stock. The appraisal could differ from the safe-harbor estimate and still be defensible if it uses the Black-Scholes model with different estimates for the factors. For example, the appraisal could use independent estimates of volatility and dividend yield that differ from the quantities reported in the company's financial statements. The appraisal could then reduce the amount computed, using the Black-Scholes model for lack-of-marketability or other discounts.

Regardless of how taxpayers choose to compute the value of their ESOs, the amount determined for transfer tax purposes should include the value of potential future appreciation of the underlying stock, even if the stock's price is below the option's exercise price. In Example 1, above, it was assumed that the option was "in the money" on June 1, 1998, because the stock price was $12 per share and the ESO's exercise price was $10 per share. If, however, the stock price had been $9 per share, the options would still have had value, according to the Black-Scholes option pricing model. The value of each option would have been $3.04 and the total value of all 500,000 options would have been $1,520,000. All of the value assigned to the options is attributable to the possibility that, before they expire, the price of the underlying stock will increase to more than the $10 exercise price. It seems clear that, with the issuance of Rev. Proc. 98-34, the IRS will no longer accept a value of zero for out-of-the-money options.

Conclusion

With the issuance of Rev. Rul. 98-21 and Rev. Proc. 98-34, the IRS has launched a two-pronged attack that will limit taxpayers' ability to give ESOs to family members free of transfer tax. Rev. Rul. 98-21 provides that gifts of options with vesting restrictions are not deemed completed for transfer tax purposes until the options vest; this will effectively delay the valuation date of the transfer and potentially increase the determination of the options' value. The employer can remove the delay by modifying its ESO contract to eliminate all applicable vesting restrictions; however, the IRS has made it clear with Rev. Proc. 98-34 that the value of ESOs--even those with no intrinsic value--is not zero. While taxpayers may be reticent to adopt the safe-harbor provisions, they and their tax advisers should be aware of how their determination of an option's value compares to the Service's benchmark based on the Black-Scholes model.

(1) Rev. Rul. 98-21, IRB 1998-18, 7.

(2) Rev. Proc. 98-34, IRB 1998-18, 15.

(3) Rev. Rul. 196, 1953-2 CB 178.

(4) This term was introduced by the Accounting Principles Board in Opinion No. 25.

(5) See IRS Letter Rulings 9714012 (12/26/96) and 9349004 (6/8/93).

(6) Another option-pricing model mentioned in Rev. Proc. 98-34, note 2, is the binomial model. Option values based on the binomial model are very close to those produced by the Black-Scholes model.

(7) See Statement of Financial Accounting Standards No. 123 (FAS 123), "Accounting for Stock-Based Compensation" (Financial Accounting Standards Board, October 1995).

(8) The spreadsheet formulas used in this article are based on those found in Crawford, Franz and Smith, "Computing Employee Stock Option Values With a Spreadsheet," 79 Management Accounting 44 (July 1997) and Mountain. "FASB 123: Putting Together the Pieces," 181 Journal of Accountancy 73 (January 1996).

RELATED ARTICLE: EXECUTIVE SUMMARY

* The Service's two-pronged approach attacks when the gift of ESOs is deemed to have occurred and how the value is computed.

* Under Rev. Rul. 98-21, the gift of ESOs is completed on the later of the date (1) of the transfer or (2) that all of the services have been performed.

* Rev. Proc. 98-34 outlines a safe-harbor method of valuing ESOs for gift, estate or generation-skipping transfer tax purposes.

For more information about this article, contact Dr. Franz at [phone].

Diana R. Franz, Ph.D., CPA

Associate Professor University of Toledo Toledo, OH

Dean Crawford, Ph.D., CPA

Assistant Professor State University of New York at Oswego Oswego NY

Linda Campbell, CPA

Assistant Professor Bluffton College Bluffton, OH