Stock Options.

Converting an employee's benefits

Understanding the rules of stock options can make the charitable gift planning process easier for nonprofits and their donors while keeping Uncle Sam's greedy hands out of the estate.

"The use of sophisticated charitable giving techniques is coming of age in a big way with a broad spectrum of innovative nonprofit development officers and allied professional advisers," said financial planning expert Robert Lew of Planning & Financial Advisors of San Francisco. Lew joined partner and attorney Darryl D. Ott in a presentation on Navigating Stock Options at the National Committee on Planned Giving's 13th annual conference in Orlando, Fla.

Stock options "are now a source of significant wealth for many potential donors," Ott said. "The opportunities available for the charities, the allied professionals and, most importantly, the donors to use the planned giving tools to assist with the succession planning and tax reduction for their options and restricted stock are immense."

He explained: "The types of options we are talking about are compensatory options. What we're looking for is an employer-employee relationship, and these are perks to give employees some kind of stock right in this volatile dot-com economy."

A stock option is the right, but not the obligation, to buy a fixed number of shares of stock at a specific price for a specific period of time. Incentive stock options are commonly used as bonuses or as compensation at an upstart company that needs its cash to fuel growth. The assumption in granting employees stock options is that the value of shares in the company will increase.

"That was always true until a couple of months ago," Lew said, referring to the downturn in the technology sector.

Like many financial matters, rules around stock options can be confusing and rife with acronyms. "Part of the confusion is that these stock options are not always called the same thing," Lew said. "Incentive stock options are sometimes called statutory stock options, sometimes called qualified stock options -- same thing. Just remember incentive stock options or ISOs."

Stock options for employees fall into three major categories: Incentive stock options, nonqualified stock options and restricted stock.

Incentive stock options have the benefit of reduced taxation but a downside of restrictions and limitations. No tax is due when ISOs are granted or the employee becomes vested in the program. Taxes may be due when the option is exercised, however. That tax is called Alternative Minimum Tax and is distinct from regular income tax.

Although ISOs grant employees the right to buy stock at a price below full market value, upon the employee's death, the value of the shares already exercised steps up to full-market value. The difference between the full market value and the exercise price is included in the estate.

From a planned giving perspective ISOs cannot be transferred while the recipient is alive under the Internal Revenue Code. But at death, the option can be given to a charity by the estate or heirs at full-market value.

Some of the major requirements of incentive stock options include:

* Shareholders must approve the plan;

* Options can only be awarded to employees, not directors or consultants, and the employee must remain on the payroll through the date the option is exercised;

* Options must be granted within 10 years of the date the plan is adopted and must be exercised within 10 years of the date the option is granted;

* The fair value of the incentive stock option first exercisable during a year cannot exceed $100,000;

* An individual already owning more than 10 percent of the company's stock must pay at least 110 percent of the exercise price, and the option must expire within five years, versus 10 years for lesser shareholders.

Unlike incentive stock options, nonqualified stock options are not limited just to employees of the company, but they may be granted to employees, directors and consultants. Nonqualified stock options can be transferred at any time, if the plan allows.

While nonqualified stock options are more flexible and transferable than ISOs, the tax benefits are not as generous. The ability to transfer the options does give charitable gift planners some additional opportunities. Options exercised after the recipient's death trigger ordinary income tax, minus a deduction for estate taxes paid.

Lew and Ott suggested that owners who want to donate their nonqualified stock options while still alive give the options to a charitable lead trust. After the stock option is exercised, planned giving options include: an outright gift, a charitable remainder trust, a charitable lead trust, charitable gift annuities, or creating a pool income fund. For wealthy donors, a heavy tax burden on the heirs is a strong incentive to take part in planned giving. An estate with a value of $2 million could be taxed as much as $720,000 if no charitable planning is involved, Lew said.

Restricted stock is often withheld until a certain date or depends on the performance of the employee. In other words, an employee may receive stock if he or she stays with the company until a certain date or achieves certain goals. Until the stock is actually awarded, it can be returned to the company.

While restricted stock is simpler than the other two options, it offers no special tax advantages. If the donor is still alive, restricted stock cannot be given away while the restrictions are still in place. However, the stock can be willed as a gift, or a charitable remainder trust can be created. After the restrictions lapse, the living donor's planned giving options expand.

Lew said that lawyers, accountants, financial planners and planned giving experts should consult on the best options for each donor. "Right now, I think that a lot of these individual professions are taking their tools and trying to impose them on the client, rather than saying to the client: 'What are you trying to achieve?' If you understand the client's goal and you can't solve it with your particular set of ideas, well you don't have any recommendations."

Richard Williamson is a reporter for the Denver News Bureau.

Know Your Terms

Some of the key terms for planned giving experts in dealing with stock options include:

* Alternative Minimum Tax. Applied when options are exercised, the AMT is distinct from regular income tax. The rate is 26 percent on a base up to $175,000 and 28 percent above that amount.

* The 2-and-1 rule requires the grantee of options to hold the stock for two year after the grant of the option or one year after the grant is exercised to qualify for the lower capital gains tax instead of regular income tax. The rule has important implications in the use of planned giving tools.

* Code Section 83(b) Election is made with respect to restricted stock, and in special circumstances it might be made as of the date of the exercise of an incentive stock option to limit the alternative minimum tax. The election must be filed with the IRS for the taxable year in which the employee receives the restricted stock. It allows the employee to report a lesser amount of ordinary compensatory income during the year with the hope that in future years the employee will be able to report proceeds from sale of the stock as capital gains.

* The exercise price is the price that the employee must pay the company for the stock. The exercise price must be specified in the grant of the option.