Stock option plan amendment not material for sec. 162(m).

The IRS has ruled in Letter Ruling 9551024 that an amendment to a stock option plan that allows participants to transfer their stock options to family members is not a material modification for Sec. 162(m) purposes. The letter ruling was based on the proposed regulations to Sec.162(m), which have since been finalized in a manner that does not change the result of the ruling.

Letter Ruling 9551024

The company maintains a performance-based compensation plan under which stock options are granted to its executive management. The stock options are not transferable by participants except by will or the laws of descent and distribution, and are exercisable during the participant's lifetime only by the participant. The plan was approved by the company's shareholders before Dec. 20, 1993, in a manner consistent with Securities and Exchange Commission Rule 16b-3.

To facilitate estate planning for participants nearing retirement, the company proposed to amend the plan to permit participants to transfer stock options to any member of the participant's immediate family or to a trust established for the exclusive benefit of one or more members of the participant's immediate family. The transferees will enjoy the same rights as the participant, except they will be unable to transfer the stock options except by will or the laws of descent and distribution. In addition, stock options granted under the plan on or before Jan. 25, 1995 (the prior awards) will be amended in a similar manner. Since the plan's establishment, the requirements of Prop. Regs. Sec. 1.16227(e) (2) (vi) have been satisfied with respect to stock options granted.

The IRS ruled that, because the proposed amendment did not affect the timing or amount of income recognition to the participants, it would not constitute a material modification of the plan within the meaning of Prop. Regs. Sec. 1.16227(h) (3) (ii) (A). Also, the proposed amendment to the terms of the prior awards would not cause the awards to violate the "preestablished performance goal requirement" of Prop. Regs. Sec. 1.162-27(e) (2) (vi).

Planning Opportunities

Amending or implementing a nonqualified stock option plan to allow for the transfer of options may result in significant compensation and estate planning opportunities. The primary benefit of transferring stock options to a participant's family member or a trust established for a participant's family member is that appreciation in value is removed from the participant's estate.

First, the transfer by the participant will be a taxable gift equal to the fair market value (FMV) of the options at the time the options are transferred to the trust. (It has been suggested that a supportable gift tax value of such a transfer would be less than 50% of the theoretical value of a long-term marketable option on the company's stock, thereby resulting in relatively minimal gift tax consequences.) The appreciation (i.e., the difference between the value of the options when transferred to the trust and the value of the stock at exercise) will completely escape transfer tax. Thus, the transfer tax cost of such a transfer would be significantly less than the cost of transferring the stock after the option is exercised.

Second, the participant will be subject to income tax on the exercise of the options on an amount equal to the stock's FMV less the exercise price. Because the participant will remain liable for the income tax on the exercise of the options, the payment of that liability will not be subject to gift tax, even though the payment will benefit the participant's family rather than the participant.

Finally, the employer's income tax deduction will be unaffected by the transfer of the options. Thus, the employer will be entitled to a compensation expense deduction when the executive exercises the options, in an amount equal to the amount the executive includes in income. (The IRS has recently confirmed this result in Letter Ruling 9616035.)

FROM PETER I. ELINSKY, CPA, J.D., LL.M., AND BRIAN CUMBERLAND, J.D., LL.M., WASHINGTON, D.C.