The perfect gift?

If you asked your children for their idea of the perfect gift, you probably would hear answers such as a new car, the clown payment on a house, or a trip to the South of France next summer. If you asked your financial advisor's input, on the other hand, he or she likely would respond from an estate-planning perspective. To them, the perfect gift is one with little current value but large potential value. It is also one that would incur little or no ("gift tax") cost today, while allowing all future appreciation to take place outside your estate.

For a senior executive, the asset that best fits this description may well be a compensatory stock option. By its definition, an option to buy stock has little value at the time it's granted but has the potential to be exceptionally valuable as the stock price increases. There are a number of advantages to making such a gift to your heirs using a technique known as Executive Option Transfer.

Here's how it works: At the time you are granted a stock option, you gift the option directly to your heirs or to a trust for their benefit. The option has little value at this point, because the exercise price is usually equal to the fair market value on the date of grant. Once the gift value is determined - using a quantitative valuation model to value publicly traded stock options - discounts can be taken from this fair market value number, relying on the principles of illiquidity and lack of marketability, to further reduce the gift tax value. You then pay the gift tax or use part of your annual exclusion ($10,000 per donee) or lifetime estate and gift tax exclusion ($600,000).

At some future date, when the option has appreciated in value, your heirs or trustees for the benefit of heirs, exercise the stock option. The entire proceeds pass to your heirs free of further estate and gift taxes. However, at the time of exercise, you are required to pay the income tax on the option spread, just as you would pay the tax if you had not transferred the options but had simply exercised them in your own name. This clearly needs to be considered in terms of cash flow, as the option proceeds will not be available to help fund the tax liability. The key here, however, is that this payment of the income tax is not considered [TABULAR DATA OMITTED] a taxable gift to your children.

The chart above illustrates the power of this technique. You are granted 10,000 options at $30 per share. They are later exercised at $60 per share. If you exercised the options, paid the income tax, and passed the reinvested proceeds on to your heirs 20 years after exercise, you would leave them $197,000 after estate taxes. With the Executive Option Transfer technique, the amount you pass to your heirs increases to $612,000. The benefit comes from the future appreciation on the option and the reinvested option proceeds, plus the fact that your heirs do not pay the income tax on the option exercise.

While this is clearly a powerful technique for passing on wealth to future generations, there are a few potential drawbacks:

* Your company stock-option plan probably states that your options are nontransferable. The plan will need to be amended to permit "limited" transfers to family members or to a trust for the benefit of family members. At minimum, this change probably will need board of directors' approval.

* The executive must cede control over the timing of exercise and over resulting proceeds once the options are transferred. From a tax standpoint, the transfer must be irrevocable for it to be a completed gift.

* If the stock does not appreciate in value, you may have used part of your estate tax exclusions and/or paid gift tax with no benefit to your heirs.

* There are legal fees, trustee fees (if a trust is utilized), and stock-option valuation fees associated with an option transfer.

* This technique works only with non-qualified or non-statutory options. Incentive stock options are not transferable under the tax laws.

* The IRS could audit your gift tax return at time of transfer, and valuation of compensatory stock options has no real precedent in the tax law.

* The exercised option stock may need to be held for two years after exercise, depending upon the type of SEC registration utilized.

* The IRS has looked favorably on the technique in recent times. But the tax aspects of this transaction are not risk-free, which means the IRS could change its interpretation of the law in the future or challenge the transfer if the gift is not properly structured.

Nevertheless, while not a convertible car or waterfront mansion, an Executive Option Transfer makes the "perfect gift" - one equally satisfactory to giver and receiver.

Thomas J. Ross Jr. is a partner in Coopers & Lybrand's Personal Financial Services (PFS) Practice and a member of its PFS National Steering Committee. Steven A. Calvelli is a senior manager in the same practice.