Transfer of nonqualified stock options to charity.

In Letter Ruling 9737014, the IRS explained two methods of making a non-arm's-length transfer of nonqualified stock options that will not trigger income recognition until the options are subsequently exercised. In both cases, the options were substantially vested and the employee-optionee-donor retained control over the timing of exercise during his lifetime. This resulted in the Service finding that no completed gift had been made.

In the first case, to remain anonymous, a donor transferred stock options to a combined custody and brokerage account held on behalf o the employee by a financial intermediary and subject to the terms of a gift administration agreement. Under the agreement, the intermediary was required to exercise the options on a specified date, which the donor retained the ability to change. On exercise, the intermediary was to sell the shares immediately, and deposit the net proceeds in the account from which a wire transfer would be made to the specified charities. The letter ruling explained that the net proceeds of the sale meant the gross proceeds less the exercise price, withholding taxes and costs relating to the option's exercise and its transfer. (It was assumed that the intermediary paid the exercise price and withholding taxes to the donor's employer directly.)

In the second case, an optionee irrevocably donated options to a charity, but retained the power to veto the charity's proposed exercise of the options during his life and to designate the withholding tax rate and the spread on exercise. The charity had two methods by which it would be able to exercise the options. It could either pay the exercise price and all applicable taxes to the donor's employer and then receive the shares, or it could arrange for a same-day sale with a broker who would deliver the exercise price and taxes to the donor's employer.

In both cases, once the donor died, the charities were free to exercise the options at any time.

The IRS ruled that the donors will not recognize income or gain on the transfer of the options, but will recognize compensatory income when the options are exercised. The amount of this income is equal to the excess of the optioned shares' fair market value on the date of exercise over the option's exercise price.

The Service also ruled that when the exercise occurs during an optionee's lifetime, his recognized income is wages for Federal income tax withholding purposes under Sec. 3401, not the result if the exercise occurs after the optionee's death. In either event, however, the income will be treated as compensatory income and the employer will be allowed a deduction equal to the amount of compensation income recognized by the optionee.

As a follow-up, Letter Rulings 9737015 and 9737016 covered the charitable deduction and estate and gift tax issues not addressed in Letter Ruling 9737014. In both cases, the IRS found that the optionee's reserved right to control the date of exercise prevented the completed transfer of the options to the charity. Accordingly, in the first instance, no completed charitable contribution for purposes of Sec. 170 occurred until the intermediary made a wire transfer of money to the charity. In the second instance, no completed charitable contribution occurred for purposes of Sec. 170 until the charity exercised the options. The Service also ruled that because the character of what the charity receives is compensation (and not capital gain) to the donor, Sec. 170(e)(1) did not apply to reduce the charitable contribution deduction, because the option would not have appreciated in value at the time of the contribution.

For gift tax purposes, the IRS ruled similarly in the first case that a completed gift occurred when the intermediary made the wire transfer to the charity. However, in the second case, the Service ruled that a completed gift occurred when the donor approved the charity's exercise and designated the withholding tax rate and the spread on exercise.

Finally, for estate tax purposes, the IRS ruled that, in both instances, to the extent the donated options had not been exercised during the donor's lifetime, the, value of the options would be includible in the donor's estate under Secs. 2036 or 2038 and the estate would be allowed a charitable deduction under Sec. 2055(a) (if not disallowed under Sec. 2055(e)).

While these rulings do not address the consequences of transfers to charity when the options are not substantially vested, it appears that the same rationale should prevail, and that a completed transaction will occur only to the extent the charity actually receives money or a quantifiable right to property.