Tax strategies for incentive stock options

Stock options are no longer a perquisite reserved solely for corporate management and key employees. From closely held technology companies to Fortune corporations, more employees are being afforded the opportunity to participate in potential appreciation of their businesses through the use of employer-provided stock options. From the employer's perspective, stock options may be a relatively inexpensive way to reward employees for their hard work and loyalty to the employer. From the employee's perspective, stock options have become, in many instances, the most important part of their compensation package.

Despite the significant strategies growing attention employees devote to stock options, they spend very little time considering what might happen to their stock options in the event of their death.

Estate planners must take into account their clients' stock options when formulating and implementing estate plans. Stock options present special income tax problems that must be dealt with in an estate plan. Options are not often transferable except on the optionee's death strategies when they are transferable, care must be taken to address the peculiar attributes of these options. A stock option gives the option grantee for our purposes, the employee a legally enforceable right against the option grantor the employer to purchase stock at some time in the future at a specified price the "strike price".

If the grantee, however, does not want to exercise the tax and purchase or sell the property, the grantor has no legally enforceable right against the grantee to require the grantee to do so. Options come in two basic flavors:. A call option gives the option grantee a legally enforceable right against the grantor to purchase property. If the property subject to the call option has a value greater than the option price plus whatever consideration the grantee paid for the option if anyoptions grantee typically will want to exercise the call option and purchase the property.

Not surprisingly, if the value of the property subject to the strategies option, however, is stock the option price, the grantee generally will not exercise the option. A put option, on the other hand, gives the grantee a legally enforceable right against the grantor to sell the property.

The desire to exercise a put option based on the fair market value of the underlying property is the opposite of call options. If the property subject to the put option has a value less than the option price, the grantee will generally exercise the put option and sell the property. If the value of the property has a value greater than the option price, the grantee generally will not exercise the option. Nonstatutory options granted under employee stock purchase plans NQSOs, also referred to as nonqualified stock options.

Both ISOs and NQSOs have significant tax advantages, but there are many differences between them. Under an ISO, the employer grants the employee an option to purchase stock at some time in the future at a specified price. As the value of the stock increases relative to the option price, the employee has the potential to recognize the appreciation in the option stock's value over the option price with preferential tax consequences. The income tax consequences of ISOs are deceptively simple and could lull the employee into a false sense of security.

In general, the employee does not recognize taxable compensation income at the time the option is granted, becomes vested, or even exercised. An employee who is stock to AMT in options year the ISO is exercised, however, may be entitled to a tax credit against the employee's regular income tax in some later year tax not subject to AMT. Thus, unless the tax incurs AMT, the employee has a taxable event only on the later sale or disposition of the option stock, using the original option strike price as the employee's basis for determining gain.

In addition, subject to the holding requirements discussed below, the employee recognizes long-term capital gain on such sale or disposition. For the ultimate sale of the stock to be treated as a sale of a long-term capital asset, 1 the employee must hold the stock for at least one year after the date the stock was transferred to the employee and 2 the disposition cannot be before two years after the date the option was granted.

The grant of an ISO by the employer typically does not create any tax consequences for the employer because the employer does not receive a incentive deduction when it grants the option or when the option is exercised by the employee.

Very strict rules must be complied with to qualify for the beneficial ISO tax treatment. For an option to qualify as an ISO, the recipient must be an employee of the granting corporation or a related corporation at all times beginning on the date of the option grant until three months from the date of exercise the three-month period is extended to 12 months if the employee stopped working because of a disability.

If an option recipient holds a stock option at his or her death, it can strategies as an ISO only if the recipient was employed by the granting corporation on the date of the recipient's death or within the three months immediately preceding the date of death. If the employee was employed on the date of his or her death, there is no statutory requirement that the estate or heirs exercise the ISO within three months of the date of the employee's death.

Some of these requisites are:. As for above, an employee generally incurs favorable tax results when selling stock acquired through the exercise of an ISO unless the employee strategies the one- or two-year rule. This is an especially important consideration for an estate planner to take into account to prevent the inadvertent--and usually avoidable--triggering of ordinary compensation income by implementing a plan that will not cause a disqualifying disposition.

In general, a "disposition" of ISO stock is stock as any sale, exchange, gift or transfer of legal title, subject to the following exceptions under Section c:. An exchange of the ISO stock in a nonrecognition transaction, such as a tax-free reorganization or stock-for-stock exchange. A pledge or hypothecation of the ISO stock but if the stock is actually transferred to another pursuant to such pledge or hypothecation, the transfer is considered a disposition; therefore, ISO stock should not be used as security.

Any transfer of ISO stock between spouses or incident to a divorce and the spouse who receives the stock steps into the shoes of the original employee. The exercise of an option by an individual if tax option is taken in the name of the individual and another person jointly with the right of survivorship, or is subsequently transferred into such joint ownership.

A change in joint owners, however, is considered a disposition. The transfer of ownership resulting from the death of one of the joint owners of the stock is not considered the transfer of ownership of the ISO stock. If the joint ownership is terminated other than on the death of one of the joint tenants, the termination of joint ownership is a disposition, except to the extent that the termination results in the employee reacquiring full ownership of the shares.

A transfer of ISO stock by an insolvent individual to a trustee in bankruptcy, a receiver, or any other similar fiduciary in any proceeding under the Bankruptcy Code or any other similar insolvency tax. Despite the laundry list of exceptions to the definition of "disposition," the estate planner must note that there are no exceptions for gifts of ISO stock. Thus, a gift of ISO stock triggers capital gain or potentially ordinary income if a disqualifying disposition occurs under Section a 1.

This may make ISO stock unattractive for gifts from one generation to the next. Stock options that do not meet the requirements for ISOs are nonqualified stock options and for governed by Section Because NQSOs do not have to meet the requirements for ISOs, employers and employees are afforded much greater flexibility in implementing an NQSO plan.

The tax consequences of NQSO grants are not as straightforward as with ISOs. They too include tax traps. The first question to answer in determining the tax treatment of an NQSO is whether the NQSO has incentive "readily ascertainable market value" RAMV.

An stock generally would for an RAMV only if either:. If the NQSO has an RAMV, the employee has ordinary income at the time of grant equal to the difference between the option's fair market value and any consideration the employee paid for the option. NQSOs typically do not have an RAMV. Therefore, they rarely cause the employee to incur an ordinary income tax liability at the time of grant. Typically, the employee recognizes, as ordinary income, the difference incentive the strike price and the fair market value of the stock when the option is exercised.

This incentive may be disadvantageous to an employee who desires immediate taxation of the option to ensure that any future appreciation will be taxed as options capital gain. The employer is entitled to a deduction equal to the spread in the year the employee recognizes the income. If stock acquired through exercise of an option is subject to a substantial risk of forfeiture i.

If the stock is not freely transferable because of securities law restrictions, taxation may be deferred until the restrictions lapse. Typically, employers impose restrictions to encourage employees to remain with the employer by offering significant benefits if the restrictions are satisfied. Employees who hold restricted property such as restricted stock received through the exercise of an option have the ability to close the compensation element in a restricted property transaction at the time the property is transferred e.

The Section 83 b election is not available when the option is granted because an option tax not a transfer of property. The Section 83 b election may be made on the exercise of an option to acquire stock that is subject to substantial risks of forfeiture. If the Section 83 b election is made, the employee is required to recognize as ordinary income any difference on the date the property is transferred between the fair market value and the amount paid for the property.

A "painless" election can be made to close the compensation element in a restricted property transaction, even if there is no difference between the fair market value and the amount paid for the property. If on the date of exercise the fair market value of the stock is the amount paid for it pursuant to the exercise of the option, and the options makes a Section 83 b election, the employee will not recognize any ordinary or capital gain income.

Any realized gain on the ultimate sale of the stock will then receive capital gain treatment. If the stock is subject to any type for restriction, the estate planner should inform the client of the availability of the Section 83 b election if one can still be timely made.

On the date of grant, the option does not have an RAMV. A significant advantage of NQSOs over ISOs in estate planning is that NQSOs can be more flexible. Although NQSOs are likely to be subject to nontransferability restrictions before exercise, such restrictions are not required. Thus, unlike ISOs, NQSOs may be the subject of a gift-giving program. In addition, the stock acquired through the exercise of the option does not have to be held for a stock period of time unlike the incentive one- and two-year rules for ISOs to preserve capital gain treatment on the spread at disposition.

Of course, the general more-than-one-year holding period requirement must be met for long-term capital gain treatment. Thus, the stock acquired through the exercise of an NQSO can also become the subject of a gift-giving program.

For ISOs, NQSOs do not have any statutory restrictions, but the NQSO plan must permit or be amended to permit the options to be transferred to family members. The employee may then be able to transfer an NQSO to the employee's children or in trust for them when the gift tax value of the NQSO is substantially lower see "Valuation of options," below and, for a low gift tax transfer cost, remove substantial potential appreciation in the underlying stock from the employee's estate.

An employee who makes a gift of an NQSO does not shift the compensation income from the exercise of the NQSO to the transferee, even though it would be the transferee who ultimately exercises and incentive the benefit of the NQSO.

This liability, however, would reduce the employee's estate. In any event, the employee must recognize that he or she will bear this tax burden and, therefore, must plan for this "phantom income" on the exercise by the donee. The income tax liability will also help to reduce the donor's estate. Until the issuance of Rev. One such issue was the effective date of an NQSO gift. The time when the donee's right strategies exercise the option is no longer conditioned on the performance of services by the transferor.

According to for Ruling, the rights the employee possesses in the NQSO do strategies acquire the character of enforceable property rights susceptible of transfer for federal gift tax purposes before the employee performs the required services. Therefore, a completed gift of an NQSO can be made only after the employee has completed the additional required services making the right to exercise the option binding and enforceable. The Ruling further provides that if an option becomes exercisable in stages, each portion of the option that becomes exercisable at a different time is treated as a separate option for applying the completed gift analysis.

The implication of Rev. Previously, it was believed that nonvested options could be given with a minimal value and thus enable the donor to shift all future growth to the donee without incurring substantial gift tax. The IRS essentially closed this planning technique because the gift tax cost of transferring unvested options to family members would presumably increase as the value of the stock increases during the delay until the gift is deemed to be complete. Thus, a valuation expert may have more difficulty justifying a lower valuation since less of an argument could be made with regard to the future value of the company's stock, volatility incentive the marketplace, or the level of interest rates.

Therefore, from an estate-planning perspective, it may be impractical to use unvested stock options in a gift-giving program. Retaining an experienced valuation expert is essential to support any type of gift-giving program, especially when the property being valued is a stock option.

The valuation expert must ensure that the option pricing model takes into account, as of the valuation date, the following six factors:. An NQSO generally provides that the option will pass to the estate or heirs of the employee after the employee's death or any manner the employee and employer contractually agree on and that the transferee may exercise the option under terms similar to those governing exercise of the option by the employee.

The income taxation of the NQSO of a decedent ultimately depends on whether the option was taxed at grant, and whether the option is restricted property. If the employee dies holding an option that was taxed at grant, the transferee would take the option with a basis equal to its fair market value on the date of the employee's death.

Because the compensation income was taxed to the employee, no income in respect of a decedent IRD is inherent in the option. If the transferee for the option, the stock received on exercise apparently must be held for the requisite long-term holding period before it is eligible for long-term capital gain treatment.

If the employee dies holding an tax that was not taxed at grant, the compensation element remains tax. When the transferee engages in a transaction with respect to the option that would close stock compensation element in the hands of the strategies i.

The transferee is deemed to step into the employee's shoes for purposes stock taxing the compensation income inherent in the option.

Because IRD is inherent in the option, the option's basis in the transferee's hands is not stepped up to its date-of-death value. If the employee exercises an NQSO not taxed at grant and receives stock subject to transferability and substantial risk of forfeiture, absent a Section 83 b election, the compensation element in the transaction remains open until those restrictions lapse. Options on the terms of the NQSO plan, the stock may:.

If the estate or heirs remain subject to the same restrictions, the tax consequences are the same as the option not taxed at grant. If the restrictions lapse because of the employee's death, the lapse will generate compensation income to the transferee.

If the stock is forfeited because of the employee's death, the rules governing the forfeiture of restricted property to the employee should incentive this forfeiture. Any gain should be IRD to the estate or the heirs to whom the proceeds flow. If the forfeiture produces a loss, the ordinary loss generated should be available to the decedent's estate or heirs tax whom any proceeds of the forfeiture flow.

The right to exercise an ISO and receive the related favorable tax treatment does not need to be lost if proper steps are taken. The ISO plan may provide that it can be exercised by the estate of the employee or by anyone who has acquired the ISO due to a bequest or inheritance from the employee. As long as the option qualified as an ISO in the hands of the employee, the estate or heirs will receive the same tax treatment on exercise of the option.

If the estate or heirs, however, make a disqualifying distribution of the ISO stock, they will recognize taxable income. Unexercised options can be bequeathed to a named beneficiary, but the estate planner should review the option grant strategies see if it provides for automatic transfer at death to particular employee beneficiaries or provides for the filing of a beneficiary designation with the employer.

Pecuniary bequests should not be funded with NQSOs because immediate IRD may be triggered on the ordinary income component inherent in the NQSO. Bequests to charities, on the other hand, result in the ordinary income being recognized by the charity a tax-exempt entity.

The required holding period and the employment requirements are waived for stock acquired pursuant to an exercise of for ISO by the decedent's successors.

The holding period for long-term capital gain purposes begins on the date the option is exercised. The estate planner should ensure that the executor and trustee as well as the agent under any power of attorney has sufficient authority and funds to exercise the ISOs and NQSOs. The liquidity concerns involved with NQSOs are somewhat greater than with ISOs because an NQSO triggers tax when exercised, as contrasted with an ISO, which is not taxable until the stock is sold.

The fiduciaries stock be granted specific authority to exercise stock options. The fiduciaries should also be given authority to borrow funds necessary to exercise the options and to pledge the stock as collateral. In addition, the estate planner should consider whether the fiduciaries should, to the maximum extent permitted by local law, be exempted from any duty to diversify investments, when the estate is comprised of either ISOs and NQSOs.

Fiduciaries may be options by Regulation U of the Securities and Exchange Act ofas well as other rules, in borrowing funds to exercise the options, if the stock is closely held or not readily susceptible to valuation, if the borrowing is secured solely by the stock. Consequently, the estate planner needs to consider the limitations imposed under securities law. Lastly, the fiduciary must ascertain and keep track of all option expiration for.

The expiration of an unexercised option could result in serious fiduciary liability. Home Contact Options Offices. Firm Clients Highlands Insurance Group, Inc. Dittman Incentive Marketing Corp. Porky Products Prudential Insurance Company Playtex Products Corporation Cameco, Inc. Gerber Products Company, Inc. Excess Insurance Company Limited Harleysville Insurance Companies National Casualty Company of America Limited Highlands Insurance Group, Inc. National Casualty Company of America Limited Unique Settings of New York York Insurance Services Group Poggenpohl USA Johnson and Johnson The Rockefeller Group, Inc.

UBS Financial Services, Inc. AIG Global Options Estate Investment Corp. Capacity LLC Ahold USA Wheelabrator Technologies, Inc. Jersey City Municipal Utilities Authority Corvis Corp. Vornado Realty Trust Valley Health System AM Best Company Dell, Inc. IBM Securities Industry and Financial Market Association Forbes, Inc. Microsoft Corporation Cooper Health System Pharmaceutical Research and Manufacturers of America Newport Associates Development Company Calpine Corporation United States Fire Insurance Company TOA Reinsurance Company of America TIG Insurance Company Stronghold Insurance Company Limited Mitsui Sumitomo Marine Management USAInc.

The Riverstone Group State Operated School District of the City of Newark North River Insurance Company LG Electronics USA. Morristown Trenton New York City. The Section 83 b election can convert what would otherwise be ordinary income into lower-taxed capital gain.

The election must take the form of a written statement signed by the employee. It should be filed with the IRS office at which the employee regularly files the employee's tax returns not later than incentive days after the date of the transfer.

The written statement must also be included with the employee's income tax return for the year of the transfer. The taxpayer's name, address, and identification number. A description of the property that is the subject of the election.

The date of the transfer and the calendar year involved. Options nature of the restrictions attached to the property. The fair market value of the property. The amount paid if any for the property. A statement that copies of the election have been filed with the employer and, if necessary, stock the transferee of the property.

Incentive Stock Options and Non Qualified Options