Source: http://corporate.findlaw.com/business-operations/transferable-employee-stock-options.html
Timestamp: 2018-02-25 07:18:31
Document Index: 70505386

Matched Legal Cases: ['§422', '§422', '§2031', '§421', '§83', '§2511', '§25', '§25', '§2511', '§25', '§1', '§1']

Employee stock options often represent a significant portion of an executive's net worth. This may be particularly true for executives working for technology or other emerging growth companies, due to the prevalence of stock options in these companies and their potential for significant appreciation in value. With a top federal estate tax rate of 55%, it is becoming increasingly common for executives to consider removing this asset from their taxable estate by transferring the options to family members or to a trust for the benefit of family members. A transfer of employee stock options, however, involves consideration of various estate, gift and income tax rules.
This article examines the federal estate, gift and income tax consequences of option transfers by an employee and addresses certain related securities laws issues. As this article points out, employers and employees who are interested in pursuing an option transfer should proceed with caution.
Employers commonly grant stock options to employees, either in the form of "incentive stock options" ("ISOs") or "nonqualified stock options " ("NSOs"). ISOs offer employees certain tax benefits and are subject to qualification requirements under the Internal Revenue Code ("IRC"). (IRC §422.) Among other things, ISOs are subject to a general prohibition against transfer, although ISOs may be transferred to an employee's beneficiaries (including the employee's estate) upon the employee's death. (IRC §422(b)(5).) An option that is transferred (or transferable) during the employee's lifetime, whether by its original terms or by subsequent amendment, will not qualify as an ISO but will instead be treated as an NSO for tax purposes.
Even though NSOs are not subject to the ISO nontransferability limitation, many stock option plans contain restrictions on transfer similar to those that apply to ISOs. Employers that do allow employees to transfer their options generally do so on a restricted basis by, for example, limiting option transfers to the employee's family members or to a family trust.
If an employee dies holding unexercised employee stock options, the value of the option at the time of death (i.e., the difference between the fair market value of the shares and the option exercise price) will be included in the employee's estate and subject to estate tax. (IRC §2031.) Typically, following the employee's death, the options may be exercised by the executive's estate or by his or her heirs. In either case, the income tax consequences upon exercise after the employee's death depend on whether the option is an ISO or an NSO.
In the case of an ISO, exercise will not generate taxable income and the purchased shares will have a tax basis that "steps up" to their fair market value at the time of the executive's death. (IRC §421(a)(1),(c)(3).) A subsequent sale of the shares will generate capital gain or loss. In the case of NSOs, exercise will trigger ordinary income measured as the difference between the fair market value of the shares at the time of exercise and the option exercise price, subject to a deduction for any estate tax paid with respect to the NSO. There is no step up in the tax basis as the result of the employee's death. (IRC §83 (a).)
As mentioned above, however, ISOs are not transferable during the employee's lifetime. Since ISOs do not present the same estate planning opportunities as NSOs, this discussion is limited to the transferability of NSOs (including ISOs that become NSOs as a result of an amendment to permit transferability or as a result of an actual option transfer).
A transfer of employee stock options out of the employee's estate (i.e., to a family member or to a family trust) offers two main estate planning benefits: first, the employee is able to remove a potentially high growth asset from his or her estate; second, a lifetime transfer may also save estate taxes by removing from the employee's taxable estate the assets that are used to pay the income and gift taxes that result from the option transfer. At death, estate taxes are computed on the basis of the decedent's gross estate prior to the payment of taxes. In other words, estate tax is paid on the portion of the estate that is used to pay estate taxes.
For example, if the decedent's taxable estate is $1 million and the estate tax is $300,000, the estate will have paid estate taxes on the $300,000 used to pay the tax. By removing from the decedent's taxable estate assets that will otherwise be used to pay the tax, only the "net" value of the decedent's estate is taxed at death. If the employee transfers options and incurs gift and later income taxes as a result (discussed below), the ultimate estate tax burden is reduced.
A transfer of property by way of gift is subject to the gift tax rules. These rules apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. (IRC §2511; Treas. Reg. §25.2511-2(a).) For gift tax purposes, an option is considered property. (See Rev. Rul. 80-186, 1980-2 C.B. 280.)
When an option is transferred by way of gift, the amount of the gift is the value of the option at the time of transfer. The gift tax regulations provide that the value of property for gift tax purposes is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both being reasonably knowledgeable of the relevant facts. (Treas. Reg. §25.2512-1.)
Applying this standard to NSOs is particularly challenging given their unique characteristics. Moreover, there does not appear to be any IRS precedent for valuing NSOs for gift tax purposes, and it is not clear how the IRS would value an NSO upon audit. (In PLR 9616035, the IRS suggested that specific methods of payment under the options should be considered in valuing the options for gift tax purposes.)
The restrictions and conditions that are typically imposed on employee stock options, such as limits on transfer, vesting conditions and expiration provisions tied to employment should support a lower valuation than traded options, especially if the option transfer occurs shortly after the option grant date when the option is unvested and the option "spread" is minimal (or nonexistent).
While recent refinements to option valuation methodology for SEC disclosure and financial accounting purposes might be helpful, an employee who wishes to transfer an NSO should be prepared to defend the option valuation used for gift tax purposes and should consider obtaining an independent valuation.(See Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation.)
Complete Gift Requirement
To be an effective transfer, the gift must be complete. (IRC §2511.) A gift is incomplete if the donor retains any power over the disposition of the gifted property after its purported transfer. (Treas. Reg. §25.2511-2(b),(c).) Thus, for example, an option transfer to a typical revocable "living" trust is considered incomplete.
The IRS has addressed the gift and income tax consequences of an employee's transfer of an NSO in a series of private letter rulings beginning in 1993. (PLRs 9722022, 9714012, 9713012, 9616035, 9514017, 9350016 and 9349004.) In these rulings the IRS determined that the employee's transfer was a completed gift for gift tax purposes.
However, in four of these rulings the options involved were fully vested and exercisable at the time of transfer. (PLRs 9722022, 9514017, 9350016 and 9349004.) PLRs 9714012, 9713012 and 9616035 are silent on this point, although PLR 9616035 implicitly suggests that the options are exercisable following transfer by stating that, after the transfer, "family members may exercise the options and purchase stock at their discretion."
The IRS has yet to specifically determine whether a transfer of unvested options results in a completed gift for gift tax purposes. Typically, the exercisability of unvested options is based upon the employee's continued employment with the employer, and it is possible that the IRS will not consider the gift to be complete until the option becomes exercisable.
This could significantly undermine the intended estate planning benefits since the value of the option could be much higher at the time of vesting than at the time of grant. Under different circumstances the IRS previously concluded that where an employee-donor could defeat a transfer by terminating his employment, the transfer was an incomplete gift. (See Action on Decision/CC-1990-026 (September 24, 1990).)
Nevertheless, so long as the employee does not retain rights in the option, the transfer of an option should be considered complete even though the option is not then exercisable and will expire upon the employee's termination of employment. In PLRs 9722022 and 9616035 the IRS noted that while the exercise of the transferred option might be accelerated upon the employee's retirement, disability or death, these events were acts of independent significance, and their resulting affect on the exercisability of the transferred option should be considered collateral or incidental to termination of employment. (See also Rev. Rul. 84-130, 1984-2 C.B. 194; Rev. Rul. 72-307, 1972-1 C.B. 307; but see PLR 9514017 in which the IRS seemed to specifically limit this analysis to vested options.)
The gift tax rules provide that the first $10,000 of gifts made to any one person during a calendar year ($20,000 with respect to joint gifts from a husband and wife) are excluded in determining the amount of taxable gifts made during the calendar year. The annual exclusion is not available, however, in connection with gifts of future interests, relating generally to gifts the enjoyment and possession of which are postponed to a future date. The IRS might view the transfer of an unexercisable NSO as a gift of a future interest, which would not qualify for the annual exclusion.
Even if the option is not considered a future interest, a transfer of an NSO, other than by outright transfer, may not qualify for the annual exclusion unless the transfer meets the requirements of Internal Revenue Code Section 2503(c) (relating to transfer to minors), or, in the case of transfers to an irrevocable trust, the trust includes so-called "Crummey" provisions (relating to the right of beneficiaries to demand a portion of the trust corpus).
The federal income tax consequences resulting from a gift of NSOs are more predictable than the gift tax consequences described above. In general, the transfer itself should not have any income tax consequences to the employee or the donee, although the employee (or the employee's estate) remains taxable on any gain realized in connection with the option exercise.
Option Grant/Amendment
NSOs are not taxed at grant unless they have a "readily ascertainable fair market value" within the meaning of Treasury Regulations. (Treas. Reg. §1.83-7(b).) Given the stringent tests imposed under these rules, it is unlikely that an NSO with limited transferability would be considered to have a readily ascertainable fair market value, and the IRS has so held. (PLR 9722022.) As a result, transferable options should not be taxed at grant but should instead be taxed at exercise in accordance with the principles of Internal Revenue Code Section 83. (See, e.g., PLR 9616035.)
In general, under Section 83(a), exercise of an NSO triggers ordinary compensation income equal to the difference between the fair market value of the purchased shares and the option exercise price (i.e., the "spread").
For purposes of Section 162(m) of the Code, which imposes a $1 million limit on the deductibility of compensation paid to certain officers of public companies, the IRS previously concluded that an option or plan amendment to permit limited transferability is not considered a material modification of the option or plan for purposes of the private to public exemption from Section 162(m) or the transition rule "grandfather" provisions.(PLRs 9722022, 9714012 and 9551024; Treas. Reg. §1.162-27(f) and (h)(3).)
The employee will not recognize any income or gain upon the transfer of an option. Nor will the donee recognize any taxable income as a result of the transfer.
Upon option exercise by the donee, the employee/donor (or the employee's estate if the employee is deceased) will recognize ordinary compensation income generally measured as the difference between the fair market value of the purchased shares and the option exercise price. If the donee exercises the options before the employee's death, any income taxes paid by the employee escape estate tax at the employee's death.
Thus, in effect, the employee has made a tax free gift to the donee in the amount of the income taxes paid as a result of the exercise. If the purchased shares are subject to a "substantial risk of forfeiture," the date of taxation and measurement of ordinary income in connection with the option exercise may be deferred unless the employee makes an election under Section 83(b) of the Internal Revenue Code. The employer is entitled to a corresponding deduction.
The IRS rulings are silent as to the tax withholding obligations resulting from the option exercise, although presumably the compensation income recognized by the employee/donor as a result of the exercise would be subject to ordinary income and employment tax withholding. (See Rev. Rul. 67-257, 1967-2 C.B. 3359.) If the option shares are used to satisfy the tax withholding obligations, the donee will be considered to have made a gift to the employee-donor for the amount of taxes paid. This result would suggest that option exercise and any withholding should be coordinated among the employer, the employee/donor and the donee.
Consequences to Donee
The donee incurs no liability in connection with the option transfer or its exercise. After exercising the option, the donee's tax basis in the purchased shares is equal to the sum of (i) the option exercise price and (ii) the ordinary income recognized by the donor in connection with the option exercise. (See PLR 9421013.) Upon a subsequent sale or exchange of the shares, the donee will recognize capital gain or loss as applicable.
Transferable options held by employees of public companies raise a number of issues under federal securities laws. In addition, private companies must be sensitive to applicable state securities laws.
Rule 16b-3. 1996 changes to the so-called "short swing" profit trading rules under Section 16 of the Securities Exchange Act of 1934 (the "New Rules") greatly simplify the Section 16 analysis relating to transferable options. Section 16 subjects officers, directors and 10% shareholders ("insiders") of public companies to reporting obligations and potential liability in connection with transactions involving company securities. Rule 16b3 offers insiders broad exemptions from Section 16 with respect to compensatory transactions.
Effective November 1, 1996, options no longer have to be nontransferable to enjoy exemption under Rule 16b3. As a result, under the New Rules the grant of a transferable NSO or an amendment to an existing option to permit transferability should not be considered a "purchase" under Section 16 that can be "matched" with a sale of employer securities during the six months before and after the option grant. (Note that under the New Rules, amending an option to permit its transfer will not be treated as a cancellation/regrant for Section 16 purposes as was the case under prior rules. SEC Release 34-37260, fn. 169.)
Different rules may apply, however, in the case of options amended prior to November 1, 1996, since the amended options may be subject to the prior rules. Moreover, in the case of an option transfer by an insider to a family member living in the same household as the insider, the option will be considered indirectly owned by the insider and will remain subject to continuing reporting under Section 16(a) of the Securities Exchange Act of 1934. A plan amendment permitting option transfers does not generally require shareholder approval.
Tradeability of Shares
Form S-8 is the standard SEC registration form for public company securities to be issued to employees under employee equity plans. In essence, registration on Form S8 ensures that the shares employees receive under such plans will be freely tradeable on the open market. Unfortunately, Form S8 is generally limited to share issuances to employees and does not extend to shares issued in connection with an option transferred by the employee-donor during his or her lifetime.
Although the SEC is considering changing this limitation, under current law option shares issued to the donee of an option will not be freely traded but will instead be considered "restricted" (i.e., transferable subject to the restrictions on transfer imposed under Rule 144 of the Securities Act of 1933). As a result, shares issued to the donee will be subject to the holding period requirement under Rule 144. Under limited circumstances, Form S3 may be available to cover resale of option shares by the recipient.
Companies considering amending options to permit transfers should also be sensitive to the financial accounting consequences of such an amendment. In particular, companies should consult their auditors to determine whether such an amendment triggers a new measurement date. Amending an option to permit transfers to the employee's family or family entities (e.g., family trusts or family partnerships) should not trigger a new measurement date. If a new measurement date is triggered, the company would be required to recognize compensation expense based on the difference between the option exercise price and the value of the option shares at the time of the amendment.
The consequences of option transfers can be uncertain. ISOs cannot be transferred and continue to qualify as ISOs, but NSOs may be transferred if the option plan permits it. Employee/donors must confront a number of complex gift and income tax concerns as well as the potential lack of marketability of the transferred option shares before deciding to pursue an option transfer. Nevertheless, in certain situations the estate planning benefits of an option transfer can be substantial and may still outweigh these disadvantages.