Corporate Finance

More Options in Stock Options

Uncle Sam has provided new leeway in stock options, as long as they're vested.
Gordon WilliamsJuly 1, 1997

Judging from the media drumbeat over “obscene” levels of executive compensation, you’d expect Washington, D.C., to be casting a cold eye these days on stock options. Actually, the reverse is true, at least in some quarters. Fact is, options are getting a boost from the nation’s capital, in the form of tax and regulatory relief.

Here’s the background. Generally, the tax hits facing recipients of options are similar to the hits on stocks they’d buy and sell themselves. The recipient pays tax on the difference between the exercise price of the option and the fair market value of the stock when the option is exercised. However, for options, the difference in value is taxable at ordinary income rates instead of the capital gains rate, which can be much lower. When the grantee dies, all the stock acquired when the option was exercised is part of his or her estate–taxable at estate-tax rates that can run as high as 55 percent.

One way to soften the tax blow is to give the options away before they are exercised and before they run up in value. The grantee still keeps whatever income tax liability there will be when the option is finally exercised, by whoever actually exercises it. But giving away the option takes the stock out of the grantee’s estate, turning the tax double whammy into a single whammy.

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A gift tax might not even be due, if the value of the unexercised options is less than the $10,000 that you can give without paying gift tax to each of as many people as you wish each year ($20,000 if you and your spouse give jointly). Since the value of the unexercised option presumably is pretty low in the early stages (you’ll probably want a certified appraiser familiar with financial instruments to give you a precise value), you can give a lot of options and still stay within the annual exclusion. If you and your spouse want to give away more than $20,000 to someone or if the gift exclusion is not available, you can start using your $600,000 unified tax credit and still avoid owing a gift tax.


Until recently, however, those traditional estate-planning moves were generally unavailable in stock options. The reason: few companies allowed options to be transferred. “Corporations intended stock options to be extra compensation to executives,” says David Rhine, national director of family wealth planning for accounting firm BDO Seidman LLP. “When they created their option plans, companies didn’t have gifts of those options in mind.”

But that’s starting to change, thanks to Uncle Sam’s forbearance. For one thing, the Internal Revenue Service, in a series of private letter rulings, has accepted the idea that option grantees can give away unexercised options and shift the eventual asset to someone else. Private letter rulings are case-specific, meaning they fall short of an IRS pronouncement specifically endorsing gifts of unexercised options. But such gifts are being made, and the IRS isn’t challenging them, so grantees who give would seem to be on safe ground.

Meanwhile, the Securities and Exchange Commission recently relaxed Section 16b-3 of the SEC’s rules under the Securities and Exchange Act of 1934–the so-called short- swing profit rule. The rule prohibits corporate insiders from buying and selling stock within six months. And as it stood, the mere grant of an option constituted a purchase and started the clock ticking for purposes of the short-swing rule. But late last year, the SEC amended 16b-3 so that grants of options that are transferable need not be treated as a purchase.

Alan Halperin, an attorney with the New York firm Stroock & Stroock & Lavan LLP, says that one reason companies didn’t allow options to be transferred “was to make sure their executives didn’t unwittingly trigger the short-swing profit rule.” Now they needn’t worry.

And while a company’s stock option plan must specifically allow for gifts of unexercised options, that doesn’t require much. All it usually takes is a simple amendment of the plan that needn’t be subject to stockholder approval. “It usually just takes a stroke of the pen,” says Rhine. “It doesn’t cost the company anything, and it makes the benefit twice as valuable to executives as it was the day before they amended the rules.”

Indeed, Halperin says that many companies are amending their plans to make such transfers possible. Hard numbers are difficult to come by, because few companies want to make public the details of their programs. Halperin himself won’t name any of his clients that are amending their plans, though he says that more than a few are. And he says it’s safe to assume the numbers are based on all the activity in Washington. “A lot of private letter rulings are coming out now,” he says.

Specific rules about transferability vary from company to company, says Robert Coplan, national director of the Center for Family Wealth Planning at Ernst & Young LLP. But he says that most companies that have amended their stock option plans allow transfers only to family members, or to trusts or partnerships created for the benefit of those family members. Most limit transferability to top-tier executives or directors. “There’s too much bookkeeping involved for a company to open up transfers to everybody,” says Halperin.

“Also,” he says, “it really only makes sense for executives with enough capital to be able to make the transfer, pay the income tax, and still live comfortably–and with enough wealth to create a taxable estate.”

That last point isn’t a universally shared view. “We suspect that many middle-to-upper- level executives will also appreciate being able to transfer at least a portion of their options to family members,” The Corporate Executive newsletter told readers in its September/October 1996 issue.


How far can you go? Whether such gifts can include options that haven’t even been vested isn’t yet clear, says Coplan of Ernst & Young.

The potential appeal certainly is. The earlier you make a gift, the better. And the less value an option has, the more you can give away–and remove forever from your estate– without triggering a gift tax. Assuming stock prices will go up with time, the value of an option is never lower than when it is first granted and before it is vested. Not only does the option per se have a lower value at that point, but there often will be a discount from that low valuation based on the possible loss of the option if the executive leaves before vesting. The company, in amending its plan, can set any rules about transferability it wants–including transfers of nonvested options.

But the IRS hasn’t yet given its blessing to this arrangement. All IRS rulings to date on giving away options involved those that were exercisable when the gift was made. None has involved gifts of nonvested options, and there’s no solid indication of when such a ruling will come. Coplan hopes for some IRS guidance this year, noting that the IRS’s 1997 business plan includes the intention of publishing guidance on gifts of nonvested options. Still, he concedes, he can’t be sure when that guidance will come or what position the IRS will finally take.

Some months ago, the IRS seemed close to ruling in favor of such gifts. That no longer appears to be the case. One New York attorney says he placed three phone calls to the IRS recently, hoping for guidance. Each time, he says, he was stonewalled. This attorney thinks the IRS has read the many media accounts of astronomical executive salaries and is wary of ruling in favor of what might be seen as further sweetening of executive compensation.

Another possible complication could be some hostile press reaction to efforts by Travelers Group to contribute stock options to its 401 (k) plan. While the Labor Department still has to approve Travelers’ plan, the IRS has already given its tacit blessing, in a private letter ruling. Michael Gettelman, a San Francisco attorney and editor of The Corporate Executive, thinks the media response to the Travelers situation may have spooked the IRS and caused it to delay deciding on the nonvested-options issue.

Until the IRS does rule on this point, executives might consider holding off making gifts of nonvested stock options–even if their company plans permit it. If the IRS ultimately says no, says Halperin, gifts of unvested stock would no longer count as completed gifts–exposing you to gift taxes you hadn’t intended to pay. “If you transferred unvested options valued at $1 and their value climbed to $4 when vested, the $3 spread would be subject to the gift tax,” he says.

But there’s nothing to stop executives from exploiting the estate-tax advantage of giving away vested stock options before they are exercised. All it takes is a company that has amended its stock option plan to make such transfers possible and an executive savvy enough (and well-heeled enough) to see the substantial advantages. And it may be wise not to wait too long to exploit them. If public anger over executive compensation reaches a high enough pitch, Congress could easily become convinced that this is yet another loophole for the already wealthy–and force the regulators to close it.