Highly compensated executives constantly are confronted with the daunting challenge of developing a plan to transfer their hard-earned wealth to their heirs in the most tax efficient manner possible. Until the Securities and Exchange Commission ("SEC") amended its rules several years ago, stock options (as opposed to the shares acquired upon the exercise of stock options) did not figure prominently in an executive's estate planning, since most options were required to be non-transferable in order to take advantage of the exemption from liability provided under Section 16(b) of the Securities Exchange Act of 1934 (the "Exchange Act"). Amended Rule 16b-3 promulgated under Section 16 of the Exchange Act, however, does not require options to be non-transferable in order to take advantage of the exemption provided in that rule.
Since Rule 16b-3 was amended, both executives and their employers have been exploring the possibilities of allowing the transfer of stock options to provide executives with an opportunity to reduce gift and estate taxes. Until quite recently, however, corporations were hindered from taking full advantage of amended Rule 16b-3 because Form S-8, which is generally used to register the acquisition of stock pursuant to the exercise of stock options, did not cover the offer and sale of securities issuable upon exercise of stock options by any person other than the original holder of the option. On February 25, 1999, the SEC announced amendments which allow the use of Form S-8 to register the offer and sale of securities issuable upon the exercise of options that have been transferred to family members. This article discusses the estate planning opportunities available to executives by transferring nonstatutory stock options to (or to a trust for) family members and outlines tax, securities law and corporate governance issues that should be considered.
Recent Developments in the Law
Previously, Rule 16b-3 provided a safe harbor from the short-swing profit provisions of Section 16 (which generally requires the disgorgement of profits by "insiders" from any purchase and sale or sale and purchase of securities, including options, within a six month period) for a holder of nontransferable options granted under a plan that met the requirements of Rule 16b-3. Historically, stock options granted to executives of publicly-traded corporations were nontransferable in order to benefit from the exemption from liability provided under Rule 16b-3. Effective as of August 15, 1996, the SEC rescinded the non-transferability requirement. Under the current (post-August 1996) rules, "insiders"- directors, officers and greater than 10% owners -may transfer their nonstatutory stock options with the benefit of the exemption. Furthermore, amended Rule 16b-5 under the Exchange Act provides that "both the acquisition and the disposition of equity securities shall be exempt from the operation of Section 16(b) of the Exchange Act if they are: (a) bona fide gifts; or (b) transfers of securities by will or the laws of descent and distribution." This rule applies especially to family members and trusts providing favorable estate planning alternatives previously unavailable to insiders.
In order to comply with the registration requirements of the Securities Act of 1933 (the "Securities Act"), public companies generally use a Form S-8, a simple registration statement, to cover the offer and sale by them of securities issuable upon exercise of options granted under employee stock option plans. Prior to the recent SEC amendments, Form S-8 was not available for use in respect of securities issuable upon the exercise of transferred options. Instead, the public company issuer was required to register the offer and sale of shares underlying transferable options on a Form S-3, which is not available to all issuers, or a Form S-1, which is much more complex and burdensome. Alternatively, the option transferee would receive "restricted" stock and would be unable to resell the securities acquired upon exercise of the transferred option absent an exemption from compliance with the registration requirements of the Securities Act.
This would generally require a sale made pursuant to an effective S-3 or S-1 Registration Statement or a sale made in compliance with Rule 144 promulgated under the Securities Act. Rule 144 requires, among other things, that the option transferee hold the securities for a one-year period prior to any sale. The SEC's most recent amendments make Form S-8 available for the offer and sale by a public company of securities issuable upon exercise of options by an employee's family member or family-related trusts who have acquired the options from the employee through a gift or domestic relations order. In addition, the rules permit the use of Form S-8 for the issuance of stock upon the exercise of options by the executors, administrators or beneficiaries of the estate of a deceased employee.
Nonstatutory Stock Options
Nonstatutory stock options are options that do not qualify as either options granted pursuant to an employee stock purchase plan or incentive stock options. Unlike incentive stock options, which are regulated by Section 422 of the Internal Revenue Code (the "Code") as to the maximum allowance for grants by the employer, non-transferability, exercise times and employment status of the option holder, nonstatutory stock options have no qualification rules and may be granted to persons who are not employees (e.g., consultants). Conditions placed on these options are specified by the employer at the time of grant. Although incentive stock options potentially offer an executive more favorable income tax treatment, nonstatutory stock options have a wider scope of estate planning opportunities.
Tax Aspects of Transferable Stock Options
Income Tax Consequences
An optionee generally recognizes no income at the time of grant of a stock option. When the option is exercised, the optionee will recognize ordinary income in an amount equal to the spread between the exercise price of the option (the price the optionee pays to exercise the option) and the fair market value of the stock on the date of exercise.
When an option is transferred by gift, the original optionee will recognize ordinary income at the time that the transferee exercises the option. The corporation that granted the option has the same withholding and reporting obligations as it would have upon the exercise of any other stock option.
Estate and Gift Tax Consequences
Federal gift and estate taxes are imposed under a unified system which, subject to certain exclusions and deductions, taxes gifts and estates at rates generally ranging from 37 percent to 55 percent. If the transfer of an option to a family member qualifies as a completed gift, to the extent its fair market value exceeds the annual exclusion amount,3 it is subject to federal gift tax at such time, and presumably the tax will be less than at a future date when its value has appreciated. The donor's available unified credit against gift and estate taxes (currently $650,000 and scheduled to increase to $1 million in the year 2006) can be leveraged by using it at a time when the option is lower in value, thereby sheltering future appreciation from both gift and estate tax.
An additional advantage of transferring an option to a family member as a gift is that gift taxes are "tax exclusive" (i.e., no gift or estate taxes are paid on amounts paid as gift taxes), whereas estate taxes are "tax inclusive" (i.e., estate taxes are paid on amounts paid as estate taxes), thereby resulting in lower effective tax rates for gifts. For example, in order to make a gift of $3,000,000, the donor must pay $1,290,800 of federal gift tax for a net cost of $4,290,800. In order to pass $3,000,000 to heirs under a will, it would cost $5,868,445.
Federal gift taxes are imposed on the donor and apply to completed transfers of property by gift. A transfer of property by gift is considered complete when the donor has "so parted with dominion and control over the property as to leave him or her no power to change its disposition, whether for his or her own benefit or the benefit of another." A gift is incomplete if, among other things, the donor reserves the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves.
Until recently, it was an open issue whether there could be a completed gift of a non-vested (forfeitable) option. In a 1998 Revenue Ruling, however, the IRS held that: "the transfer to a family member, for no consideration, of a nonstatutory stock option, is a completed gift under section 2511 on the later of (i) the transfer or (ii) the time when the donee's right to exercise the option is no longer conditioned on the performance of services by the transferor." In other words, for gift tax purposes, a transferred option is not a completed gift until the option is fully vested (nonforfeitable). This ruling has to some degree mitigated interest in transferring nonvested options because when an option is fully vested, its value presumably will be higher than it was at the original time of grant.
However, from an estate planning perspective, transferring the option under these conditions still removes the option (and the underlying stock if the optionee were to exercise the option) from the optionee's estate. In addition, the payment of income taxes by the original optionee at the time the transferee exercises the option removes additional money from the optionee's estate, in essence making a tax free gift to the transferee of the income tax liability.
Another issue with respect to a transferred option is how to determine its value. In a 1998 Revenue Procedure, the IRS provided a methodology for valuing a transferred option for gift, estate and generation-skipping transfer taxes. The revenue procedure applies only to the valuation of nonpublicly traded compensatory stock options on publicly traded stock and provides that taxpayers may use a generally recognized option pricing model, such as the Black-Scholes model, or an accepted version of the binomial model to value the option. (A number of other conditions and requirements also apply.) The methodology offered by the revenue procedure is merely a safe harbor. As it is a safe harbor, it offers a very conservative approach to valuing an option. A taxpayer may wish to seek professional advice in obtaining a valuation from an independent appraiser that could result in a lower valuation.
Drawbacks of Transferable Stock Options
As the amount of income an executive will recognize upon a family member's exercise of a transferred option depends upon future stock prices and the timing of the tax liability cannot be predicted with certainty, corporations and executives need to give careful consideration as to how the executive will be able to satisfy a potentially large withholding tax obligation on the income when recognized.
Section 16(a) of the Exchange Act requires insiders (officers, directors and greater than 10 percent shareholders) to file public reports with respect to transactions in equity securities (including options) of their corporations. Pursuant to Section 16(b) under the Exchange Act, issuers may recover profits realized by such insiders from purchases and sales or sales and purchases of the issuer's equity securities within a six-month period.
In conjunction with the amendments to the Form S-8 rules, the SEC issued amendments to the proxy disclosure rules regarding the reporting of options that have been transferred. The summary compensation table must include options granted to an optionee that subsequently were transferred. Similarly, such options must be included in the option/stock appreciation rights grants table (a required table in a proxy statement which provides information with respect to grants of stock options and stock appreciation rights). The SEC suggests, but does not require, that transferability of an option be disclosed.
Corporate Governance Issues
There is a concern from a corporate governance standpoint that the transfer of options to a family member diminishes the intended incentive value of the option grant. In order to address this concern, some corporations have imposed restrictions as to whom options may be transferred (such as only to immediate family members). Transferability also may, for example, be conditioned upon obtaining the approval of a corporation's compensation committee or upon satisfying specified share ownership guidelines.
The amendment of a plan to allow the transferability of options to family members does not require shareholder approval under Rule 16b-3. However, state corporate law or the terms of a plan may, under some circumstances, require shareholder approval of such an amendment.
The changes to Rule 16b-3, Form S-8 and recent IRS rulings have opened up new opportunities in estate planning for highly compensated executives. Executives now have the opportunity to transfer nonstatutory stock options to their children or other family members via gift. By transferring an option before the value of the underlying stock appreciates, the benefits are a lower estate tax and a lower, if any, gift tax. However, prior to transferring an option, a number of tax and other issues must be considered.