Navigating Stock Options and Other Stock Rights

Navigating Stock Options and Other Stock Rights

Article posted in Publicly Traded Securities on 11 April 2001| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 18 May 2011
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Summary

Darryl Ott and Robert Lew discuss charitable planned giving techniques for the increasingly popular (and complex) assets known as incentive stock options, non-qualifed stock options, and restricted stock in this informative article. The article includes a number of case studies illustrating the charitable planning techniques that may be used with these assets.

by Darryl Ott and Robert Lew

Darryl D. Ott of Morgan, Miller & Blair in Walnut Creek, California, has been involved with wealth transfer planning for high net worth individuals for 30 years, and with charitable planned giving for over 10 years. He is a former member of the board of directors and past president of the Northern California Planned Giving Council, and has been a presenter for NCPG, and other national and local organizations on a variety of wealth transfer topics. Ott has a JD degree from the University of California, Hastings College of the Law, San Francisco, and is a Certified Specialist of Taxation Law with the California State Bar.

Robert Lew is the owner of Planning and Financial Advisors, a firm specializing in estate planning and insurance services located in San Francisco, California. Prior to his current position, he worked for over seven years for nonprofit organizations such as the American Red Cross. Lew has been active in planned giving for over eight years. He is a former member of the board of the Northern California Planned Giving Council and currently serves on the board of the National Committee on Planned Giving.


The purpose of this article is to provide assistance to charitable gift planners and other professional advisors in understanding the very complex income tax rules and the other legal requirements of incentive stock options, non-qualified stock options, and restricted stock. In addition, it is important for charitable gift planners to be exposed to specific case studies that illustrate the means of integrating charitable planned gifts with these important wealth building tools, and to understand how options and other stock rights fit into the overall wealth transfer planning for these very important potential donors.

There is one assumption that underlies the entire discussion regarding stock options. The assumption is that on the date of the exercise of the option, the fair market value of the stock of the company is greater than the exercise price specified in the option. While there may be some circumstances when a grantee of an option might want to exercise a stock option if the exercise price is greater than the fair market value of the stock, it is extremely unlikely.

All references in this article to specific tax and legal requirements for the stock options and the restricted stock are limited to those required by federal laws. The tax and legal requirements for any state should be referred to specifically.

Definitions

2 and 1 Rule. The "2 and 1 Rule" is a rule that only relates to incentive stock options and that is applicable only after the incentive stock option has been exercised, and where the grantee-employee is the owner of the stock of the employer. In order for the grantee-employee to be able to report the gain on the sale of the stock as capital gain, and not as ordinary compensatory income, the 2 and 1 Rule requires the grantee-employee to own the stock prior to the sale for a period that is the longer of either two years after the date of the grant of the incentive stock option, or one year after the date of the exercise of the incentive stock option. This rule has very important implications for the ability of the grantee-employee to use any planned giving tools. Moreover, the 2 and 1 Rule is no longer applicable after the death of the grantee-employee.

Alternative minimum tax. The calculation of "alternative minimum tax income" (AMTI) is entirely distinct and apart from the calculation of taxable income for regular income tax purposes. AMTI is computed in the same way as taxable income for regular tax purposes, except: 1) certain items of income and deductions used in the regular taxable income are adjusted; and 2) certain items of preference are added back to the taxable income to arrive at the AMTI. The tentative "alternative minimum tax" (AMT) is equal to 26% of the alternative minimum tax base up to $175,000 and 28% of the alternative minimum tax base over $175,000. The alternative minimum tax base is the AMTI reduced by various exemption amounts. The AMT so calculated is then compared to the taxpayer's regular income tax, and if the AMT is greater, the AMT is the amount that must be paid for that taxable year. For purposes of this article, the amount by which the fair market value of the shares acquired at the time of the exercise of an incentive stock option exceeds the exercise price, is an item of tax preference that must be included in the AMTI.

Basis. Exercise price plus the amount realized as income at exercise.

Compensatory stock options and compensatory restricted stock. The terms "compensatory stock options" and "compensatory restricted stock" mean any options for the acquisition of stock of a company granted either to an employee, such as incentive stock options, or to employees, directors, and consultants, such as non-qualified stock options, and any restricted stock issued to employees of a company as a form of compensation. These terms are very generic. These compensatory stock options must be distinguished from "investment options," such as those traded on the Chicago Board of Options Exchange, since the income tax effects with investment options are very different from those with compensatory options.

Disqualifying dispositions. A "disqualifying disposition" is a reverse application of the 2 and 1 Rule. If, after the exercise of the ISO, the stock is sold, exchanged, given, or otherwise transferred within two years of the date of the grant of the ISO, or within one year of the date of the exercise of the ISO, the employee must report the "gain" (the difference as of the sale date between the sales proceeds and the strike price) as ordinary compensation income and not as capital gain.

Exercise date. The "exercise date" of the option is the date of the delivery of the exercise of the option.

Exercise of option. The "exercise of option" is generally a written notification to the company by the grantee of the option of his or her intention to acquire a specified number of shares of stock of the company pursuant to the grant of the option.

Exercise price. The "exercise price" is the price that the grantee must pay to the company on the exercise date to acquire the stock of the company. The exercise price must be specified in the grant of the option. Same as "Strike strike Priceprice."

Grant date. The "grant date" is the date that the company gives (grants) the option to purchase stock in the company, whether as an incentive stock option or as a non-qualified stock option, to the grantee. The rights of the grantee to acquire the stock are governed by the terms of the grant of the option.

Grant of option. The "grant of option" is generally a written document given to the grantee of the option that specifies all of the terms of the option such as the exercise price, the term of the option, the vesting schedule, the number of shares of the company's stock that may be acquired, whether or not the option is transferable, if it is transferable, to whom it may be transferred, and whether or not the option may be exercised by a designated beneficiary after the date of the grantee's death.

Incentive stock options. An incentive stock option (ISO) is an option issued pursuant to a plan adopted by the employer corporation that conforms to all of the statutory requirements of Internal Revenue Code (IRC) §§ 421 through 424 when granted. Also known as statutory options.

IRC § 83(b) election. An "IRC § 83(b) election" is made with respect to restricted stock, and in some very special circumstances might be made as of the date of the exercise of an incentive stock option to attempt to limit the alternative minimum tax. The election, which must be filed with the IRS for the taxable year during which the employee first receives the transfer of the restricted stock, allows the employee to report a lesser amount of ordinary compensatory income during this year of receipt of the stock, with the hope that in future years, when the employee sells the stock at a higher value, the employee will then be able to report this appreciation as capital gain income rather than as ordinary compensatory income.

Minimum holding period. The amount of time that an employee must hold shares received upon exercise of an ISO to obtain favorable statutory treatment, namely: 1) two years from the date the option was granted; and 2) one year from the date the option was exercised.

Non-qualified stock options. A non-qualified stock option (NQSO) is an option to acquire stock of a company that does not, for any one of a number of reasons, satisfy all of the IRC requirements for incentive stock options. Also known as non-statutory options.

Option. The term "option" as used in this article is the right of an individual to purchase, for a stated price, a specified number of shares of stock from a company by virtue of an offer of the company that continues for a stated period of time.

Restricted stock. Restricted stock is stock that has any contractual or securities law restrictions imposed on the transfer of shares.

Sale date. The "sale date" is the date that the owner of the stock of the company (whether as a result of the exercise of an option, or the acquisition of restricted stock) actually sells the stock and disposes of his or her interest in the stock. The sale date is sometimes referred to as the disposition date.

Vesting. "Vesting" is the point in time when the grantee of an option (pursuant to the terms of the grant of the option) or the owner of restricted stock (in accordance with the terms of the restricted stock agreement) becomes indefeasibly entitled to acquire (with an option) or to retain ownership of (with restricted stock) the stock of the company. The vesting is generally spread out over a period of years at increasing percentages, but there are no particular legal requirements as to how quickly the rights to the stock must vest.



Incentive Stock Options

An incentive stock option (ISO) is an option issued pursuant to a plan adopted by the employer corporation that conforms to all of the statutory requirements of IRC §§ 421 through 424 when granted. Some of the basic requirements are that: 1) the shareholders must approve the plan; 2) the ISO must be granted to an employee of the company (not a director or consultant) and, basically, the individual must remain an employee through the date of the exercise; 3) the exercise (strike) price for the stock must equal or exceed the fair value of the company's stock as of the date of the grant; 4) an option must be granted within 10 years of the date of the adoption of the plan and must be exercised within 10 years of the date the option is granted; 5) the fair value of the ISO stock that is first exercisable during a year cannot exceed $100,000 based on the value of the company's stock as of the date of the grant; and 6) an individual already owning more than 10% of the company's stock must pay at least 110% of the fair value as the exercise (strike) price and the option must expire within five years as compared to 10 years for lesser shareholders. In accordance with the provisions of IRC § 422, an ISO is not transferable. Due to all of these requirements and restrictions, ISOs themselves (as opposed to the stock acquired by the exercise of the ISO) do not lend themselves to much, if any, prior wealth transfer planning, income tax planning, or charitable gift planning.

There are no income tax consequences to the grantee-employee of the option as of the date of the grant of the option. Generally, there are no regular income tax effects with ISOs as of the date of the exercise of the option by the grantee-employee. However, the difference, as of the date of the exercise of the ISO, between the fair value of the stock, as of the date of the exercise, and the strike price for the stock is an item of preference for purposes of the alternative minimum tax (AMT) calculations. The possibility of the imposition of the AMT can create a very difficult cash management situation for the grantee-employee after the exercise of the ISO, and, therefore, after the acquisition of the stock because the donor may have AMT to pay to the IRS as a result of his or her exercise of the ISO, but may not have any cash with which to pay the AMT. An obvious solution to this cash dilemma is to sell some of the stock acquired by the exercise of the ISO at least up to an amount that creates regular tax equal to the AMT. But such sales of too much of the stock would then lead to other adverse income tax consequences.

One of the other requirements of an ISO is to enable the grantee-employee of the ISO (and now owner-employee of the stock of the company) to obtain long-term capital gain treatment upon a sale of the stock known as the "2 and 1 Rule." The 2 and 1 Rule will permit the owner-employee to report the gain on the sale of the stock as capital gain if, after the exercise of the ISO, the stock is not sold within two years of the date of the grant of the ISO, or not within one year of the date of the exercise. A disposition (whether a sale, exchange, gift, or other transfer of legal title) of the stock that occurs after the expiration of the 2 and 1 Rule time periods is referred to as a qualifying disposition.

A disqualifying disposition is a reverse application of the 2 and 1 Rule. If, after the exercise of the ISO, the stock is sold, exchanged, given, or otherwise transferred within two years of the date of the grant of the ISO, or within one year of the date of the exercise of the ISO, the employee must report the "gain" (the difference, as of the sale date, between the sales proceeds and the strike price) as ordinary compensation income and not as capital gain. The difference in federal income tax rates between those for ordinary income and those for capital gains can be significant. The difference in the combined rates for federal income taxes can be as much as 19%. Needless to say, if the owner-employee needs the cash to pay the AMT, or otherwise is just wanting to diversify, or simply feels that the stock has reached its peak in value, the owner-employee's advisors, including gift planners, must understand and be able to explain the difference in the income tax treatment to the owner-employee. There are a few limited exceptions to the disqualified disposition rules, such as the transfer of the stock by a decedent by bequest or other form of inheritance. However, it is this 2 and 1 Rule that causes the owner-employee of the stock to report any gain as ordinary income on a transfer by gift of his or her ISO-created stock to a charitable remainder trust before the satisfaction of the 2 and 1 Rule.

There are now a multitude of methods related to the exercising of an ISO that in some instances provides some income tax and cash flow assistance to the grantee-employee in the exercise of the ISO, and the ownership of the stock of the company resulting from the exercise of the ISO. These methods are generally variations that provide financing assistance to the grantee-employee. A detailed explanation or analysis of these methods is clearly beyond the scope of this article. However, some of the methods are: 1) using stock of the employer to pay for the exercise of the ISOs; 2) under certain limited circumstances exchanging ISO stock for similar company stock; 3) granting a "reload" option when company stock is used to pay for the exercise price for the company stock then being acquired; 4) providing tandem stock appreciation rights (SARs) so long as the SARs meet certain requirements; and 5) providing financing through a broker for a "cashless exercise" of the ISOs.

Following the death of the grantee-employee, if the ISO plan permits the beneficiaries of the grantee-employee to exercise the ISO, then as long as the option was an ISO as of the date of the grantee-employee's death, the beneficiaries of the ISO will receive the same tax treatment on the exercise of the option as would have been realized by the grantee-employee. The transfer of the ISO to the beneficiaries, or the transfer of the stock of the employer to the beneficiaries that has not yet satisfied the 2 and 1 Rule is not a disqualifying disposition of the stock. Moreover, the estate or heir who receives the ISO does not have to comply with the 2 and 1 Rule at all with respect either to ISO stock received by the beneficiaries from the grantee-employee, or stock received by the beneficiaries following their exercise of the ISO. The death of the grantee-employee eliminates the need to comply with any of the ISO holding period requirements. However, the date of death of the grantee-employee will be the starting date for the measurement of the capital gain holding periods that will be used to determine whether any post-death appreciation is either short-term or long-term capital gain.

In addition, the ISOs receive a full step up in basis just like any other asset of a decedent, and no ordinary income or capital gain will be reportable on the stepped-up basis portion on a later exercise of the ISOs or disposition of the ISO stock by the beneficiaries. Also, due to this step up in basis of the ISO, the death of the grantee-employee eliminates the occurrence of any AMT on the subsequent exercise of the ISO by the beneficiaries, at least with respect to the pre-death bargain element in the ISO.

The fair market value of the ISO, as of the date of the death of the grantee-employee, is an asset that will be includable in the taxable estate of the grantee-employee. The fair market value of an ISO is basically the difference between the fair value of the stock of the company, as of the date of the death of the grantee-employee, and the strike price. Generally, the plans for the ISOs permit the recipient from the grantee-employee to exercise the ISOs in the same manner as the grantee-employee, and to receive the same income tax treatment on exercise, and on any subsequent disposition as would have applied to the grantee-employee if he/she would have lived. If the deceased grantee-employee was employed by the employer as of the date of his or her death, there is no statutory requirement that the recipient must exercise the ISO within three months of the grantee-employee's death.

Even though a transfer of an ISO upon the death of the grantee-employee is permitted by the statutes and is not a disqualifying disposition, and even though the recipient of the ISOs, following the death of the grantee-employee, is entitled to the special income tax reporting rules discussed above as would have been available to the grantee-employee, the recipient is also still subject to the same reporting requirements as would have applied to the grantee-owner. And, in addition, the ISOs still are not otherwise transferable by the recipient. So, the limitations on the planning possibilities for the recipient and on the transfer of the ISOs to charities still apply. Again, it is only after the exercise of the ISO, and the ownership of the underlying stock itself, that traditional gift planning possibilities will arise. In fact, the net effect of all of the post-death rules for ISOs is that the ISO stock is to be treated by gift planners no differently from any other asset in an estate of a decedent.



Non-Qualified Stock Options

A non-qualified stock option (NQSO) is an option to acquire a company's stock that does not, for any number of reasons, satisfy all of the IRC requirements for incentive stock options. Unlike incentive stock options, the issuance of an NQSO is not limited just to employees of the company, but they may be granted to employees, directors, and consultants to the company. Also, unlike the requirements for incentive stock options, NQSOs can be transferable at any time, either before or after exercise of the option if the plan adopting the NQSOs or the grant of the option permits the transfer. This transfer possibility does provide some additional planning opportunities for allied professionals and charitable gift planners. IRC § 83 is involved in the analysis of the income tax effects of non-qualified stock options.

Generally, the grantee of the NQSOs will not recognize taxable income on the date of the grant of the option. The tax reason is simply that, pursuant to the provisions of IRC § 83, the option does not have a "readily ascertainable fair market value." In effect, the compensatory aspects of the option are held "open" until the option is exercised. Since, at the time of the grant of the NQSO there is not a tax event, the income tax effect in the future is to treat the appreciation in the value of the property underlying the option between the date of the grant and its exercise as compensation income and not capital gain. Under these circumstances, the grantee of the NQSO would generally want to treat the value of the option, as of the date of its grant, as compensation income rather than as of the date of the exercise of the option. The reason for this preference is that the amount of ordinary compensation income that would be reportable, as of the date of the grant, would generally be less than the reportable ordinary compensation income as of the date of the exercise of the option. And, therefore, the ultimate capital gain that would be reported upon the eventual sale of the stock would be greater.

However, the IRC specifically and purposefully makes it difficult, for this very reason, for the grantee of the NQSO to report any ordinary compensation income, as of the date of the grant, of the NQSO. If an NQSO is not actively traded on an established market, which is highly likely, then IRC § 83 has four rigorous tests that must be met for the NQSO to have a readily ascertainable fair market value. The effect of these requirements is to force the taxation of the value of the NQSO to the date of its exercise. However, from a non-tax standpoint, an NQSO is still a very attractive compensation device for executives and employees of a company. The options are generally granted without requiring the grantee to make any payment for it as of the date of the grant; the income tax effects are delayed, and the NQSOs also offer significant upside if the company "takes off" as is generally expected.

On the date of the exercise of the NQSO, the grantee will be required to recognize ordinary compensation income in an amount equal to the excess of the fair market value of the stock, as of the date of the exercise, over the exercise (strike) price paid for the stock on such date. There are issues from the company's standpoint concerning the company's obligations to report this inclusion of income by the grantee to the government and, therefore, the obligation of the company to withhold income taxes from the grantee as of the date of the exercise of the NQSO.

Unlike incentive stock options, there is not any concept of a "qualifying" or "disqualifying" disposition of the stock. Following the exercise of the NQSO and the acquisition of the stock of the company and, additionally, the reporting of the ordinary compensation income at such time, the stock will be treated in the same manner as any other investment stock of the grantee-owner. The holding period for the determination of future capital gain recognition (more than 12 months) commences as of the date of the exercise of the NQSO. The basis of the stock acquired by the exercise of the NQSO is the amount paid by the grantee for the stock (the strike price) plus the amount of the ordinary compensation income reported by the grantee as of the date of the exercise. As a result, the basis of the stock is generally its full fair market value as of the date of the exercise of the NQSO. So, on a future disposition of the stock by the grantee-owner, any increase in value of the stock over its value, as of the date of the exercise of the NQSO, will be taxed as capital gain income. And, if the disposition occurs more than 12 months after the date of the exercise of the NQSO, then the appreciation will be treated as long-term capital gain, and will qualify for taxation at the lower capital gain income tax rates.

Due to the fact that NQSOs can be transferred if the plan adopting the NQSOs, or the grant of the option permits the transfer, this possibility opens up some charitable and non-charitable planning opportunities. Most importantly for the planned giving community, the IRS, in private letter ruling (PLR) 200002011 (and subsequently reinforced in PLR 200012076), reached several favorable conclusions concerning a transfer by a decedent of NQSOs, to a charitable organization at the time of her death. The IRS concluded that the decedent's estate would be entitled to a full charitable deduction for the fair market value of the NQSOs passing to the charity, and that when the charity exercises the NQSOs, the charity and not the estate of the decedent will be required to report the income.

Also in this PLR, the IRS concluded that the transfer of the NQSOs, and the reporting of the income upon the exercise of the NQSOs, were "income in respect of a decedent," which is the same conclusion used for the disposition of qualified retirement plan accounts and individual retirement accounts. See case study 3 for a discussion of the gift planning possibilities with testamentary transfers of NQSOs. There is a different tax result, however, with lifetime, non-arm's length transfers of NQSOs. In PLR 9722022, the grantee transferred NQSOs to an irrevocable trust for the benefit of family members.

The IRS concluded that the transfer of the NQSOs to the trust did not cause the grantee to recognize income as of the date of the transfer and, most importantly, that upon the subsequent exercise of the NQSOs by the trust, the grantee and not the trust would recognize taxable compensation income equal to the excess of the fair market value of the shares received as of the date of the exercise (determined as of the exercise date) over the option price paid for the shares. The word "charity" could be substituted for the word "trust" in PLR 9722022 with a similar result. And, with a further conclusion that the grantee would receive a charitable income tax deduction, as of the date of the exercise of the NQSOs, by the charity in the same amount as the amount of the taxable compensatory income to be reported by the grantee as of such date. See case study 4 for a discussion of the gift planning possibilities with lifetime transfers of NQSOs.

Following the death of the grantee-employee, if the NQSO plan permits the beneficiaries of the grantee-employee to exercise the NQSO, and if the NQSO was not taxed at the date of the grant thereof, then the NQSO will pass to the beneficiaries of the grantee-employee with the potential taxation of the compensation income element left open. So, after the date of the death of the grantee-employee when the beneficiaries engage in a transaction that "closes" the option transaction (an exercise of the option), it will be the beneficiaries who will report the ordinary compensation income (see Treas. Reg. §§1.83-1(c) and (d)). The "open" income tax treatment of this asset applies the same rules with the same income tax effects as with any other assets that involve "income in respect of a decedent." Most notably, these rules and the tax treatment are the same as those involved with qualified retirement plans and individual retirement accounts. These IRD rules provide planning opportunities for gift planners that will be discussed in more detail in case study 5. The fair market value of the NQSO, as of the date of the death of the grantee-employee, is an asset that will be includable in the taxable estate of the grantee-employee. The fair market value of an NQSO is basically the difference between the fair value of the stock of the company, as of the date of the death of the grantee, and the strike price.

The possibility for testamentary planning with NQSOs is much better than with ISOs. As discussed in case studies 3, 4, and 5, there are more "pre-exercise" planning opportunities with NQSOs than are available for ISOs.



Restricted Stock

The area of "compensatory" transfers of property using restricted stock is governed by IRC § 83. For purposes of this article, the term "property" will mean stock of the employer's company. When an employer "transfers" stock that is "restricted," and that is subject to a "substantial risk of forfeiture" to an employee "in connection with the performance of services," then the analysis of the income tax effects to the employee are not too dissimilar to those discussed above with respect to incentive stock options and non-qualified stock options. Perhaps the best way to explain "restricted stock" is by way of an example. On July 1, 2000, Dotcom Corporation transfers 1,000 shares of its common stock to its employee, Ms. Technonerd (Ms. T), who does not pay anything for the stock. On the date of the transfer, the shares have a value of $1.00 per share. The agreement between Dotcom and Ms. T specifies that if Ms. T leaves the employ of Dotcom before July 1, 2002, she will forfeit all rights to the stock that must then be returned to Dotcom without Ms. T receiving any payment for the stock. In addition, Ms. T is prohibited by the employer's restricted stock plan from transferring the stock during the period that the "substantial risk of forfeiture" (the employment condition) continues to apply other than on her death or to a limited class of permitted transferees such as her family members and charities. A legend to this effect is stamped on Ms. T's stock certificate. Assume that the value of the stock on July 1, 2002, which is after Dotcom's IPO, will be $50.00 per share. Assume also that Ms. T remains in the employ of Dotcom past July 1, 2002. For purposes of the following discussion, July 1, 2000, is the date of the "transfer" of the "property" (the stock), and July 1, 2002, is the date that the stock is transferable and no longer subject to the substantial risk of forfeiture.

Contrary to the rules discussed above with respect to incentive stock options and non-qualified stock options as of the date of the grant of the options, the date of the "transfer" of the restricted stock to the employee is significant. Depending upon what course of action the employee takes on the date of the transfer, the employee may, or may not, have an income tax reporting event as of that date. In the example set forth above, Ms. T will not have any income to report if she does nothing because the stock that she received is subject to a "substantial risk of forfeiture." However, see below for the income tax effects to Ms. T, as of the date the stock is no longer subject to the substantial risk of forfeiture, if she does nothing as of the date of the transfer. The effects later will be quite severe.

Ms. T does, however, have a choice as of the date of the transfer of the property (July 1, 2000, in our example). Ms. T can file an IRC § 83(b) election with the IRS. If she does file this election, then Ms. T will be required to report, as ordinary compensatory income, the value of the stock as of the date of its transfer to her (July 1, 2000). In our example, this amount will be $1.00 X the 1,000 shares or only $1,000 of ordinary income. Her basis in the stock will be $1,000, and the holding period for capital gain considerations will commence as of the date of the transfer of the stock to her (July 1, 2000). Then on July 1, 2002, when the substantial risk of forfeiture expires, Ms. T will not have any further income to report to the IRS. And even more importantly, if Ms. T were to sell the stock on July 2, 2002, the $49 of appreciation realized after July 1, 2000, will be reportable by Ms. T as capital gain.

The income tax effects, as of the date that the stock is no longer subject to the substantial risk of forfeiture, depends on the course of action that the employee took as of the date of the transfer of the stock to her by the employer. If the employee did nothing, as of the date of the transfer of the stock, which means that the employee did not file an IRC § 83(b) election, and did not report any income to the IRS in year 2000, then the employee will have to report, as ordinary compensatory income in the year that the substantial risk of forfeiture lapses, the full value of the stock as of such date. So, in our example, by doing nothing on July 1, 2000, and reporting no income to the IRS in year 2000, Ms. T will have to report to the IRS, as ordinary compensatory income for year 2002 (the year that the substantial risk of forfeiture expires), $50.00 X 1,000 shares or $50,000. Her basis in the stock will be $50,000, and her holding period for capital gain considerations will commence as of the date that the substantial risk of forfeiture lapses (July 1, 2002). So, Ms. T will have to wait until July 2, 2003, to sell the stock if she wants to report any further appreciation in value as long-term capital gain. If the employee does file an IRC § 83(b) election when she receives the restricted stock, then in the later year when the substantial risk of forfeiture lapses, the employee will not have any further income to report to the IRS.

In our example, if Ms. T files the IRC § 83(b) election, then on July 1, 2002, she will not have any further income to report. Her next tax event will be when she sells the stock. If the employee fails to satisfy the condition of the restrictions and, therefore, the substantial risk of forfeiture actually occurs, the employee will lose the ownership, and the company will regain the ownership of the stock. Regardless of whether or not the employee has filed an IRC § 83(b) election, there will not be any income tax effect to the employee on the forfeiture and transfer of the stock back to the company, i.e., the employee will not be able to report a taxable loss of any nature on the transfer of the stock back to the company.

Before the employee has reported the income to the IRS with respect to the transfer of the stock, which means that the employee did not file an IRC § 83(b) election at the time of the transfer of the stock to her, and the substantial risk of forfeiture has not yet lapsed, a disposition of the stock by the employee, which can occur by reason of the employee's death and by reason of any other disposition so long as the substantial risk of forfeiture remains in effect, will create rather complex income tax results to the employee. In an arm's length disposition, the employee reports the amount realized through the disposition as compensation income, and IRC § 83 has no further application to the transaction. If, however, the stock is disposed of in a non-arm's length transaction (such as a gift to a family member or to a charity), there are two potential tax events to the employee--the disposition and the lapse of the restrictions. The disposition does not terminate the application of IRC § 83 to the employee; rather IRC § 83 continues to apply until the restrictions lapse. If the employee is not paid anything for the stock, as of the date of the disposition (in a true gift situation), then there will not be any income for the employee to report at that time. And, then on the lapse of the restrictions, the employee (not the transferee) will report the same amount of ordinary compensatory income at that time as if the employee had not previously disposed of the stock. If the non-arm's length disposition is to a charity, and if the disposition occurs before the restrictions lapse, then the employee-donor will report the compensatory ordinary income and receive a charitable income tax deduction only in the year that the restrictions lapse.

After the employee has reported the income to the IRS with respect to the transfer of the stock, either as of the date of the transfer (by filing an IRC § 83(b) election), or as of the date that the restrictions lapse (by previously not filing an IRC § 83(b) election), the ownership of the stock for income tax purposes will be treated in exactly the same manner as the ownership by any individual of similar stock that was not previously restricted stock. The primary issue will then be whether or not, on a later sale of the stock, the owner will be entitled to report any further appreciation as long-term capital gain. The planning choices for gift planners will also then be the same as with any other stock investments based primarily on whether or not the stock is a long-term capital gain asset. There is, however, one significant remaining non-tax issue if the stock is disposed of before the substantial risk of forfeiture lapses, even if the employee has filed the IRC § 83(b) election. That issue is that if the forfeiture condition occurs (in our example if Ms. T's employment terminates before July 1, 2002), the transferee (the family member or the charity) will no longer be the owner of the stock and, generally, will not be paid anything for the stock as of the date of the forfeiture.

Currently, there do not appear to be many planning opportunities, if any, to assist the employee-donors to avoid the imposition of the ordinary compensatory income during their lifetimes with restricted stock. There is one testamentary planning opportunity with restricted stock that is discussed in case study 6.

If the employee's death occurs after the transfer of the stock and before the restrictions lapse, and if the restricted stock plan of the employer permits a transfer to the deceased employee's family members or other beneficiaries without a triggering of the forfeiture restriction, then the employee's death itself does not close the compensation element of the transaction. Treas. Reg. § 1.83-1(d) specifies that the compensation element in the restricted stock that remains unreported as of the date of the employee's death is to be considered as "income in respect to a decedent." This is the same treatment that is imposed upon any balances remaining in any qualified retirement plans (like 401(k) plans) and individual retirement accounts (IRAs). Hopefully, most gift planners are becoming familiar with the severe tax (both estate tax and income tax) consequences that these assets are subjected to upon the death of the employee. Hopefully, also, most gift planners will also be familiar with the testamentary planning considerations that are available with IRA accounts and charitable remainder trusts. The testamentary planning considerations for restricted stock are discussed in case study 6. The fair market value of the restricted stock, as of the date of the employee's death, will be includable in the employee's taxable estate for federal estate tax purposes. In determining the fair market value of the restricted stock, the existence of the substantial risk of forfeiture must be considered.

As previously discussed, the open compensation element in restricted stock, as of the date of the death of the employee, will be treated as "income in respect of a decedent" under the IRC. By analogy, the private letter rulings that permit the testamentary transfer of IRD assets contained in qualified retirement plans and individual retirement accounts to charitable remainder trusts following the death of the participant-donor, it seems appropriate, if the employer's restricted stock plan permits transfers, for the employee-donor to transfer the restricted stock (for which no IRC § 83(b) election was filed and that is still subject to the substantial risk of forfeiture) to a charitable remainder trust for the benefit of the members of the employee-donor's family and for the benefit of the donor's favorite charities. This planning opportunity will be illustrated in detail in case study 6.



Gift Planning Strategies For Stock Options And Restricted Stock

Transfer of ISO stock to a charitable remainder trust. The first gift planning strategy involves a transfer of the stock acquired through the exercise of an incentive stock option as contrasted with a transfer of the incentive stock option itself. After the donor has exercised the incentive stock option, and after the donor has satisfied the 2 and 1 Rule, the donor establishes a charitable remainder trust, gives the shares of the ISO stock to the CRT and then the CRT sells the stock. This strategy provides nothing new or unusual from a planned giving standpoint except for the emphasis on the fact that the donor had owned the stock long enough to satisfy the 2 and 1 Rule. This strategy is illustrated in case study 1.

Transfer of ISO stock to a charitable lead trust. This gift planning strategy also involves a transfer of the stock acquired through the exercise of an incentive stock option as contrasted with a transfer of the incentive stock option itself. The donor has exercised the incentive stock option and currently owns the stock. The donor wants to establish a charitable lead trust to benefit his/her favorite charity. The donor can establish the charitable lead trust and transfer the ISO stock to the CLT only after he/she has owned the stock long enough to satisfy the 2 and 1 Rule. This illustrates two planning principles involving ISOs: 1) the inability to provide any planning suggestions or opportunities with regard to the incentive stock options that by the very terms of the enabling IRC sections are non-transferable; and 2) the need for the donor to satisfy the 2 and 1 Rule before any gift planning strategies are implemented. See case study 2.

Transfer of NQSOs to a charity. This gift planning strategy is simply an illustration of the fact situation found in PLR 200002011. In this situation, the employer's plan for its non-qualified stock options allows the options to be transferred prior to their exercise to family members and to charities. The grantee-donor, therefore, transfers, at his/her death, some NQSOs to his/her favorite charity before the options are exercised. After death, and after the receipt of the options by the charity, the charity exercises the NQSOs and becomes the owner of the stock. The charity then sells the stock to obtain the cash. The income tax and estate tax effects on the donor's family are illustrated in more detail in case study 3.

Transfer of NQSOs to a charitable lead trust. This gift planning strategy is an extension of the facts considered by the IRS in PLR 9722022. The donor, during her lifetime, establishes a charitable lead trust and transfers a portion of her options into the CLT. The plan established by the donor's employer for the NQSOs allows such a transfer prior to the exercise of the options. See case study 4.

Testamentary transfer of NQSOs to a charitable remainder trust. This gift planning strategy is believed to be more innovative and relies on the Treasury Regulations that require the beneficiaries of the deceased grantee-employee to report the compensation income in the NQSOs as "income in respect of a decedent" when they, the beneficiaries, exercise the NQSOs after the grantee-employee's death. This IRD characterization, and the prior IRS private letter rulings that allow the IRD from qualified retirement plans and IRAs to be "transferred" to a charitable remainder trust following the death of the IRA participant, seem also to be applicable to NQSOs. After the donor's death, the donor's will (or living trust document) simply requires that a charitable remainder trust be set up following the donor's death and that the NQSOs or some part of them are to be transferred to the CRT. (Obviously it is imperative that the employer's plan for the NQSOs allows such a transfer.) The CRT then exercises the NQSOs, and the CRT reports the IRD rather than the donor's estate or the donor's estate beneficiaries. See case study 5.

Testamentary transfer of restricted stock to a charitable remainder trust. This last gift planning strategy is similar to the strategy discussed above except that it involves the testamentary transfer of restricted stock rather than NQSOs. In this strategy, the employer's restricted stock plan allows the restricted stock to be transferred following the death of the employee, subject to the continuing restrictions. Since Treas. Reg. § 1.83-1(d) categorizes the compensation element in the restricted stock after the employee's death to be "income in respect of a decedent," the deceased employee-donor can direct that, following death, the restricted stock is to be transferred to a charitable remainder trust. The existing private letter rulings that allow the IRD from qualified retirement plans and IRAs to be "transferred" to a charitable remainder trust following the death of the IRA participant seem also to be applicable to restricted stock. See case study 6.



Case Studies And Specific Applications For Stock Options And Restricted Stock

The six case studies that follow will provide insights into some of the alternative ways that gift planners can assist their potential donors who are the owners of stock options with the structuring of gift transactions that provide, in each case, significant benefits for the donors or their families and for the charities of their choice.

In each of the six following case studies, the assumptions set forth below have been used with additional assumptions being stated in each particular case study itself when necessary.

Assumptions:

Description

Assumption

Description

Assumption

7520 interest rate

7.0%1

Present value interest rate (inflation)

2.5%

Combined federal and state ordinary income tax rate

40%

Before tax total rate of investment return

8%

Combined federal and state capital gain tax rate

28%

Federal estate and gift tax exemption equivalents

Used; all transfers are taxable

Federal estate and gift tax rate

50%



1This assumed 7520 interest rate (or the charitable mid-term rate (CMFR) is the average over the last three years of the 7520 rates.

Case Study 1
Stock from incentive stock options, after the satisfaction of the 2 and 1 Rule,
charitable remainder trust.

In spite of her age, Ms. Technonerd has had a very important position with Dotcom Corporation for many years. In fact, Dotcom Corporation was one of the first Silicon Valley start-ups. During the past several years, Dotcom has had steadily increasing earnings. As one of its ever-increasing employee benefits, Dotcom granted its key employees incentive stock options (ISOs). Ms. T was one of these employees.

Ms. T exercised her ISOs more than two years ago. She has, therefore, satisfied the 2 and 1 Rule. Even though Ms. T's salary from Dotcom has increased significantly, she and her husband are interested and would welcome some additional income for their retirement years. The donors have also been very active with local charities, and one of the planned giving officers from one of these charities has explained to them the benefits of a charitable remainder trust. Mr. and Ms. T decide to set up a charitable remainder unitrust for their joint lifetimes with a payout rate of 8%. They transfer some of Ms. T's stock in Dotcom valued at $2,000,000 to the CRUT. The stock has an income tax basis of $200,000 that was the exercise price of the ISOs.

So what are the financial results to Ms. T, her husband, child, and to the charity?

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of stock

$2,000,000

Exercise price/income tax basis in the stock

$200,000

Ages of the donors

65 and 63

Term of the CRUT

Joint lives/23 years

CRUT payout rate

8%



Financial Results:

Description

No planning: death at life expectancy

Charitable remainder unitrust for benefit of donors

Charitable remainder unitrust and a wealth replacement trust

Sales price now

$2,000,000

$2,000,000

$2,000,000

Total income taxes

$486,000

$0

$0

After-tax sales proceeds held for the benefit of the donors

$1,514,000

$2,000,000

$2,000,000

Income tax deduction

$0

$353,060

$353,060

Income tax savings

$0

$141,224

$141,2241

First year after-tax income and tax savings

$72,672

$237,224

$96,000

Subsequent annual after-tax income

$72,672

$96,000

$96,000

Cumulative annual after-tax income paid through life expectancy

$1,671,456

$2,445,224

$2,208,000

Life insurance death benefit

$0

$0

$770,509

Net after-tax wealth received by the family of the donors

$757,000

$02

$770.5092

Benefit to charity

$0

$2,000,000

$2,000,000



1In this situation, the $141,224 of income tax savings are used to purchase a single premium, second-to-die life insurance policy, on the lives of the donors. The insurance policy was designed to perform under adverse conditions including a 10% reduction from the current earning rate.

2In the interest of simplicity, these figures ignore the opportunity and the strong likelihood that the donors will be able to re-accumulate a significant amount of wealth over their lifetimes by using the CRT alternative, due to the fact that they will receive a significantly higher after-tax income stream from the CRT for a very long time.

Case Study 2
Stock from incentive stock options, after the satisfaction of the 2 and 1 Rule,
charitable lead trust.

Mr. PropellerHead (PH) is an employee of a corporation, WebSite Corporation, which is a "less mature" business entity than Dotcom Corporation. However, WebSite has just recently successfully completed its IPO, and the future for WebSite looks very promising. In fact, some of PH's stock in WebSite, which he acquired just over two years ago from the exercise of some of his incentive stock options, has a current value of $2,000,000 and is expected to be valued 10 years from now at $8,000,000.

PH and his wife have two very young children who seem destined for Harvard and Stanford in several years. Mr. and Mrs. PH have listened to the planned giving officer at their college alma mater and are ready to set up a charitable lead annuity trust (CLAT) with a portion of the WebSite stock. The charitable lead annuity trust will have a term of 10 years (to tie-in to when their oldest child will be ready for college), and their alma mater will be the recipient of the annual "lead" payments from the CLAT that will be set at $90,000 (4.5% X $2,000,000) for the full 10 years.

The financial results shown below assume that PH and his wife both die in year 10 following the establishment of the CLAT, so that an overall comparison of the alternatives can be properly evaluated. In fact, however, PH and his wife actually live long and healthy lives, enjoy being with their family, and since they had such a positive experience with this first CLAT, they become significant philanthropists in their community.

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of stock today

$2,000,000

Fair market value of stock in 10 years

$8,000,000

Exercise price/income tax basis in the stock

$200,000

Charitable lead annuity trust payout rate

4.5%

Charitable lead annuity trust term

10 Years



Financial Results:

Description

No planning: gift in 10 years at death

Gift now and death in 10 years

Gift now through a 10- year charitable lead annuity trust

A

Value of stock today and at date of the gift

$2,000,000

$2,000,000

$2,000,000

B

Reportable taxable gift today

$0

$2,000,000

$1,367,876

C

Gift tax paid today by donors

$0

$1,000,000

$683,938

D

Adjustments due to early payment of gift tax

$546,5121

($252,554)2

--

E

Annual gross/after-tax dividends

$90,000/$54,000

$90,000/$54,000

$90,000/$90,000

F

Cumulative after-tax, invested value of dividends

$672,900

$672,900

$0

G

Dividends paid to charity over 10 years

$0

$0

$900,000

H

Value of stock in 10 years

$8,000,000

$8,000,000

$8,000,000

I

Income tax basis for stock

$200,000

$200,000

$200,000

J

Income taxes on long-term capital gains paid in 10 years

$0

($2,184,000)

($2,214,800)

K

Subsequent federal estate taxes

($3,244,450)

$0

$0

L

Net after-tax wealth received by the family of the donors

$5,974,962
(D+F+H+K)

$6,236,346
(D+F+H+J)

$5,785,200
(H+J)

M

Benefit to charity

$0

$0

$900,000



1 This adjustment is the gift tax of $683,938 paid in the charitable lead trust example invested at 4.8% after tax for 10 years, which is then reduced by 50% for the estate tax that otherwise would be payable.

2This adjustment is the difference between the $1,000,000 of gift tax paid in the "gift now" example and the $683,938 of gift tax paid in the "charitable lead trust" example invested at 4.8% after tax for 10 years, which is then reduced by 50% for the estate tax that otherwise would be payable.

Case Study 3
Non-qualified stock options, transfer of the options at death,
and prior to exercise directly to a charity.

In addition to receiving her incentive stock options from Dotcom Corporation, Ms. Technonerd also was granted an even greater number of non-qualified stock options (NQSOs) in Dotcom. These NQSOs actually form a very significant portion of Ms. T's overall wealth. The various tranches of the options, all of which are now vested, are exercisable over differing periods of time, at different prices. The top echelon at Dotcom are actually very enlightened, and they have amended all of their NQSO plans to allow the options to be transferred to members of the families of the grantee-employees, or trusts for their benefit, and to charities.

During one of Ms. T's conversations with her favorite planned giving officer at her favorite local charity, Ms. T came to understand the devastating income tax and estate tax effects on her family after her death when her family exercises her NQSOs. Ms. T believes that she can provide a very significant gift to her favorite charity at a very low "cost" to her family by amending her living trust to make a gift at her death of some of her NQSOs directly to the charity. Ms. T does make that amendment to her living trust. Her gift includes the NQSOs and enough cash for the charity to be able to exercise the options after the charity receives the options.

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of option

$1,800,000

Exercise price for the stock

$200,000



Financial Results:

Description

No planning: death now

Direct gift at death of the non-qualified stock option to charity

Fair market value of option at death

$1,800,000

$1,800,000

Additional cash for exercise of the option

$200,000

$200,000

Total assets for family or charity

$2,000,000

$2,000,000

Total estate taxes

$640,000

$0

Total income taxes on IRD

$720,000

$0

Net after-tax wealth received by the family of the donors

$640,000

$0

Benefit to charity

$0

$2,000,000



Case Study 4
Non-qualified stock options, transfer of the options during lifetime,
and prior to exercise to a charitable lead trust.

WebSite Corporation has been very interested in retaining its valued employees. So, in addition to the adoption of incentive stock option plans, WebSite has also created a number of NQSO plans. Mr. PropellerHead (PH) is one of the employees who now owns vested NQSOs. The plans for these NQSOs allow the options to be transferred to members of the families of the grantee-employees, or trusts for their benefit, and to charities.

Since PH and his wife had such success with the charitable lead annuity trust that they established to provide for their children's education in case study 2, they also immediately establish a second CLAT with a long-range view for their children. And, instead of funding the CLAT with stock, PH and his wife transfer some of the NQSOs to the CLAT instead. The NQSOs that are transferred to the CLAT have a relatively small value at the time of the transfer, and the exercise price for the NQSOs is very insignificant. Mr. and Mrs. PH understand, however, that they must also transfer enough cash to the CLAT, in addition to the NQSOs, so that the CLAT will have the liquidity to make the payments to their college over the 10-year term of the CLAT. PH again expects the value of the stock to be $8,000,000 at the end of the term of the CLAT. After the end of the 10-year term of the CLAT, the trust does not immediately distribute to the children, but the assets in the trust are then held for the benefit of the children for a number of years.

As in case study 2, the financial results shown in the financial results table below assume that PH and his wife both die in year 10 following the establishment of the CLAT, but, as before, they continue to live a long, full, and philanthropic life.

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of option today

$200,000

Fair market value of stock in 10 years

$8,000,000

Exercise price/income tax basis in the stock in year 10

$0 (Nil)

Charitable lead annuity trust payout rate

6.0%

Charitable lead annuity trust term

10 Years



Financial Results:

Description

No planning: death in 10 years; option exercised just after donors' death

Gift now of the option through a charitable lead annuity trust; option exercised just after donors' death

A

Value of option today

$200,000

$200,000

B

Additional liquid assets transferred to the charitable lead trust

--

$200,000

C

Adjustment due to transfer of additional assets to the charitable lead trust

$159,8131

--

D

Reportable taxable gift today

$0

$231,433

E

Gift tax paid today by donors

$0

$115,717

F

Adjustment due to early payment of gift tax

$92,4662

--

G

Value of option in 10 years

$8,000,000

$8,000,000

H

Total estate taxes

($2,400,000)

$0

I

Total income taxes at ordinary income tax rates

($3,200,000)

($3,200,000)3

J

Adjustment for donor estate's payment of the income taxes after death in the charitable lead trust

$1,600,0004

--

K

Value of additional assets remaining in the charitable lead trust

--

$20,560

L

Net after-tax wealth received by the family of the donors

$4,252,279
(C+F+G+H+I+J)

$8,020,560
(G+K)

M

Benefit to charity

$0

$240,000



1This adjustment is the additional assets of $200,000 paid into the charitable lead trust invested at 4.8% after tax for 10 years, which is then reduced by 50% for the estate tax that otherwise would be payable.

2This adjustment is the gift tax of $115,717 paid in the charitable lead trust example invested at 4.8% after tax for 10 years, which is then reduced by 50% for the estate tax that otherwise would be payable.

3This figure is the ordinary income tax at a rate of 40% of $3,200,000 paid in the charitable lead trust example by the donor's estate after his death.

4This adjustment is the income tax of $3,200,000 paid in the charitable lead trust example by the donor's estate, which is then reduced by 50% for the estate tax that otherwise would be payable.

Case Study 5
Non-qualified stock options, transfer of the options prior to exercise,
but following the death of the option holder to a charitable remainder trust.

Ms. Technonerd wants also to provide benefits for her daughter, following her death, from more of her Dotcom Corporation vested non-qualified stock options and ultimately for her favorite local charity. The planned giving officer suggests the following gift planning strategy to Ms. Technonerd. Ms. T and her husband think that this strategy is so significant and so powerful for their family and the charity that, without any further coaxing, they immediately make an appointment with their equally enlightened attorney who makes the appropriate amendments to their estate planning documents.

The estate planning documents for Ms. T and her husband are amended to provide that following both of their deaths, a charitable remainder unitrust will be established for the lifetime of their daughter who is now 35-years old. The CRUT will provide for a payout rate to their daughter of 6%. The CRUT will be funded after both of their deaths with some of the NQSOs of Dotcom that have a value of $1,800,000 and a strike price of $200,000. The gift to the CRUT includes cash of $200,000 so that the CRUT will be able to exercise the NQSOs without diminishing the principal of the CRUT.

This gift planning strategy provides significantly greater benefits for Ms. and Mr. T's daughter over her lifetime than if the NQSOs were simply transferred to her by Ms. and Mr. T after their deaths, primarily due to the imposition of the income tax on the "income in respect of a decedent," which their estate would be required to pay if the NQSOs are transferred directly to their daughter. This strategy, and its financial results, are very similar to those expected from a testamentary transfer of assets in qualified retirement plans and individual retirement accounts to a charitable remainder trust.

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of option today

$1,800,000

Exercise price/income tax basis in the stock

$200,000

Age of the donors' child

35

Child's life expectancy and term of the charitable remainder trust

42 years

CRUT payout rate

6%



Financial Results:

Description

No planning: death now

Gift of the option at death to a charitable remainder unitrust

Fair market value of option at death

$1,800,000

$1,800,000

Additional cash for exercise of the option

$200,000

$200,000

Estate tax deduction

$0

$215,280

Total estate taxes

$540,000

$892,360

Total income taxes on IRD

$720,000

$0

Adjustment due to the exercise price and the estate tax being paid from other assets in the charitable remainder trust example

$546,1801

--

After-tax amount available for investment

$1,086,180

$2,000,000

Annual after-tax income (range)

$52,137

$72,000-$162,158

Cumulative annual after-tax income paid through life expectancy

$2,189,739

$4,670,080

Present value of the cumulative income stream

$1,346,200

$2,616,046

Present value of invested principal

$385,034

--

Present value of net after-tax wealth received by the family of the donors

$1,731,234

$2,616,026

Present value of benefit to charity

$0

$215,260



1This adjustment is the exercise price of $200,000 and the estate tax of $892,360 paid from other assets in the charitable remainder trust example, which are then reduced by 50% for the estate tax that otherwise would be payable.

Case Study 6
Restricted stock, transfer of the stock prior to lapse of restrictions, but following the death of the stockholder to a charitable remainder trust.

This case study is actually quite similar to the strategy shown in case study 5, except that the asset used to fund the 6% charitable remainder unitrust for the benefit of Ms. and Mr. T's daughter is restricted stock rather than non-qualified stock options.

Again, the top management of Dotcom Corporation is to be commended. One of the restricted stock plans that Dotcom adopted (and, of which, Ms. T is a participant) creates "substantial risks of forfeiture" of the stock based on earnings performance goals for the company rather than the more usual restrictions based on the continued employment of the employee-owner of the restricted stock. The plan also allows the restricted stock to be transferred to members of the families of the owner-employees, or trusts for their benefit, and to charities.

So when Ms. T and her husband visit their attorney to amend their estate plan to provide for the creation of the charitable remainder trust following their deaths for some of the non-qualified stock options as described in case study 5, they also include provisions for the establishment of another, but similar, charitable remainder trust that will be the recipient of a portion of the restricted stock. The restricted stock has a value today of $2,000,000. And, in fact, after the deaths of Ms. and Mr. T and the receipt of the stock by the CRUT, Dotcom achieves its earnings goals specified in the restricted stock plan and the stock is no longer restricted.

Since, at the time of Ms. and Mr. T's deaths, the restrictions on the stock had not yet lapsed, the compensation income element "built in" to the restricted stock is considered as "income in respect of a decedent," which is potentially taxable to their daughter at ordinary income tax rates. Similarly, as in case study 5, this gift planning strategy provides significantly greater benefits to their daughter when compared simply to allowing their daughter to receive the restricted stock directly. And, of course, there is ultimately a significant benefit to the favorite charity of Ms. and Mr. T.

Additional Assumptions:

Description

Assumption

Description

Assumption

Fair market value of restricted stock today

$2,000,000

Age of the donors' child

35

Child's life expectancy and term of the charitable remainder trust

42 years

CRUT payout rate

6%



Financial Results:

Description

No planning: death now

Gift of the restricted stock at death to a charitable remainder unitrust

Fair market value of restricted stock at death

$2,000,000

$2,000,000

Estate tax deduction

$0

$215,280

Total estate taxes

$600,000

$892,360

Total income taxes on IRD

$800,000

$0

Adjustment due to the estate tax being paid from other assets in the charitable remainder trust example

$446,1801

--

After-tax amount available for investment

$1,046,180

$2,000,000

Annual after-tax income (range)

$50,217

$72,000-$162,158

Cumulative annual after-tax income paid through life expectancy

$2,109,099

$4,670,080

Present value of the cumulative income stream

$1,296,624

$2,616,046

Present value of invested principal

$370,855

--

Present value of net after-tax wealth received by the family of the donors

$1,667,479

$2,616,026

Present value of benefit to charity

$0

$215,260



1This adjustment is the estate tax of $892,360 paid from other assets in the charitable remainder trust example, which is then reduced by 50% for the estate tax that otherwise would be payable.



Conclusion

Incentive stock options, non-qualified stock options, and restricted stock are a source of significant wealth for many potential donors. While the gift planning strategies discussed in this article may have fairly limited application, they are also very powerful. And, even though the application of the strategies may be seen as fairly narrow, the opportunity to build strong and obviously very beneficial mutual relationships between potential donors and charity can perhaps open other avenues and assets to charitable giving.

The opportunities available for charities, allied professionals and, most importantly, donors to use planned giving tools to assist with the succession planning and tax reduction for their options and restricted stock are immense. The reasons are at least twofold the amount of wealth involved with options and restricted stock in our country is ever increasing, and these sophisticated charitable giving techniques are extremely powerful. As planners, all of us must continue to expand our knowledge of these techniques, to emphasize the use of these techniques, and to encourage all of the donors that we advise to use them for their benefit, and for the benefit of their favorite charities.



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