Web site:
The Planned Giving Design Center, LLCs group location on the PGDC website.
Phone:
704.698.4050
by Philip T. Temple & Fred J. Marcus
A recent report by the New York investment firm of Sanford C. Bernstein and Co., Inc. states that approximately 45% of employee compensation is in stock options. This increased interest in stock options means the charitable gift planner and estate planner need to know the basic ground rules regarding stock options, and how they can be dealt with in charitable gift planning and estate planning.1
Stock options are a contractual right given by a corporation to an employee (and, sometimes, to an independent contractor) to purchase stock in the corporation at a stated price per share for a stated period of time. There are two basic types of options.
Nonstatutory (Nonqualified) Options [IRC § 83]: Generally, this type of option is not taxable to an employee when granted, unless the option has a readily ascertainable value (i.e., it is actually traded on an established securities market) at the time of grant. Compensation is realized when the option is exercised or "otherwise disposed of." Compensation is equal to the difference between the fair market value of the stock at the time of exercise and the exercise price.
An employee may choose to recognize compensation income on grant by making an IRC § 83(b) election. This is seldom done, however, because of the difficulty in ascertaining the value of those options. No income will then be realized on their subsequent exercise.
Statutory Options: This includes incentive stock options (ISOs) and employee stock purchase plans. An ISO is a compensatory option where the employer grants the employee the right to purchase the employer's stock at some time in the future at a specified price. In general, ISOs may not be granted to an individual who, at the time, owns more than 10% of the voting power of the corporation. Attribution rules apply. And no more than $100,000 of ISO grants for any employee may become exercisable for the first time in any one calendar year. [IRC § 442(d)]
An employee stock purchase plan is used by employers as a method for employees to purchase stock of the employer usually using payroll deductions to pay for the shares.
These plans grant options to employees to purchase company stock. What the option price is and when the option is granted are variables. Some employers sponsor offerings to all employees of stock at a certain price, and the employee may accept the offering and receive stock once the offering price is paid. Other plans may provide that an employee's payroll deductions are used to purchase stock at a specified time (such as the end of each calendar quarter). Payroll deductions that were not enough to purchase a full share of stock may be carried over into the next purchase period.
The most important feature of a stock purchase plan is that it can offer options with an option price of between 85% and 100% of the fair market value of the stock, either at grant or at exercise.
Among other requirements, the employee (optionee) will not be taxed upon the grant or exercise of a statutory option provided the option:
General Tax Treatment: The employee does not recognize taxable compensation income at the time the option is granted or at the time the option is exercised (unless exercised more than three months after leaving employment). The price for such avoidance is that the employee must not dispose of the stock until the later of two years from the date the option was granted or one year from the date the employee received the shares upon exercise. A disposition includes a sale, exchange, or gift.
If the employee disposes of the stock before the holding period is up, he must recognize as compensation income the difference between the option exercise price and the fair market value of the stock at the time of the option exercise. In addition, he will recognize income equal to the difference between his basis in the stock (the exercise price increased by the amount included in gross income as compensation) and the amount he receives in the disposition.
If the employee waits to dispose of the stock until after the holding period, there will be no compensation income, but there will be possible capital gains (mid- or long-term, depending on how long the stock is held). The capital gains would be the difference between the amount received in the disposition over the basis in the stock (i.e., the amount the employee paid when exercising the option).
Alternative Minimum Tax (AMT) implications for ISOs: While the exercise of an ISO does not result in current taxable income, there are implications with regard to the AMT. When calculating income for AMT purposes, the difference between the fair market value and the exercise price will be considered part of AMT income.
Example:
In 1998, A exercises 1,000 options for X Corporation stock at $50 per share when the fair market value of X Corporation stock was $75. In calculating A's AMT, $25,000 will be added as an item of adjustment. If A makes a disqualifying disposition of the ISO stock in 1999, the $25,000 that was recognized as compensation income in 1998 will not be reflected in the calculation of taxable income for AMT purposes in 1999. If, however, A sells all his ISO stock after the expiration of the ISO holding period at $100 per share, the gain on the sale of stock for AMT purposes would be $25,000 ($100,000 of proceeds on sale, less $50,000 [the cost basis of stock] and less $25,000 [the amount previously recognized as AMT income]).
Holding Period: The holding period for capital gains treatment does not begin until the option is exercised. Accordingly, stock must be held at least 12 months after exercise to obtain long-term capital gains treatment with 20% maximum tax rate. Where does cash for exercise come from?
Generally, a disposition is any sale, exchange, gift or transfer of legal title of the stock. IRC § 424(c) provides certain exceptions:
Outright Gift of Acquired Stock to Charity (Intervivos or Testamentary): As long as the employee has held the stock for the required holding period - at least two years from the grant of the option, but also more than one year after its exercise - the gift is subject to the same deductibility rules as with any gift of appreciated long-term capital gain property: a charitable deduction at fair market value, subject to the 30% ceiling, and no capital gain imputed to the donor.
Charitable Remainder Trust: After the holding period, an employee contributes acquired stock to a charitable remainder trust, and the trust sells stock. Another option is for the employee to establish a charitable remainder trust with other assets to offset gain in connection with exercise of option.
Charitable Lead Trust: An employee establishes a charitable lead trust with cash proceeds of sale or with other assets to offset gain in connection with exercise of option.
Charitable Gift Annuity: An employee transfers stock to charity in exchange for an annuity.
Lifetime Gifts: Lifetime gifts are an important element of estate planning. Assets with significant appreciation potential are attractive property for giving. Options often fill the bill in this regard. However, the gift is not completed until employee performs services that are a precondition to exercise of the option. [Rev. Rul. 98-21]
Tax Implications for Option Holder: A transfer by gift is not considered disposition because it is not at arm's-length. [Reg. § 1.83.7(a)] The transferor, not the transferee, recognizes ordinary income on exercise. The transferee benefits because the option appreciates without being subject to income tax. Payment of income tax on exercise should not be considered a further gift subject to gift tax.
Tax Implications for Transferee: On exercise of option, the transferee gets the cost basis equal to the sum of consideration paid by the transferee on exercise and amount of income realized by the donor. The transferee recognizes capital gains (or loss) only upon sale of the acquired stock. The holding period begins on date of exercise.
Federal Law: For those employers whose stock is subject to SEC regulations, there are three primary securities law issues that must be considered in the establishment of an 153 plan: securities registration, proxy disclosure, and "short swing profits." The stock to be offered under the option plan must be registered, usually through filing a Form S-8. Participants will receive information regarding the ISO plan and its operation, although this information does not necessarily have to be a separate document for securities law purposes. Annual proxy statements must disclose the existence and the details of an ISO plan, as well as the stock options granted to or exercised by directors and officers.
Under § 16(b) of the Securities Exchange Act, an officer, director, or owner of over 10% or more of the stock of a company (insider) may be sued by a shareholder for any profits realized by the insider for a purchase or a sale of a company stock within a six-month time frame (short swing profit).
The Securities and Exchange Commission amended its rules regarding "short swing profit" liability effective May 1, 1991. SEC Rel. No. 28869 (2/8/91) provides that the grant of the option is considered a purchase of company stock for determination of "short swing profits."
However, the grant is exempt from "short swing profit" liability if it is pursuant to a written employee benefit plan that is approved by the shareholders and that specified the basis for determining eligibility to participate in the plan, and that either:
The plan, or a written agreement, with the employee also must provide that derivative securities are not transferable other than by Will or the laws of descent or distribution, or pursuant to a qualified domestic relations order.
SEC Rule 144 Stock: Regardless of whether they are publicly traded or not, securities are subject to certain Securities and Exchange Commission rules regarding their sale if they are acquired, directly or indirectly, in a transaction or chain of transactions not involving a public offering (in which case they are "restricted securities") from: 1) the company issuing them; or 2) an individual or company affiliated with the issuing company (generally including officers and directors of the company, in which case they are "control securities"). SEC Rule 144 provides a safe harbor for the sale of these securities if all the conditions of the rule are met.
Generally, Rule 144 requires that a charity and its donor together must hold restricted securities for a minimum of one year before their sale in accordance with the rule. It also imposes a value limitation on the amount of securities that can be sold by affiliates of the company during any three-month period and may require aggregation of the charity's sales with the donor's. Adequate current information on the issuing corporation must be on file with the SEC. The SEC, as well as the principal national exchange on which the securities are listed, must be notified of the sale.
Securities laws do not generally prohibit giving options, but donor's restrictions on sale do apply to the donee (including charity).
The rule that a donor receives a fair market value charitable deduction for income tax purposes for gifts of publicly traded stock to a private foundation is now permanent and retroactive to June 30, 1998.
ESOP is tax qualified, defined contribution employee benefit plan whereby, in return for meeting certain rules that protect the interests of plan participants, the ESOP sponsors receive various tax benefits. Ordinarily, to set up an ESOP, the company creates a trust fund for employees and funds it by one, or a combination of the following tax deductible methods:
The employer can deduct (within limits) contributions to an ESOP, including both principal and interest on loan proceeds the ESOP uses to buy company stock. The employer can generally deduct reasonable cash dividends, if paid to an ESOP and used to repay the ESOP loan or passed through to participants on ESOP held stock.
The shareholders of a closely held corporation can defer taxation on the gain resulting from their sale of company stock to an ESOP, provided the ESOP owns 30% or more of a company's shares after the sale, by reinvesting sale proceeds in qualified replacement property (QRP) consisting of stock or bonds in operating companies in the United States.
A CHESOP is a combination of an ESOP and a gift to charity. The simplest way to implement this is to have the shareholder donate his/her privately held stock to a nonprofit institution, which then sells the stock back to an ESOP established by the company. The donor gets a charitable deduction for the full fair market value and avoids capital gains on the appreciation, or the owner of shares can use the proceeds of the sale to an ESOP to purchase a QRP and then give the QRP to a qualified charity. The individual owns the QRP with the same holding period and basis as the stock sold to the ESOP, but avoids capital gains and gets the full fair market value deduction by giving QRP to charity or, perhaps, to a qualified charitable remainder trust, retaining an income stream.
The following case study, Exhibit A, demonstrates a variety of options when selling stocks. The discussion includes selling stock in the same year with contributions of cash to a life income trust, charitable lead trust, and gift annuity. Also shown is the sale of stock after 18 months with contributions to a life income trust, charitable lead trust, and gift annuity. We believe the comparisons speak for themselves.
Harry and Phyllis
Harry and Phyllis, both age 65, own incentive stock options worth $750,000. They intend to exercise their options, and then either hold the stock for at least 12 months, or sell it earlier.
The questions they face are:
Besides the options, Harry and Phyllis own $1.5 million of other assets. For this case study, we will assume the remaining assets generate nontaxable income to this couple. Overall, they seek the following:
Assume Harry and Phyllis exercise 10,000 options of X Corporation stock at $25.00 per share, when the fair market value of X Corporation stock is $75.00 per share. Assume further that X Corporation stock is worth $100.00 per share 12 months after exercise.
Choice 1: Analysis Of Exercise And Sale Of Stock In The Same Year
Step 1: Exercise of Options
Exercise Price $250,000
Alternative Minimum Tax
(AMT) Adjustment 500,000
AMT2 $100,000
Step 2: Sale of Stock
Price $750,000
Basis 250,000
Gain $500,000
Federal and State Tax (45%) $225,000
Net Proceeds (after tax and
payment for stock) $275,000
Income on Net Proceeds (7%) 19,250
Federal and State Tax on Income (34%) (6,545)
Spendable Income $12,705
Estate
Sale Proceeds $275,000
Other Assets 1,500,000
Gross Estate $1,775,000
Estate Tax3 (205,250)
Net to Heirs $1,569,750
Net to Charity -0-
Choice 2: Analysis Of Exercise And Sale Of Stock In The Same Year Followed By Contribution Of Cash To 7% Charitable Remainder Trust
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
Charitable Deduction (77,358)
AMT $84,528
Step 2: Sale of Stock
Price $750,000
Basis 250,000
Gain $500,000
Less Charitable Deduction4 $(77,358)
Federal and State Tax (45%) $190,188
Net Proceeds (after tax and
payment for stock) $309,812
Income from CRT 21,000
Income from Balance 687
Federal and State Tax on Income (34%) (7,374)
Spendable Income $14,313
Estate
Sale Proceeds after $300,000 gift to CRT) $9,812
Other Assets 1,500,000
Gross Estate $1,509,812
Estate Tax5 (98,827)
Net to Heirs $1,410,985
Net to Charity $300,000
Choice 3: Analysis Of Exercise And Sale Of Stock In The Same Year Followed By Contribution To Charitable Lead Trust
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
Charitable Deduction6 222,384
Exemption 13,096
AMT $52,904
Step 2: Sale of Stock
Price $750,000
Basis 250,000
Gain $500,000
Less Charitable Deduction $(222,384)
Federal and State Tax (45%) $124,927
Net Proceeds (after payment
on exercise and tax on sale) $375,073
Contribution to Grantor Lead Trust 350,000
Income on Balance of Proceeds 1,755
Federal and State Tax on Income (34%) (596)
Spendable Income $1,159
Estate
Sale Proceeds $375,073
Other Assets7 1,500,000
Gross Estate $1,875,073
Charitable Deduction for Lead Interest (222,384)
Net Estate 1,652,689
Estate Tax8 (155,102)
Net to Heirs $1,719,9719
Net to Charity (Income from Lead Trust for 15 years) $367,500
Choice 4: Analysis Of Exercise And Sale Of Stock In The Same Year Followed By Contribution To Charity In Exchange For Charitable Gift Annuity
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
Charitable Deduction10 96,430
AMT $80,714
Step 2: Sale of Stock
Price $750,000
Basis 250,000
Gain $500,000
Less Charitable Deduction $96,430
Federal and State Tax (45%) $181,606
Net Proceeds (after payment
on exercise and tax on sale) $318,394
Income from Gift Annuity 20,400
Income on Balance of Net Proceeds (7%) 1,288
Federal and State Tax on Income (34%)11 (7,374)
Spendable Income $14,314
Estate
Sale Proceeds (after $300,000
contribution for gift annuity) $18,394
Other Assets 1,500,000
Gross Estate $1,518,394
Estate Tax12 (102,174)
Net to Heirs $1,416,220
Net to Charity $300,000
Choice 5: Analysis Of Exercise Followed By Sale Of Stock After 12 Months
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
AMT $100,000
Step 2: Sale of Stock
Price $1,000,000
Basis 250,000
Gain $750,000
Federal and State Tax (29%)13 $217,500
AMT Credit (67,500)
Net Tax $150,000
Net Proceeds (after tax and
payment for stock) $500,000
Income on Net Proceeds (7%) 35,000
Federal and State Tax on Income (34%) (11,900)
Spendable Income $23,100
Estate
Sale Proceeds $500,000
Other Assets 1,500,000
Gross Estate $2,000,000
Estate Tax14 301,000
Net to Heirs $1,699,000
Net to Charity -0-
Choice 6: Analysis Of Exercise Followed By Contribution Of Stock After 12 Months To 7% Charitable Remainder Trust
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
AMT $100,000
Step 2: Sale of Stock through CRT
Price $1,000,000
Basis 250,000
Gain $750,000
Taxable Gain -0-
Net Proceeds (after AMT and
payment for stock) $650,000
Income from CRT 45,500
Less Charitable Deduction15 (13,650)
Federal and State Tax on Income (34%) 10,829
Spendable Income $34,671
Estate
Sale Proceeds -0-
Other Assets 1,500,000
Gross Estate $1,500,000
Estate Tax16 86,000
Net to Heirs $1,414,000
Net to Charity $650,000
Choice 7: Analysis Of Exercise Followed By Contribution Of Stock After 12 Months To Charity In Exchange For Charitable Gift Annuity
Step 1: Exercise of Options
Exercise Price $250,000
AMT Adjustment 500,000
AMT $100,000
Step 2: Transfer of Stock for Gift Annuity
Price $1,000,000
Basis 250,000
Gain $750,000
Taxable Gain -0-
Net Proceeds (after AMT and
payment for stock) $650,000
Income from Gift Annuity 44,850
Less Charitable Deduction17 (13,455)
Federal and State Tax on Income(34%)18 10,674
Spendable Income $34,176
Estate
Sale Proceeds -0-
Other Assets 1,500,000
Gross Estate $1,500,000
Estate Tax19 86,000
Net to Heirs $1,414,000
Net to Charity $650,000
| Exercise And Sale (Same Year) |
Exercise In One Year--Wait 12 Months For Sale (Assume $250,000 Additional Appreciation) |
||||||
| Choice 1 | Choice 2 | Choice 3 | Choice 4 | Choice 5 | Choice 6 | Choice 7 | |
| Exercise & Sale | Exercise & Sale & Cash To CRT | Exercise & Sale & Stock To CLT | Exercise & Sale & Stock To Charity For Gift Annuity | Exercise & Sale | Exercise & Stock To 7% Charitable Remainder Trust | Exercise & Stock To Charity For Gift Annuity | |
| Tax on Exercise | $100,000 | $84,528 | $52,904 | $80,714 | $100,000 | $100,000 | $100,000 |
| Net Proceeds (after tax and payment for stock) | 275,000 | 309,812 | 375,073 | 318,394 | 500,000 | 650,000 | 650,000 |
| Spendable Income | 12,705 | 14,313 | 1,159 | 14,314 | 23,100 | 34,671 | 34,671 |
| Net to Heirs | 1,569,750 | 1,410,985 | 1,719,971 | 1,416,220 | 1,699,000 | 1,414,000 | 1,414,000 |
| Net to Charity | -0- | 300,000 | 367,50020 | 300,000 | -0- | 650,000 | 650,000 |
It's a timely topic, as shown by recent articles in, for example, The New York Times. See the April 5, 1998 issue of Money & Business for an article entitled "Flying High on the Option Express" and the April 19, 1998 section "The Week in Review" for a discussion entitled, "Feeding the New Work Ethic," with a subhead of "Stock Options Stoke Corporate America's Lottery Fever."back
20% rate under Taxpayer Relief Act of 1997. Phase out of exemption over $150,000 and completely phased out at $330,000.back
Assume full use of $1,250,000 joint exemption available in 1998. Joint exemption increases to $2,000,000 by 2006.back
Charitable contribution deduction for $300,000 gift to 7% Life Income Trust.back
Assume full use of $1,250,000 joint exemption available in 1998.back
Assume $350,000 to 15-year 7% grantor lead unitrust produces $222,384 deduction, which can be utilized against 50% of Adjusted Gross Income.back
Assume $250,000 of other assets used to exercise option.back
Assume full use of $1,250,000 joint exemption available in 1998.back
$375,073 not distributed until Lead Trust term ends in 15 years.back
Deduction for establishment of $300,000 charitable gift annuity agreement.back
Actual tax may be less because of taxation of gift annuity payments.back
Assume full use of $1,250,000 joint exemption available in 1998.back
Federal capital gains rate of 20% and State tax of 9.3%. Assume results in no deduction for State taxes.back
Assume full use of $1,300,000 joint exemption as of 1999.back
Total charitable contribution deduction of $184,905 for $650,000 gift to 7% Life Income Trust for couple both age 67. Can be used in year of gift against 30% of adjusted gross income and carried forward up to five years.back
Assume full use of $1,300,000 joint exemption as of 1999.back
Deduction of $217,219 for establishment of $650,000 charitable gift annuity for couple both age 67.back
Actual tax may be less because of taxation of gift annuity payments.back
Assume full use of $1,300,000 joint exemption as of 1999.back
Income from lead trust for 15 years.back
