Probate & Trust Law Section Conference Manual ... - Minnesota CLE

The Well-Prepared Executive: Personal Wealth Preservation Strategies
which generally follow the common law factors.
Treas. Reg. § 1.421-7(h)(1); Ellison v.
Commissioner, 55 T.C. 142 (1970), acq. 1971-1
C.B. 2. Thus, ISOs may not be granted to directors
or independent contractors.
(2) Termination of Employment
If the recipient of an ISO leaves
employment for any reason other than death, then
the employee must exercise the ISO within 3
months in order to preserve the ISO treatment. The
only exception is if the employee leaves due to a
disability, in which case the 3-month period is
extended to one year. IRC § 422(c)(6). Leaves of
absences of less than 90 days for whatever reason
are not considered leaving employment. Treas. Reg.
§ 1.421-7(h)(2). If the leave extends beyond 90
days, however, employment will be considered
terminated at the end of the 90-day period and the
employee has 30 days from that date to exercise the
ISO. If these time limits are not met, the option
converts to a non-qualified option, discussed below.
(3) Death of ISO Holder
Upon the death of an ISO holder, the ISO
plan may allow the executive of the deceased
employee’s estate or any person who acquired the
ISO by bequest or inheritance to exercise the ISO.
Treas. Reg. § 1.421-8(c)(i); Prop. Treas. Reg. §
1.421-8(c)(i). If the employee was employed on the
date of death, the ISO does not have to be exercised
within 3 months of death. The employee must,
however, have been employed for at least 3 months
prior to death. The ISO holding periods are waived,
but the stock will still need to be held for 1 year
after exercise to get long-term capital gain
treatment. IRC § 1.421-8(c). This same rule applies
if the employee dies holding stock obtained by
exercising an ISO. Treas. Reg. § 1.421-8(d); Prop.
Treas. Reg. § 1.421-8(d). The favorable ISO tax
treatment will carryover to the estate or the heirs.
Thus, no tax will be triggered upon exercise of the
ISO (other than potential AMT). Instead, the
executor, beneficiary, or heir will be subject to tax
when the stock is sold. ISOs receive a complete
step-up in basis equal to fair market value of the
option on the date of the holder’s death (except in
2010).
(4) No Nondiscrimination or Coverage Rules
There are no nondiscrimination or coverage
requirements like there are for qualified plans.
Thus, ISOs can be granted to whichever employees
the employer desires, including only to highly
compensated employees.
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(5) Employer Corporations Only.
ISOs can be granted only to employees of
the granting corporation or a parent corporation or
subsidiary corporation of the granting corporation.
A parent or subsidiary corporation means at least
50% ownership. IRC § 422(e) and (f). ISOs may
not be granted to an employee of an affiliated
partnership of the granting corporation. This creates
an issue in implementing a common strategy to
minimize the corporate Texas franchise tax by
operating a corporate business through a lower-tier
partnership. ISOs may not be granted to employees
of the lower-tier partnership. This issue can be
avoided by having the partnership elect to be taxed
as a corporation for federal tax purposes under the
“check the box” regulations. Treas. Reg. §
301.7701-3. Alternatively, the individuals could be
employed by a corporate subsidiary rather than the
partnership. The corporate subsidiary could then
enter into a services agreement with the partnership.
b. Fair Market Value Exercise Price.
Exercise price of ISO must not be less than
the fair market value of the stock at the time of
grant. IRC § 422(b)(4).
(1) Greater than 10% Shareholders.
Exercise price on ISOs granted to a 10% or
greater shareholder by vote, at the time the ISO is
granted, must not be less than 110% of fair market
value on the date of grant. IRC § 422(c)(5). Certain
attribution rules apply in determining whether a
person is a 10% shareholder. IRC §§ 424(d)(1) and
(2).
(2) Determination of Fair Market Value.
The Board of Director’s good faith
determination of fair market value is sufficient in
this instance. Treas. Reg. § 422(c)(1); Treas. Reg. §
14a.422A-1T (Q&A 2(c)(4)); Prop. Treas. Reg. §
1.422A-2(e). Thus, the Board will not later be
second guessed if the determination, in hindsight,
appears to be wrong. The Board must, however,
establish that it made a good faith determination of
fair market value given all the facts and
circumstances at such time. The Board should
memorialize its fair market value determination in
the Board minutes. See Keogh v. Commissioner,
T.C. Memo 1992-131, aff’d by unpublished op., 95-
2 U.S.T.C. 1995 (2d Cir. 1995), cert. denied No.
95-1014 (U.S. 1/22/96)(denying ISO treatment
where no evidence that the option price was
intended to be the stock’s fair market value).
(3) Effect of Restrictions on Stock.
In making its good faith determination of