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

The Well-Prepared Executive: Personal Wealth Preservation Strategies
Commissioner v. LoBue, 351 U.S. 243 (1956)
(holding that options with a 75% discount should be
taxed at exercise and not a grant); Victorson v.
Commissioner, 326 F.2d 264 (2d Cir. 1964)
(treating an option granted to an underwriter with an
exercise price equal to .2% of the stock value as a
grant of an option); Simmons v. Commissioner, 23
T.C.M. 1423 (1964) (same where exercise price was
equal to .1% of the underlying stock value); but see
Morrison v. Commissioner, 59 T.C. 248, 260
(1972), acq., 1973-2 C.B. 3 (holding that the grant
of an NQO with an exercise price of $1 to purchase
stock with a value of $300 that was “the substantial
equivalent of the stock itself”). Notwithstanding the
favorable case law, prudence dictates that deeply
discounted options should be avoided if the taxpayer
wants to avoid the risk of immediate taxation. A
prominent treatise suggests that a 90% discount
creates a high risk; a 75% to 90% discount creates
moderate risk; and a 50% or less discount creates
very little risk. Martin D. Ginsburg and Jack S.
Levin, Mergers, Acquisitions, and Buyouts
1314.1.2 (1999); see also Keith A. Mong,
Discounted Options as an Alternative to Deferred
Compensation, 39 Tax Mgmt. Memo 167 (1998)
(concluding that only discounts in excess of 75%
would likely be challenged by the IRS). If the grant
of a deeply discounted NQO is treated as the
issuance of the underlying stock, the executive will
be taxed under the restricted stock rules discussed in
Part III(A) above.
(3) No IRC § 83(b) Election.
Executives may not make an IRC § 83(b)
with respect to NQOs. This is one of the potential
disadvantages of NQOs over restricted stock. If the
NQO is to be granted “at the money,” the employer
should consider allowing the executive to
immediately exercise the NQO into restricted stock
subject to the desired vesting provision. The
executive could then exercise the NQO and make
the IRC § 83(b) election with respect to the
restricted stock received. Because the exercise price
is equal to the value, no income would be reported
with respect to the IRC § 83(b) election. Thus, all
future appreciation would be capital gains when the
executive sold the stock. See Part III(B)(5)(c)
above.
b. Transfer of NQO.
An arm’s-length disposition of an NQO will
trigger compensation income equal to the amount
realized on the sale less the tax basis in the NQO
(which will usually be zero). Treas. Reg. § 1.83-
1(b)(1). A non-arm’s-length disposition such as a
10
gift or contribution to a related entity does not close
the compensation element and the executive is still
subject to tax when the NQO is exercised by the
transferee even though the executive no longer owns
the NQO. Treas. Reg. § 1.83-1(c).
(1) Gift Tax Issues.
Transfer of NQO is treated as a completed
gift when the donee’s right to exercise the option is
no longer conditioned on the donor’s future
services. Rev. Rul. 98-21, 1998-18 IRB 7. Thus, if
the NQO is not vested, the gift will be when the
NQO becomes vested, at which time the value of the
stock may be higher. In valuing the gift of an NQO,
Rev. Proc. 98-34 sets forth a methodology that
requires valuing the option privilege.
(2) Estate Tax Issues.
An NQO that is gifted prior to death will
not be included in the executive’s estate upon his
death, so long as he does not retain any rights or
powers associated with the transferred NQO. If the
executive dies owning NQOs, the compensation
element remains open, even though the option
passes to the estate or to beneficiaries. When the
estate or beneficiaries exercise the option, the
compensation income is triggered. There is no step
up in basis of the NQO’s value to date of death
value.
c. Exercise.
Executive recognizes ordinary
compensation income upon exercise of the NQO in
an amount equal to the value of the stock at exercise
less the exercise price. IRC § 83(a).
(1) Stock Restrictions are Ignored in
Determining
Value.
For purposes of determining fair market
value upon exercise of the NQO, restrictions on the
stock such as securities law, lock-up, and similar
restrictions are ignored. IRC § 83(a). The only
restrictions that are not ignored are those which by
their terms will never lapse. See Part II(B)(3)(a)
above.
(2) Receipt of Restricted Stock.
If the stock received upon exercise of the
NQO is subject to a substantial risk of forfeiture
(i.e., not vested), then the executive will not be
taxed on exercise of the NQO. Instead, the rules for
restricted stock discussed in Part II above will apply
to the receipt of the restricted stock. In general, the
executive would be taxed when the stock became
vested. Alternatively, the executive could make an
IRC § 83(b) election to be taxed on the restricted