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

the initial appraisal is arranged for the initial gift of
the NQSOs to the GRAT.
With the IRS’ acquiescence in the result of
the Walton case, donors are now free to select a
fixed payout term, which can be valued without
regard to the possibility that the donor will die
during the annuity term. 10 This in turn allows the
GRAT to be “zeroed out” so that little or no gift tax
is imposed on the transfer of NQSOs to the GRAT.
Moreover, because the Section 2702 regulations
allow for adjustments to be made to annuity
payments to take account of incorrect valuations,
there is little risk that a transfer to a GRAT will
trigger an inadvertent gift tax.
Of course, the estate tax benefits of a GRAT
are completely secured only after the annuity has
been paid in full. If the donor dies during the
annuity term, then the remaining trust corpus is
included in the donor’s estate for estate tax
purposes. However, this provides one practical
benefit to the donor. Since the trust is already
subject to estate tax inclusion during the annuity
term, the donor can act as the trustee of the GRAT
during this period without adding to the adverse tax
consequences. Acting as trustee during this period
allows the donor to control the exercise of the
options during the annuity term. This can be
particularly important to corporate executive, whose
stock and option transactions are subject to close
scrutiny under the securities laws and by the
marketplace. Nevertheless, the donor must
relinquish the trustee position when the annuity term
ends, or the GRAT will not achieve the desired
transfer tax benefits.
C. Sales and Other Lifetime Transfers of NQSOs
Except for the GRAT strategy mentioned
above, each of the gift strategies involves one
serious problem – the potential for gift tax liability.
The donor may, of course, mitigate this liability by
using available exclusions and credits. However,
the annual exclusion provides only minor relief,
while the $5.25 million gift tax exemption can be
exhausted where the client has significant option
wealth. Hence, it is not unusual for any significant
transfer strategy to involve serious gift tax
questions.
10 See IRS Notice 2003-72, 2003-44 I.R.B. 964.
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Consequently, as with other assets, a
number of transfer strategies have developed for
transferring NQSOs 11 via sale transactions,
primarily as a means of avoiding gift tax exposure.
As noted earlier, the income tax consequences of a
sale depend upon whether the transaction is
considered an arm’s-length disposition. If it is, then
the employee is required to include in gross income
as compensation the full value received in the
exchange. 12 For example, if an employee holding
an NQSO with a strike price of $50 sells it to a third
party in an arm’s-length sale for $60, then the
employee immediately recognizes $60 of
compensation income.
Thereafter, Section 83 has no application to
the option. Therefore, the buyer recognizes no
income on the later exercise of the option. The
stock received upon exercise is a capital asset,
having a basis equal to the sum ($110) of the strike
price ($50) plus the amount paid for the option
($60). Further, any capital gain or loss recognized
upon the subsequent sale of the stock will be longterm
if the buyer holds the stock for more than 1
year after exercise, and short-term in any other case.
Continuing the above example, if the buyer
exercises the NQSO at a time when the FMV of the
stock is $120, he recognizes no income or gain at
that time for tax purposes. If he later sells the stock
for $150, he will then recognize capital gain equal to
the $40, the excess of the $150 sale price over his
basis of $110. Such gain will be long-term capital
gain if the sale occurs more than 1 year after the
option was exercised.
The tax consequences of a non-arm’s-length
disposition are radically different. In such cases, the
NQSOs remain subject to Section 83 after the sale,
even though Section 83 applies to the consideration
received in the sale. As a result, the employee is
potentially required to recognize compensation
income in two tranches – first, at the time of sale
(determined in the manner similar to an arm’slength
sale) and again when the buyer exercises the
options. The compensation income on exercise
equals the excess of the FMV of the stock at that
time over the sum of the strike price plus the amount
11 The discussion of these transactions is generally
limited to NQSOs since ISOs are non-transferable.
12 Technically, the employee should be able to deduct the
adjusted basis of the options, but this is usually zero, at
least where the transferor is the employee.