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

taxed to the employee in the prior non-arm’s-length
sale.
To illustrate, let’s change the facts in the
above example and assume that it is not at arm’slength
because the sale price is $50 ($10 less than
FMV). In that case, the employee realizes
compensation income equal to the $50 received in
the sale. However, when the options are exercised,
he is charged with an additional $20 of
compensation (i.e., the excess of the $120 FMV of
the stock at exercise over the sum of the employee’s
prior compensation income of $50 plus the $50
strike price paid by the buyer). On the buyer’s side,
the transaction resembles the original example,
except that the buyer paid $10 less for the NQSO.
This means that the buyer’s basis for the stock
should be only $100 (rather than $110), and that his
capital gain on sale of the stock will be $50 (rather
than $40).
Note that only $100 of net income and gain
was realized by the employee and the seller
combined (i.e., $150 sales proceeds less the $50
strike price). Nevertheless, the employee was
charged with $60 of compensation, while the buyer
paid tax on $50 of gain. The difference is the
additional compensation recognized by the
employee when the NQSO was exercised by the
buyer. If the employee had retained the NQSO and
exercised under the same circumstances, then the
total income would have been only $100. However,
in transferring it to another in a non-arm’s-length
transaction, he exposed the parties to double
taxation on a portion of the income stream. While
from an equity standpoint one can argue that the
buyer should be allowed to offset the additional
compensation taxed to the employee at exercise
against the sales proceeds, support for that notion in
the Code or the regulations is hard to find.
With these general rules in mind, let’s now
apply them to some specific transactions that have
been popular recently.
1. Sales to Descendants. For the client
with a substantial estate, one tax-efficient strategy to
reduce potential estate tax liability is to shift some
growth in the estate to heirs without paying gift
taxes. In addition to GRATs mentioned above, sales
for current FMV are the most common method of
achieving this objective. The idea is to exchange a
potentially high-performing asset with another that
is likely to yield considerably less. As a result of
– 5 –
this exchange, the arbitrage between the two returns
is shifted to the heirs, reducing the ultimate estate
tax burden of the transferor.
Applying these principles to NQSOs
(assuming of course that they are transferable)
sometimes involves a sale by the employee to his
children. The most significant threshold issue of
course is valuation. Failure to assess the true FMV
at the outset exposes the transfer to potential gift
taxes that the transferor is trying to avoid. Prudence
dictates that a formal appraisal be obtained. For
reasons mentioned earlier, it is likely that the
appraisers will not use the IRS safe harbor valuation
method.
However, assuming that the options’ value
has been properly determined, the sale can proceed.
The usual assumption is that the options will be held
for some period after purchase (in order to take
advantage of their growth potential). As a result, the
value represented by the options themselves cannot
directly be tapped as a source of payment in the sale.
Usually, the heirs do not have the cash to pay the
purchase price either. So, the consideration is often
an installment note, which allows the buyers to pay
over time.
However, any installment note must be
planned with care. In order to avoid gift tax
exposure, the note must have a FMV equal to the
FMV of the NQSOs. Fortunately, Section 7872
provides a safe harbor. As a result, the note should
have the requisite FMV, if it has a face amount
equal to the FMV of the options and bears an
interest rate equal to the applicable federal rate
appropriate for the specific term of the note. 13
As mentioned above, the Section 83
regulations ordinarily require the seller to recognize
compensation income equal to the amount of the
sales proceeds. Does the receipt of an installment
note change the timing of that income recognition?
Some would say (or, more correctly, would until
recently have said) that it should. These advisors
would contend that an unsecured installment note is
13 Cf. PLR 9535026. To be safe, the note should also
contain other terms customarily found in instruments of
this type between unrelated parties. Moreover, many
advisors counsel that interest should be paid at least
annually.