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

employee’s descendant, this would clearly be
undesirable from an estate tax standpoint, since
would amount to a “reverse wealth transfer.”
2. Sales to Irrevocable Non-Grantor Trusts.
The tax considerations for sales to non-grantor trusts
are largely the same as those discussed in the
immediately preceding section. Any such trust is
likely to be treated as a related party to the grantor
under the amended Section 83 regulations and
therefore will not be at arm’s-length for Section 83
purposes.
However, using a trust as the buyer provides
potential non-tax advantages. First, if the
employee’s descendants are minors or their
decisions are otherwise suspect, the sale to a trustee
shifts control over exercise, sale and reinvestment
decisions to a person who should be more reliable.
Second, assuming that the trust contains a
spendthrift clause, the trust will act as a shield
against the claims of creditors. Third, the trust
addresses “reverse wealth transfer” problem
mentioned above. Interposing the trust between the
descendant and the purchase obligations should
insulate the beneficiary’s assets from exposure to
those obligations.
However, interposing a trust also introduces
another issue – namely, whether the transaction will
be viewed as a bona fide sale. Where NQSOs are
sold to an individual for a recourse note, that
individual’s other assets implicitly back the
purchase obligation. But, where the options are sold
to an irrevocable trust, in most cases the lender’s
remedies are is limited to the trust’s assets. As a
result, in order to give the loan credence, it is
necessary to provide some additional credit support
separate and apart from the NQSOs.
The most straight-forward way to provide
this support is to “seed” the trust with additional
assets by gift prior to the sale. While there is no
published guideline on the amount of additional
assets needed for this purpose, most practitioners
require a gift of at least 10% of the sale price. It is
also possible to bolster the transaction by having the
beneficiary guarantee the note, but this exposes the
beneficiary to the reverse wealth transfer problem
mentioned above and also raises questions about the
level of consideration, if any, that should be paid for
this guaranty and the associated taxation of that
consideration.
– 7 –
3. Sales to Grantor Trusts. From a
structural perspective, a sale to a trust treated as a
grantor trust is similar to a sale to a non-grantor
trust. The primary difference is the addition of
provisions in the instrument that cause the trust to be
treated as a grantor trust for income tax purposes
(without exposing the trust to estate inclusion at the
grantor’s death). 17 However, the income tax
consequences are radically different, at least at the
outset. Importantly, under the rationale of Rev. Rul.
85-13, any transaction between the grantor and the
trust is effectively ignored for income tax purposes.
This should include the initial sale of the NQSOs to
the trust. In addition, if the buyer gives an
installment note as consideration, any debt service
payments should also be ignored. Finally, no
income should be triggered if the trustee uses
NQSOs to satisfy the note obligations.
Nevertheless, all of these aspects will be
given due effect for estate and gift tax purposes.
This is important because the primary purpose of the
transaction is to shift some of the future gains from
the NQSOs and any resulting stock to the
beneficiaries of the trust free of gift taxes. As noted
above, this is achieved if the note has a FMV equal
to the FMV of the NQSOs. The note arrangement
should have the requisite FMV if it has a face
amount equal to the FMV of the NQSOs, bears
interest at the applicable federal rate and otherwise
has conventional terms and conditions (including
some additional credit support as discussed above).
Moreover, it appears that the IRS has finally
conceded that the payment of income taxes imposed
on the grantor as a result of Section 671 is not a gift
to the trust beneficiaries for gift tax purposes. 18
If the assets other than NQSOs were sold to
the grantor trust, then the income tax analysis would
be relatively simple, at least while grantor status
prevailed. The sale and note transactions would be
ignored, and the grantor would in effect report all
income, gain and deductions attributable to the trust
property. There seems to be no reason why these
conclusions would not also obtain in the sale of
NQSOs by the grantor to a grantor trust. Section
671 provides that the grantor of the options is still
their owner for income tax purposes. If the grantor
17 The most popular provisions used for this purpose are
the powers to reacquire trust assets by substituting assets
of equivalent value and to add beneficiaries other than
after-born children. See Sections 675(4)(D) and 674(c),
respectively.
18 See Rev. Rul. 2004-64, 2004-27 I.R.B. 7.