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

emains the owner for income tax purposes, it is
difficult to see how he can be considered to have
transferred them for purposes of Section 83, since
that provision is an income tax provision.
Hence, the transfer of the NQSOs to the
grantor trust should be ignored, as well as any
payments made on the note. In addition, the basis of
the NQSOs in the trust should remain the same as it
was before the transfer (most likely zero).
Moreover, the options should remain subject to
Section 83, since they would be treated as owned by
the employee under the rationale of Rev. Rul. 85-13
in any event. As a result, any compensation income
triggered by the exercise or disposition of the
options after the sale should be treated as the income
of the grantor under Section 671. 19
Despite many years of experience with sales
to “intentionally defective” grantor trusts, one
significant question remains unresolved – what
happens when the grantor dies or grantor trust status
otherwise terminates? The commentators have
argued for a number of different results ranging
from the immediate income taxation of all the
income that was deferred to the complete exemption
of that income from tax. And, the consequences
may differ depending upon whether grantor status is
terminated by death or by some other event like the
renunciation of the power causing grantor trust
status. The IRS apparently believes that the loss of
grantor trust status completes the transfer that was
ignored under the rationale of Rev. Rul. 85-13. 20
The author believes a balanced approach is
the likely outcome. That is, any remaining income
embedded in the installment note at the time grantor
status ends becomes taxable, but the taxation of that
income is subject to the normal accounting rules
governing the recognition of income, including the
installment sale rules if they are otherwise
applicable. However, as noted above, it is highly
questionable that the sale of NQSOs qualifies for the
installment method, and other arguments for deferral
are similarly suspect.
As a result, it seems likely that any income
embedded in the installment note will be
immediately recognized and taxed as compensation
income when grantor status is lost. In addition, the
19 Moreover, this latter result seems to be dictated by
Section 83 as well, since the transfer is probably not an
arm’s-length transfer in any event.
20 Cf. Regs. Section 1.1001-2(c) Example (5).
– 8 –
grantor or his estate should have a basis in the note
at least equal to the income recognized when grantor
status is lost. If, however, the options have been
exercised prior to the loss of grantor trust status,
then the grantor will have already recognized all the
Section 83 income embedded in the options prior to
the loss of grantor status. Accordingly, there is
some question as to how the note would be treated
in that instance. In general, the note should have the
same basis as the property transferred (which will
usually be zero). However, when the NQSOs are
exercised, the resulting stock should receive a new
basis equal to its FMV on the date of exercise. The
question is whether this basis increase will also
carry through to the note. While this is the logical
result, it is difficult to see how you get there under
the existing authorities.
D. Gifts and Sales Involving Partnerships and
LLCs
As with other assets that are the subject of
wealth transfer strategies, the use of an intervening
partnership-type entity promises some advantages.
In addition to allowing the transferor to maintain
control over the gifted assets, the intervening limited
partnership (LP) or limited liability company (LLC)
also makes transfers of partial interests in assets far
easier. And, of course, interposing such an entity
also offers the prospect of lower transfer tax values,
through discounts generally available for interests
that are not marketable or controlling.
It is true that such strategies are
controversial, certainly in the eyes of the tax
authorities. This is especially true where the
underlying assets are securities. Nevertheless, as the
recent Fifth Circuit decision in the Kimball case
illustrates, courts often provide such a sympathetic
ear that even conservative clients and their advisors
must take note. Injecting a family LP or LLC into a
transfer strategy involving NQSOs thus offers
potential additional benefits.
Normally, the idea would be to transfer the
NQSOs to an LP or LLC followed by a gift or sale
of interests in the particular entity to family
members or trusts. Theoretically, this should create
a lower gift tax value or lower sale price, which in
turn should allow more wealth to be transferred for a
given tax liability than would be possible with direct
transfers of the options. However, transfers of
NQSOs are not like other transfers. They present
unique challenges.