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

ealm of the estate tax. This is confirmed by Rev.
Proc. 98-34, which sets forth a safe harbor method
for valuing options for all transfer tax purposes,
including the estate tax. As mentioned earlier, this
method is based upon the popular Black-Scholes
method, which was developed to value relatively
short-dated options bought and sold in the
marketplace. While this method may overstate the
value of options in the context of gifts and other
lifetime transfers, particularly where the option term
has several years to run, that may not be true for
valuing options held by decedents at death.
When the holder of compensatory options
dies, it is common for the remaining option term to
be truncated, even where the options are fully vested
before that time. For example, it is not uncommon
for the estate to have only a year or two after death
to exercise any vested options (including those that
might vest at death). As a consequence, the safe
harbor method of Rev. Proc. 98-34 may in fact be
more favorable for valuing the decedent’s options
than other methods favored in lifetime transfers.
Moreover, because it is a safe harbor method, using
it will remove one element of potential controversy
with the IRS in the event the decedent’s return is
selected for audit. Finally, if the options pass to the
surviving spouse under the protection of the marital
deduction, a higher valuation under the safe harbor
method could be quite valuable for basis purposes,
at least if the options are ISOs.
1. Bequests of NQSOs. The Section 83
regulations make it clear that NQSOs are treated as
income in respect of a decedent (IRD) and remain
subject to the rules of Section 83 after the
decedent’s death. 28 Consequently, they receive no
step-up in basis, and any income triggered upon the
exercise or disposition of the NQSOs after death is
taxable to the estate or the beneficiaries thereof, as
the case may be. 29 However, the taxpayer is entitled
to an income tax deduction under Section 691(c) for
the federal estate taxes paid with respect to the
NQSOs.
In effect, the estate or beneficiary, as the
case may be, stands in the place of the employee for
purposes of applying the Section 83 rules after the
employee’s death. Thus, when the estate or
beneficiary exercises NQSOs, the exercising party
realizes compensation income similar to that which
the employee would have realized had she survived
28 See Regs. Section 1.83-1(d).
29 See generally Sections 1014(c) and 691(a).
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and exercised the options under similar
circumstances. The estate or beneficiary is taxed at
ordinary rates on the option spread at exercise, and
the sale of the resulting stock is treated as the sale of
a capital asset, whose basis equals the FMV of the
stock at exercise. Any capital gain or loss on the
sale of the resulting stock is long or short-term,
depending upon the period the stock was held by the
estate or the beneficiary after exercise.
In most cases, the distribution of NQSOs to
estate beneficiaries should be a non-taxable event. 30
The future tax consequences of the options under
Section 83 should shift to the distributee. A likely
exception is where the distribution satisfies a
pecuniary bequest. In that case, the use of the
appreciated NQSOs to satisfy a dollar obligation
should probably be analyzed as a deemed sale by the
estate of the NQSOs for income tax purposes.
One interesting question is whether or not
this deemed sale is treated as an arm’s-length sale
under the Section 83 regulations. The precise
question is whether the pecuniary beneficiary is a
related party for this purpose. Section 267(b)(13)
treats the beneficiary of the estate as a related party,
except in the case of “a sale or exchange in
satisfaction of a pecuniary bequest.” Hence, it can
be argued that the deemed sale should be treated as
an arm’s-length sale. As a result, the tax
consequences of the subsequent exercise of the
NQSO by the pecuniary beneficiary may not be
governed by Section 83.
As mentioned above, the lifetime gift of
NQSOs to a charity is not a particularly tax-efficient
strategy. However, that is not true of a charitable
bequest. A bequest of NQSOs to charity qualifies
for the estate tax charitable deduction. So, it
insulates the bequest from estate tax. Moreover, the
IRS has ruled that the IRD income triggered by the
exercise or disposal of the options by the charity is
the charity’s income, not the estate’s. 31 As a result,
the IRD income should escape income tax as well.
The bottom line is that a charitable legatee
of NQSOs will be able to realize 100% of the
economic value attributable to NQSOs, whereas a
non-charitable beneficiary is doing well to realize
30 Technically, this may be a non-arm’s-length transfer.
But, if there is no consideration, no income will be
triggered. However, the options remain subject to
Section 83 in the hands of the beneficiary.
31 See PLR 200002011.