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

even 30% of that value because of the double-tax
hit. Stated another way, the charity is indifferent
whether it receives the NQSOs or non-IRD assets,
whereas the non-charitable beneficiaries are better
off with the non-IRD assets because of the step-up
in basis. Hence, clients should consider funding any
charitable bequests out of NQSOs (and similar
assets such as IRAs) before using other assets that
are more valuable to the non-charitable heirs.
2. Bequests of ISOs and ISO Stock.
Where the decedent dies holding ISOs or ISO stock,
the analysis is generally more favorable, but quite a
bit more involved, because of the peculiar tax
aspects of these instruments. The ISOs themselves
should qualify for a step-up in basis, since unlike
NQSOs they are not considered to be IRD assets in
the hands of the estate or beneficiary. Moreover, the
regulations indicate that the tax-favored treatment
accorded ISOs in the hands of the decedent carry
over to the estate and the beneficiaries. 32
In addition, Section 422(c)(1) specifically
provides that the ISO holding period requirement
does not apply to ISO stock acquired by the
decedent’s estate or beneficiaries through the
exercise of inherited ISOs. Similarly, if the estate or
a beneficiary inherits ISO stock, they are not
required to hold the ISO stock for the balance of any
unexpired ISO holding period existing at the
decedent’s death. 33 Essentially, the special holding
periods for ISO stock cease to apply after the
employee dies. As a result, the estate and
beneficiaries are free to dispose of ISO stock
immediately after acquiring it without fear of being
hit with compensation income.
However, they are subject to the normal
capital gains holding period rules for the ISO stock.
For example, if the estate exercises the decedent’s
ISOs, the resulting stock will be a capital asset. But,
a subsequent sale of that stock produces short-term
gain or loss, unless the estate holds the ISO stock for
more than 1 year after exercise. On the other hand,
immediate long-term capital gain treatment is
accorded any ISO stock held by the decedent at
death, because Section 1223(11) accelerates longterm
status for ISO stock held by the decedent.
As mentioned above, ISOs receive a step-up
in basis at the employee’s death. This has a
consequence when the ISOs are exercised by the
32 See generally Regs. Section 1.421-2(c).
33 Regs. Section 1-421-2(d).
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estate or a beneficiary. The basis of the ISO is
tacked on to the strike price paid under the ISO in
order to determine the basis of the ISO stock. For
example, assume that the decedent held ISOs having
a strike price of $10 each and that on the date of
death each ISO had a FMV of $5. If the estate
exercises the ISOs, the resulting ISO stock will have
a basis of $15 per share.
If instead of exercising the ISOs the estate
or beneficiary sells the ISOs, then favorable tax
treatment is lost. The regulations specifically
provide that the ISOs lose their tax-favored
treatment if they are exercised by a successor owner
other than the employee’s estate or beneficiary. 34
This means that the exercise of the inherited ISOs
by anyone else (e.g., a purchaser from the estate or
beneficiary or the donee of the beneficiary 35 )
triggers compensation income. Consistent with
Section 421(b), this income tax consequence should
occur in the year of exercise. The regulations also
provide that the ISOs are to be considered IRD
assets if they are exercised by any successor owner
other than the estate or a beneficiary. 36 The
apparent consequences of this treatment are the
triggering of compensation income on the exercise
of the options and the denial of any step-up in basis
or long-term capital asset treatment for the ISOs.
Unfortunately, the regulations do not
synthesize these rules into a cogent statement about
the tax consequences to the estate or beneficiary, on
the one hand, and the transferee, on the other.
Section 691(a) imposes income tax on IRD items,
but limits its reach to the estate and beneficiaries.
Accordingly, it is unlikely that a purchaser or donee
would be liable for tax on any income triggered by
Section 691. This should mean that the estate or
34 Regs. Section 1.421-2(c)(1). While there is no
authority on the specific issue, it would appear that a
pecuniary beneficiary would fall into this trap. As noted
earlier in the discussion of NQSOs held by the estate, the
funding of a pecuniary bequest with property is the
equivalent of a sale of that property. If ISOs are used to
fund a pecuniary bequest, then arguably the beneficiary
acquires them not in his capacity as such, but through a
deemed purchase.
35 Literally, the limitation on lifetime transfers of ISOs
applies only to the employee, not anyone else. Hence, it
may be that ISOs could be transferred by the estate or a
beneficiary. However, the stock option plan and grant
instrument may restrict any such transfer.
36 Reg. Section 1.421-2(c)(4)(ii).