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

Summary of Option Strategies
10. Conversion to
nonqualified deferred
compensation
(NQDC) plan
Holder exercises options using
stock to pay exercise price but
declines to accept stock;
company agrees to establish
NQDC plan (or account under
existing plan) to be “funded” with
credits equal to holder’s option
value in the form of company
stock; payout equal to company
stock plus reinvested dividends
(if any), and payable over period
elected by holder; payout can be
“secured” by contributions of
stock to “rabbi” trust, but assets
of rabbi trust subject to rights of
company creditors in event of
company insolvency
Solves option expiration
problem; instead of being forced
to exercise by expiration date and
lose almost 50% of option value
to taxes, conversion allows holder
to keep entire option value
working for him and perhaps his
heirs
If election made far enough in
advance of option expiration
(usually 6 months or more) , no
tax on conversion; ordinary tax
levied on payments from plan to
holder or heirs, as and when
received; no step-up in basis at
death, meaning that estate or
heirs pay ordinary taxes on full
amount of post-death
distributions (in addition to estate
tax on value of NQDC account at
death)
No gift tax issues; no wealth
transfer benefits; estate taxes
imposed on value of NQDC
account at death
Credits are generally limited to
company stock in order to
preserve GAAP fixed accounting
for plan (diversification in NQDC
account would likely convert plan
to GAAP variable, thus causing
reporting headaches for
company); double-tax problem at
death can be eliminated by
naming charity as successor
beneficiary, assuming holder is
other charitably inclined
11. Gift to charity Holder transfers options
remaining at death to charity
12. Option exchange
fund
J.P. Morgan proprietary product
due for release soon; contribution
of options to LLC simultaneously
with similar contributions of
options on stock of other public
companies by other executives;
LLC holds options and exercises
them at expiration; termination of
LLC after 7 years with
distribution diversified portfolio
of options and stock pro rata to
participants; estate freeze
Where holder is charitably
inclined, use of options to fund
charitable endeavors is more
beneficial than using other assets
– contribution to charity removes
not only estate tax but also
ordinary tax that would be
imposed on full amount of
distributions paid to estate or
heirs; non-charitable heirs get
more after tax (from lesser-taxed
assets that would have gone to
charity), while charity realizes
same amount
Allows diversification out of
concentration option position;
removes ordinary income taint
from options at discounted value
Estate and heirs suffer no income
tax liability upon transfer or
exercise of options
Contribution to LLC triggers
immediate ordinary tax to each
participant on value of LLC
interest received (heavily
discounted); company deducts
amount equal to seller’s income
at contribution; exercise of
options by LLC is tax-free; no tax
on liquidation of LLC; at sale of
stock, capital gains tax on excess
of stock value over initial value
of LLC interest
Bequest to charity is exempt from
estate taxes
Estate freeze feature can shift
growth to heirs or trust for heirs;
if elected, initial interest is
bifurcated into common and
preferred interests; common
interest gifted; if performance
exceeds preference return, excess
return passes to common holders
tax-free; low gift tax exposure on
gift of common interest due to
discounts and subordination to
preferred interest
Option plan must permit transfer
to charity; control over option
exercise and resulting stock shifts
to charity; strategy cannot be
implemented during life, because
exercise of options after
contribution triggers ordinary tax
imposed on donor and no income
tax deduction is allowed for
option contribution
Option plan must permit transfer
to LLC for consideration; control
over option exercise and resulting
stock shifts to LLC; holder’s
options could outperform rest of
portfolio; limited liquidity for 7-
year term of LLC; holder must
raise cash to pay initial ordinary
tax on contribution
CONFIDENTIAL
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