Law Offices of J. Edward Shillingburg
TAX MANAGEMENT MEMORANDUM
ASSIGNMENT OF EXECUTIVE STOCK OPTIONS
AND RELATED DEVELOPMENTS
by J. Edward Shillingburg
New York, NY (1)
The elimination of the non-assignability requirement in Rule 16b-3, effective November 1, 1996, provides the occasion for examining the possible uses and consequences of permitting an executive to assign his or her stock options. Option developments, including the effect of the fair value disclosures for stock options granted after 1995 under Statement of Financial Accounting Standards No. 123 ("FAS 123") and the expiration of the previously approved plan transition rule under Section 162(m) at the 1997 shareholder's meeting will also be discussed.
BACKGROUND AND POLICIES. (2)
A universal feature of stock option plans for many years has been a prohibition on the assignment of options, combined with a provision limiting exercise to the optionee. These have been features of options issued by public companies as well as privately held companies. Usually, you will find a helpful provision permitting exercise by the optionee's heirs or estate after the optionee's death. In some plans, you may also find a provision permitting exercise by a guardian of the optionee. How did this come about?
There are only limited outright statutory prohibitions on assignment.
Section 422 of the Code prohibits the assignment of incentive stock options
("ISOs") and Section 423 prohibits the assignment of options issued under
employee stock purchase plans, except to an optionee's heirs or estate.
There have been elective measures that involved non-assignability. The
regulations controlling the income treatment of non-statutory options ("NSOs")
defer the measurement of income associated with an option grant until its
exercise unless the option has a "readily ascertainable" fair market value,
i.e., it is actively traded on an established market or the taxpayer can
show that its fair market value "can otherwise be measured with reasonable
accuracy" by showing that the option is transferable and meeting other
In addition, Rule 16b-3 under Section 16(b) of the Securities Exchange
Act of 1934 provided that the grant (before 1991, the exercise) of a stock
option having certain characteristics, including non-assignability, would
not be treated as a purchase of the underlying stock for purposes of being
matched with a sale within six months before or after the grant (or exercise)
under the short swing profits forfeiture provisions of Section 16(b). This
measure was only applicable to directors, principal officers and 10% shareholders
of the issuer. (5)
State corporation laws, while providing some regulation of employee
stock options, are silent regarding assignment. (6)
Stock exchange rules, while generally requiring shareholder approval
of stock option plans, do not mandate non-assignability. (7)
There have been securities law problems for options held by non-employees
and for resales of shares acquired under them. Employee and director stock
options and shares acquired thereunder are typically registered under a
Form S-8, which refers to non-assignable options; that Form is limited
to employees, directors, former employees, executors of former employees
and certain independent contractors. (8) Rule 144 alone is not useful.
While the foregoing issues contribute, the principal reason for nonassignability
is that most issuers want to maintain the incentive effect of the options,
which would be lost if an executive could sell his or her options. In addition,
there is a reluctance to add administration to deal with options held by
just anyone, including creditors and former family members of all optionees.
Thus, the question is really how the assignment of options can preserve
the incentive effect while providing additional benefits, or perceived
benefits, to executives, and without substantial additional cost. (10)
AN APPROACH AND ANTICIPATED FINANCIAL EFFECTS
Companies are currently considering permitting limited assignability of NSOs -- limited (a) to assignments without consideration to family members and trusts and similar entities for them, and (b) to executives able to bear the financial consequences of paying the income tax triggered by the permitted transferee's exercise of the option without the executive having access to the sales proceeds. Permitted transferees would not be allowed to transfer the options to others, except in the event of their death. The following schedule compares the expected results of an executive receiving an NSO, assumed to be exercisable at grant, exercising and selling the shares after five years and reinvesting the proceeds with the results of giving the NSO to a child (or a trust or other permitted transferee), with the permitted transferee holding the option, exercising and selling the shares after five years and reinvesting the proceeds. It indicates, that if the stock doubles in price during the five years, the after-tax benefit of the gift strategy will after 15 years be three times what it would have been if the executive had not made the gift.
A MODEL PROVISION
A plan or option agreement provision providing for limited assignment
"Section X Restrictions on Transferability
ESTATE TAX CONSEQUENCES
The financial assumptions require that the NSOs be removed from the executive's federal taxable estate. As a result, the gift of the options to a permitted transferee must be structured so that the executive will not be a beneficiary of a trust or a member of a partnership holding them, the income and principal of the trust cannot be used to discharge the executive's support obligations or other legal or contractual obligations (including the executive's income tax on the exercise of the options), and the executive will not be a trustee or have power to replace the trustee or take other steps to avoid trustee decisions. (17) ("Permitted transferee" in the remainder of this memorandum refers to a family member or trust or partnership limited to such persons.)
GIFT TAX CONSEQUENCES
The assignment of vested NSOs to a family member or family entity will
be regarded as a completed gift if the executive does not retain any control
over the options. The Service has ruled that the fact that an option will
terminate earlier upon the executive's resignation or other termination
of employment is not a power to change the disposition of the option. (18)
Would the date of the transfer be deemed to be deferred for gift tax
purposes if the option did not vest until a future date or was contingent
on the executive not competing with the Company? The IRS has ruled that
the assignment of options that will become exercisable in six months is
a completed gift; (19) it has not addressed non-complete situations. (20)
The executive will incur a gift tax on a completed gift, unless his
unitary gift and estate tax exclusion is insufficient or the annual $10,000
exclusion is applicable and sufficient. (21) The gift tax is a primary
and personal liability of the executive and consequently the executive's
payment of the gift tax is not a further gift to the family member and
the cash used to pay the gift tax will not be part of the executive's taxable
estate on his death. (22)
The Federal gift tax is imposed on the amount of the gift less exclusions. Section 2512(a) provides that in the case of a gift of property, the "value thereof at the date of the gift shall be considered to be the amount of the gift." Section 25.2512-1 of the Regulations provides:
The IRS has not formally ruled on how options should be valued for gift tax purposes. The estate tax practice seems to be to include options at the amount of the excess of the trading price over the exercise price on the valuation date. (23) However, considerable knowledge has gained in recent years in valuing traded options using Black-Scholes and other mathematical formulas. The U.S. Tax Court has been recently asked to apply such formulas to options on non-traded property, including options on non-traded stock. (24) And the Financial Accounting Standards Board has recently concluded that GAAP accounting requires, effective after 1995, that a company's financials must disclose the "fair value" of stock option grants during the year. (25) FAS 123 indicates that "fair value" means:
Thus, if an executive transfers in 1996 an option granted in 1996 with an exercise price equal to the stock's trading price at grant, the company's 1996 financials will show a per share "fair value" for those options and such "fair value" is supposed to take into account, through the expected life of the option assumption, the fact that it is non-transferable and consequently likely to be exercised earlier than the 10 years or other exercise period. (29) However, if the executive promptly after grant gifts the options to a family member, the company's reported fair value per share of the options cannot be carried directly over and used as the gift tax value of those options. The company's expected life of the option, based on a large group of executives, may be different from the expected life for a particular executive. (30) In addition, if the transferred option is not exercisable at transfer, the company's "fair value" amount will not be directly applicable because it does not reflect the fact that the option is not exercisable. (31) Finally, the volatility and other Black-Scholes factors used by the company should be reviewed. (32)
Given FAS 123, it seems likely that Black-Scholes and other formulas,
with appropriate assumptions and adjustments, will become the accepted
methods for valuing executive options for gift tax purposes.
Valuation experts are currently using the Black-Scholes formula and then discounting the results by about 50% on account of the illiquidity of the options and possible lack of diversification of the trust or other family vehicle's investments. A recent Forbes article attributed the following example to Janine Racanelli of J. P. Morgan & Co.:
INCOME TAX CONSEQUENCES
The grant of an option that may be gifted to a permitted transferee will not be a taxable event for the executive because the option is not actively traded on an established market and is therefore presumed to lack a "readily ascertainable fair market value." (34)
The assignment of the typical executive NSO by the executive to a permitted
transferee will not trigger income tax to the executive if it is without
consideration. Section 1.83 7(a) provides that Section 83 will apply to
the receipt of the stock when an option lacking a readily ascertainable
fair market value at grant is exercised. If the option is sold or otherwise
disposed of in an arm's length transaction before exercise, Section 83(a)
applies to the transfer. However, if the option is transferred in a non-arm's
length transaction, the option is not treated as having been disposed of
and Section 83(a) applies when the option is exercised and stock is transferred
to the permitted transferee. (35)
The gift will not trigger income tax to the permitted transferee because
gifts are excluded from taxable income. (36)
Upon exercise by the permitted transferee, the executive (or his estate
if he is not living) has taxable income equal to the excess of the market
value of the shares at the time of exercise over the exercise price. (37)
The permitted transferee incurs no income tax on the exercise. (38)
The permitted transferee will need to provide the exercise price. Since
the permitted transferee may not have sufficient cash or previously acquired
shares, it will need to use the Plan's cash-less exercise provisions, which
assume the ability to sell promptly sufficient shares to pay the exercise
price, (39) or borrow the exercise price. (40) If the executive provides
the exercise price, it will be an additional gift to the permitted transferee
(or the partners or shareholders thereof) (41) that will reduce the executive's
lifetime unitary gift and estate tax exclusion or attract a gift tax.
The permitted transferee will receive the shares with a basis for income
tax purposes equal to the sum of the exercise price plus the income realized
for income tax purposes by the executive (or his estate or beneficiary).
Upon the sale of the shares by the permitted transferee, the permitted
transfer will have taxable long or short-term capital gain (or loss) on
the sale equal to the excess (or deficiency) of the sales price over his
or her tax basis in the shares, assuming that the shares are capital assets
in the hands of the permitted transferee.
The company would have a deduction equal in amount to the income realized
by the executive (or his estate) on the permitted transferee's exercise
of the option. (43)
Assuming that the financial consequences are attractive, what implementation
steps are necessary?
New plans may include provisions authorizing limited transferability
for NSOs. A number of companies have already adopted such plans. A number
of companies may be adopting new plans at their 1997 shareholder meetings
because the transition rule under Section 162(m) for plans approved before
December 10, 1993 expires at the 1997 shareholders meeting at which directors
are first elected. (44) However, the Regulations provided a transition
rule under which any compensation paid under a stock option plan approved
by shareholders before December 20, 1993 is treated as satisfying the director
approval and shareholder approval requirements for the exception if (i)
the directors administering the plan are "disinterested directors" and
(ii) the plan was approved by shareholders in a manner consisted with Rule
16b-3(b) or Rule 16b-3(a) (as in effect on April 1, 1990). (45) The Regulation
also provided that for purposes of satisfying the maximum shares per employee
requirement, a plan would be treated as stating a maximum number of shares
with respect to which an option may be granted to any employee if the plan
that was approved by the shareholders provided for an aggregate limit on
the number of shares that can be optioned under the plan, consistent with
Rule 16b-3(b). (46) Thus, for calendar year public companies, the 1997
shareholders meeting will be the occasion to have the company's existing
stock option plan amended to include the per-optionee limit and to be reapproved
by shareholders, or to adopt a new plan including that limitation, so that
compensation provided under options granted on and after that shareholders'
meeting continue to qualify for the exception. (47)
Shareholder approval of plans is no longer a requirement under Rule
16b-3. First, Rule 16b-3 no longer requires any plan provisions, including
any limit on the number of shares that can be subject to option. Second,
the Rule focuses on awards and it is anticipated that most companies will
use the alternative of committee approval to protect new grants from Section
Shareholder approval will be required in those states having such corporate
Stock exchange rules typically require shareholder approval of option
plans, but they have exceptions.
Finally, one should review the provisions of the old plan and related
proxy statements to see whether commitments were made to shareholders about
amendments or the adoption of new plans.
Amending Current Plans and Outstanding Options
Amendments of current plans and outstanding options to add limited transferability
does not require shareholder approval for Section 162(m) purposes because
transferability or non transferability is not a material term of an option.
Current plans may be amended without shareholder approval for Rule 16b-3
purposes because the Rule no longer has plan provision requirements. In
addition, outstanding options may be amended without the amendment being
treated as a cancellation and new grant. (50) Such amendments typically
do not require shareholder approval for stock exchange purposes or state
corporation law purposes. However, one should review the current plan and
related proxy provisions to determine whether any commitments were made
to shareholders regarding the amendment of the plan and of outstanding
Amendments should also conform the plan to the final Rule 16b-3 and
Section 162(m) requirements.
The composition of the plan administrative committee should be reviewed
against the requirements for "non-employee directors" for Rule 16b-3 purposes,
which do not fit in all respects with the requirements for "outside directors"
under Section 162(m). Some changes may need to be made before options are
next granted. (51)
There are several issues here:
Procedures should be adopted to secure payments for withholding taxes
in situations where the executive may be retired (or deceased) and the
option is held by a permitted transferee. While withholding tax is no longer
a condition to the company's being entitled to a deduction for the spread
at exercise, (53) the company will not want to be responsible for the withholding
tax itself. The plan and option agreements should make it clear that the
company will withhold from the shares subject to the option if payment
of the withholding tax is not provided. This may create a loan by the permitted
transferee to the executive or a gift, but the company should protect itself
from an impecunious executive and an uncooperative permitted transferee.
Handling withholding taxes in the case of exercise following the death
of the executive may be different because of the handling of death benefit
Limited assignment of executive stock options can preserve their intended
compensative incentive without additional cost to the company other than
administrative costs (SEC registration, etc.), while it can enable the
executive to transfer a substantially greater portion of any option appreciation
to his or her family. A number of the issues involved in such a gift appear
to be settled. Issues that still need resolution include:
(a) Valuation of options.
(b) When transfers of nonvested options are deemed to be completed gifts.
(c) Procedures permitting the permitted transferee to exercise and immediately
sell sufficient shares to cover the exercise price or to finance the purchase
price over a Rule 144 holding period.
(d) Income tax treatment of the executive's estate if the executive dies before the permitted transferee exercises the option.
1. Formerly head of the executive compensation and employee benefit practice group, Lord Day & Lord, Barrett Smith, New York, and of counsel, Morgan, Lewis & Bockius, New York. The views expressed in this memorandum are solely those of the author. For questions or comments call (973) 643-7282 or e-mail email@example.com.
2. Portions of this topic have been discussed in Mc Kinney, "The Use of Transferable Employee Stock Options for High-Level Executives," 61 Tax Notes 857 (Nov.15, 1993); Bachelder, "Developments Affecting Stock Options," N.Y. Law Journal (Aug.31, 1994), p.3; and Bachelder, "Treatment of Stock Options," N.Y. Law Journal (May 31, 1996), p.3, and in materials by Thomas C. McGraw, Morgan Guaranty Trust Co., and Thomas I. Ross, Jr., Coopers & Lybrand LLP. In addition, Jesse Brill has frequently reported on developments relating to assignable stock options in his newsletters, The Corporate Counsel and The Corporate Executive. A preliminary version of this memorandum was presented to the Tax Club of New York on September 18, 1996.
3. Such prohibitions applied to the earlier statutory options, restricted stock options and qualified stock options, under then Sections 422 and 424 of the Code.
4. Treas. Reg. _ 1.83-7. Other factors are that the option is exercisable in full immediately by the transferor, the option or underlying property is not subject to restrictions having a significant effect on the option's value and the value of the option can be measured with "reasonable accuracy." These factors were originally contained in Section 1.421-7 of the Regulations adopted in 1959, and incorporate the treatment announced in Commissioner v. Smith, 324 U.S. 177 (1945), and Commissioner v. LoBue, 351 U.S. 243 (1956). Practioners have typically relied on non- assignment to conclude that an option was not taxable at grant, but it is only one of four factors, the presence of any one of which defers the tax.
5. Proposals to revise Rule 16b-3 were issued in 1988. In 1991 revisions were issued (retaining non-assignability) which an issuer could elect to make effective or to conform to by the deferred effective date. The effective date was extended several times. Modified revisions were proposed in 1994 (retaining non-assignability) and in 1995 (eliminating non-assignability). A final revision was issued that eliminated non-assignability, effective November 1, 1996. SEC Release 34- 37260, 61 Fed. Reg. 30376 (June 14, 1996).
6. E.g., New York Business Corporation Law, _505(e); Delaware General Corporation Law _157.
7. New York Stock Exchange Listed Company Manual, __309.00, 312.03; American Stock Exchange Company Guide, _711; NASD Manual, _4460(i)(1)(A).
8. Form S-8, General Instructions A(1)(a). The SEC staff has been reluctant to conclude that stock options transferred to an executive's former spouse in connection with their divorce benefit from a Form S-8 registration. E.g., Crown Resources Corporation (avail. Sept.11, 1991). The reluctance has been put on the fact that the Form S-8 assumes that directors and employees are familiar with the financial situation of the issuer, while others who are more distant cannot be assumed to have such familiarity. Currently, the SEC is considering changes in the S-8, including an extension to family members and family entities.
9. Rule 144, 17 CFR Sec. 230.144, imposes a two year holding period after full payment for the shares (current proposals would reduce the period to one year) if there is no registration in the chain of ownership. In addition, Rule 144 imposes a volume limit on the amount of shares that can be sold, relative to the current active trading volume in the stock.
10. References in this paper to executives and executive stock options are intended to include both option plans for officers and key employees of companies with publicly-traded stock as well as option plans for outside directors. While assignment could be a feature of stock option plans of non-publicly held companies, the valuation issues are greater and __2701-2704 of the Code may have greater effect.
11.This provision was sanctioned by original Rule 16b-3, is included in Section 422 (incentive stock options) and Section 423 (employee stock purchase plans) and is universally used.
12. An exception for qualified domestic relations orders was added to Rule 16b-3 in 1991, (Rule 16b-3(f)(2)); in the 1996 revision it was modified to refer to a "domestic relations order" and moved to Rule 1 6b- 12. It would be of assistance to an executive with few assets other than his or her options who is undergoing a divorce. As pointed out above, there continue to be securities law problems associated with the spouse's sale of shares acquired under such an option.
13. Consideration should be given to limiting assignability to executives who will have sufficient assets to meet their income tax obligation on the transferee's exercise of the option.
14. To the extent that the executive retains an interest in the option through a trust or partnership interest at his or her death, that interest will be included in the executive's estate for federal estate tax purposes.
15. Some companies have included charitable organizations as permitted transferees. However, there will be little income tax benefit associated with the gift of the option (because of its modest value), and the executive will retain the obligation to pay the income tax on the spread when the organization exercises the option and will have no offsetting charitable income tax deduction at that time. The better alternative would be for the executive to retain the option, exercise it when it has become valuable and then contribute the shares, net of the exercise price, to a public charity or, under Section 1 70(e)(5), to a private foundation so that the executive receives an income tax charitable deduction based on the value of the shares (subject to the percentage limitations).
16. Arrangements for withholding taxes are important, as discussed below.
17. See Code __2033, 2035, 2036, 2037 and 2038; Ltr. 9350016 (Sept.16, 1993): Ltr. 9514017 (January 9, 1995); Ltr. 9616035 (January 23, 1996). These steps will also be helpful in disconnecting the executive from the options for purposes of applying Section 16 thereafter to the executive and the child or other permitted transferee. Rule 1 6a-8.
18. Ltr. 9514017 (January 9, 1995) (also noted that the executive had
given up the power to agree
to amendments of the option agreement); Ltr. 9616035 (Jan.23, 1996). The Service relied on Rev. Rul. 80-186, 1980-2 C.B. 280 (gift of binding option on real estate); Rev. Rul. 72-307, 1972-1 C.B. 307 (life insurance policy irrevocably assigned to another is not includible in insured's gross estate when policy is cancelable upon insured's termination of employment); Estate of Smead, 78 T.C. 43 (1982), Acq., 1984-1 C.B. 2 (life insurance irrevocably assigned to another with retained right to convert to an individual policy on termination of employment not included in insured's gross estate) Rev. Rul. 84-130, 1984-2 C.B. 194 (acq. in Smead).
19. Ltr. 9350016 (Sept.16, 1993). The IRS noted in the letter rulings referred to in footnote 18 that the fact that the executive's termination of employment could have an adverse effect on the option exercise period was not a reserved power over the option that made the gift incomplete. There has been speculation that until the option has vested, the gift is incomplete. Treas. Reg. _25.251 1-2(b)(gift is incomplete if donor reserves a power over it). However, the IRS has rejected this approach in the rulings referred to in footnote 18. In addition, while it has been speculated that the IRS might take the position that a nonvested option cannot be valued until it vests on an "open transaction" approach, that approach has been flatly rejected by the Tax Court. Compare: Rev. Rul. 69-347, 1969-2 C.B. 227 (gift of non-insured employer-provided survivor benefit payable on employee's death while employed is a completed gift, and will be valued, at employee's death); with Estate of DiMarco, 87 T.C. 653 (1986), acq. in result, 1990-2 C.B. 1 (gift of similar survivor benefit), where the Tax Court, relying on Smith v. Shau~hnessv, 318 U.S. 176, 180 (1943)("the language of the gift tax statute, 'property. . . real or personal, tangible or intangible,' is broad enough to include property, however conceptual or contingent...") to reject an "open transaction" approach and conclude that the gift had been made when employment commenced. In AOD 1990-026 (Sept.24, 1990), the IRS Chief Counsel announced an acquiescence in the result of DiMarco but maintained that the transfer was incomplete because the spouse's benefit would have been lost if the employee had terminated his employment or divorced his wife, relying on Levin v. Commissioner, 90 T.C. 723 (1989), aff'd without opinion, 891 F2d 281(3rd Cir. 1989)(employee was 80% shareholder of company that adopted survivor benefit plan one month prior to his death; held, benefit was includible in his gross estate for estate tax purposes because of his control over the company and the plan, and dictum that no gift tax was due because gift was incomplete prior to death).
20. In the non-complete situation, the option is usually exercisable provided that the executive at the time of exercise is not competing with the company. The non-complete provision is a forfeiture provision which would not defer the completeness of the gift (see rulings in fns. 18 and 19) but which would affect valuation of the option. Even if the shares were also subject to the non- complete restriction, such restrictions ordinarily would not defer income tax on the exercise unless special circumstances are present. Treas. Reg. _1.83-3(c)(3).
21. Code __ 2501, 2511; Treas. Regs. _ 25.2511-2.
22. Treas. Regs. _25.2502-2.
23. In Rev. Rul 196, 1953-2 C.B. 178, the stock option plan provided an executive's estate could request that the company purchase any unexercise options belonging to the executive at his death within a certain period following his death and in that event the company would pay the estate an amount not greater than the amount by which the trading price of the underlying shares on the day preceding the purchase exceeded the option price. The Service ruled, without discussion that the value for estate tax purposes of the options was the excess of the value of the shares under option the measuring date for estate tax purposes over the exercise price. On its facts this conclusion was probably correct, but a broader reading has sometimes been given to the Ruling that the estate tax valuation of executive stock options generally should be equal to the spread at the measurement date.
Special valuation rules apply where a taxpayer transfers an equity or trust interest to a family member and retains an interesL Code __ 2701-2704. These rules were held not to be applicable to particular executive stock options in Ltr. 9350016 (Sept.16, 1993) and Ltr. 9616035 (January 23, 1996). See also Ltr. 9222043 (Feb.28, 1992) (gift of stock options to nephews and nieces; held, they were family members for Section 2703 purposes).
24. See Berry Petroleum Co. v. Commissioner, 104 T.C. 584, 613-614 (1995) (value of option to acquire gas leases); Cramer v. Commissioner, 101 T.C. 225 (1993), aff'd. 64 F3d 1406 (9th Cir. 1995) (executives' efforts, using Black-Scholes, to demonstrate that non-transferable, non- exercisable options on privately held stock had a readily ascertainable fair market value, and were taxable, at grant was rejected).
25. FAS 123, par. 12. A company has an election whether to use fair value for accounting purposes or to continue to use the intrinsic value method of APB 25. However, it must use the fair value method for pro forma disclosure purposes.
26. FAS 123, par. 395.
27. FAS 123, par. 17.
28. FAS 123, par. 19.
29. FAS, pars. 169-170.
30. FAS 123, pars. 279-283.
31. FAS 123, pars. 17. For accounting purposes, after the fair value of the options granted has been determined, the next step in determining the company's accrued compensation cost attributable to the grant is to estimate the number of options that will vest. FAS 123, pars, 28-29, 293. In the Cramer case (fn. 24, above), one of the executive's experts concluded that non-vested options could be valued with a probability analysis to estimate the likelihood of the executive's continuing in employment to the vesting date.
32. The expected volatility and dividend factors involve a review of prior stock prices and dividends and judgments about what may be expected during the anticipated term of the option. FAS 123, pars, 284-287.
33. Carolyn T. Greer, "Stock options: how to mitigate the tax pain," Forbes, September 25, 1995, p.208.
34. The options lack transferability, may not be immediately exercisable in full, and may not have an ascertainable value. The IRS has been reluctant to treat executive stock options as taxable at grant because of the perceived revenue loss. If taxable at grant, only the modest value of the option will be treated as compensation income and any subsequent appreciation realized from the subsequent sale of the shares obtained an exercise of the option will be taxable at favorable capital gains rates. Treas. Reg. _1.83-1(a). If not taxed at grant, all appreciation over the exercise price will be taxed as compensation income. Treas. Reg. _1.83-7(a). See, e.g., Cramer v. Commissioner, fn. 24, above.
35.Treas. Regs. __.83-7(a), 1.83-6(c) (gift of restricted stock); Ltr.
9349004 (June 8, 1993); Ltr.
9616035 (January 23, 1996).
37.See Treas. Regs. __1.83-1(c); 1.83-1(d) Ltr. 9349004 (June 8, 1993); Ltr. 9616035 (January 23, 1996). While the private rulings state that the taxable income will be realized by the executive's estate if he has died before the permitted transferee has exercised, _1.83-1(d) describes restricted stock vesting on or after the executive's death as taxable "to his estate or beneficiary" under the rules of Section 691. Pending ruling applications seek to clarify whether the income could be taxed to the permitted transferee.
38. See Treas. Regs. _1.83-1(c); Ltr. 9349004 (June 8, 1993); Ltr. 9616035 (January 23, 1996).
39. Some companies are filing Forms S-3 with respect to the exercise of NSOs by permitted transferees and using Rule 144 (without the holding period but with the volume limits) for resales by permitted transferees. E.g., Merrill Lynch & Co., Inc. Form S-3, filed April 4, 1996; Merrill Lynch (available May 16, 1996). Form S-3 is available to register (a) securities to be offered for cash by the issuer, provided that the aggregate market value of the voting stock held by non affiliates is $75 million or more, and (b) outstanding securities to be offered for the account of any person other than the issuer if securities of the same class are listed on a national securities exchange or quoted on the automated quotation system of a national securities association. Form S-3, General Instructions B(l), (3).
40. The normal margin requirement for loans associated with securities
is 50% of the current market value; a permitted transferee subject to the
Rule 144 holding period might face a margin call during that period. This
limit is waived for a "cash-less" exercise by a broker "to temporarily
finance a customer's receipt of securities pursuant to an employee benefit plan registered on SEC Form S-8," but a cash-less exercise requires the ability to immediately sell the shares. Federal Reserve Board Regulation T, _220.3(e)(4), 220.4, 220.18 (12 CFR __220.3, 220.4, 220.18). A loan by the executive would be tested under _7872.
41. For gift tax purposes, a gift to a corporation is ordinarily treated as a gift to its shareholders. Treas. Regs. _25.2511-1(h); Rev. Rul. 71-443, 1971-2 CB 337 (gift to a corporation is ordinarily a gift of a future interest to its shareholders that does not qualify for the $10,000 annual exclusion).
42. See Treas. Regs. _ 1.83-4(b) (nonvested restricted stock); Ltr. 9349004 (June 8, 1993); Ltr. 9616035 (January 23, 1996).
43. Ltr. 9349004 (June 8, 1993); Treas. Reg. _1.83-6(a).
44. To qualify for the performance-based compensation exception in Section 162(m), which is generally applicable to compensation otherwise deductible in a taxable year beginning after 1993, it is necessary that the shareholders approve the material terms of the stock option plan. Material terms for stock option plans include the employees eligible to participate and the maximum number of shares that may be optioned to a single employee during a specified period. It is also necessary that option grants be made by "outside directors" and that the exercise price be at least equal to the fair market value of the underlying shares on the grant date. Treas. Regs. _1-162-27(e)(2), (3), (4).
45. Treas. Regs. _1.162-27(h)(3); Rule 16b-3(a) (as in effect on April 1, 1990) or Rule 16b-3(b) (as amended effective May 1, 1991). These provisions were substantially identical.
46. Rule 16b-3(b)(l)(iil)(A) (as in effect on April 1, 1990) referred to a plan that specified the "maximum number of shares of stock which... may be subject to stock options granted to [officers and directors] pursuant to the plan. .
47.The transition rules may have expired before the 1997 shareholders meeting because of a material modification of the plan or the issuance of all stock allocated to the Plan. Section 1.162- 27(h)(3)(iii) and the following Example indicate that the transition rule applies to compensation received under an option granted under a plan approved for Rule 16b-3 purposes as long as the grant occurred before the transition rule expired, regardless of when the option is exercised.
48. In its Release adopting the new Rule 16b-3, the SEC eliminated any shareholder approval of stock option plans and, indeed, qualification for the Rule's exception will hereafter be based on awards, not plans. An issuer may now qualify its grants for protection under Rule 16b-3 by having their terms approved by at least two "disinterested directors" or by shareholder vote or the optionee may qualify his or her option grant for protection by not disposing of the option or underlying shares for at least six months following the option grant. Rule 16b-3(d).
49. Ltr. 9551024 (Sept.22, 1995).
50. Release No.34-37260, fn. 169, 61 Fed. Reg. 30376, 30390 (June 14, 1996).
51. "Outside directors" are described in Treas. Regs. _ 1.162-27
(e)(3), while "non-employee" directors are described in Rule 16b-3(b)(3)
and in Item 404 of Regulation S-K. These two provisions do not track each
other fully. For example, a former officer cannot be an "outside director,"
but can be a "non-employee director," while a partner in a law firm providing
legal services to the company can, if certain tests are met, be an "outside
director" but is barred from
being a "non-employee director."
52.Both the acquisition and disposition of a stock option by a bonafide gift are exempted from Section 16(b) by Rule 16b-5 (17 CFR _240. 16b-5). However, a gift of an option within six months of grant which is relying on the six-month holding rule in new Rule 16b-3(d)(3) to exempt the grant or which must satisfy the six-month holding requirement in 1991 Rule 16b-3(c)( 1) will probably strip the option of its Section 16(b) protection.
53.See Treas. Reg. _l.83-6(a)(2) (1995).
54.In the case of an executive's salary that is earned but unpaid at his or her death and that is paid to the executive's estate or beneficiary, the company is not required to any withhold income taxes on such salary, and is required to withhold FICA taxes on such salary only if the amounts are paid to the estate or beneficiary before the end of the calender year of the executive's death. Code Sec. 3121(a)(14)(FICA); Rev. Rul. 86-109, 1986-2 CB 196 (income and FICA). Income occasioned by the permitted transferee's exercise of the option would seem to be even less likely to be treated as "wages" for income and FICA tax purposes.
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