An increasing number of employees is receiving stock options from their employers. The value of these options, and the estate planning opportunities they present, should not be ignored. Making gifts of stock options continues to be a valuable estate planning tool, despite stricter guidelines imposed by the IRS.

When considering whether to make a gift of a stock option, you first must answer two questions:

1. Is the stock option transferable? Under the Internal Revenue Code (IRC), an incentive stock option is nontransferable and cannot be gifted, but a nonqualified stock option may be transferable. Review the written plan establishing the option arrangement to determine whether you may transfer options to family members.

Today, recent changes to Securities and Exchange Commission regulations allow more options to be transferable. As a result, more companies are beginning to provide for the transferability, and gifting options is becoming a more popular estate planning device.

2. What is the risk involved in gifting options and your tolerance for risk? Gifting options necessarily includes some uncertainty. If the value of the stock increases after you make the gift and before the option is exercised, then the increase in value passes to the recipient (donee). For example, if the value of an option is determined to be 9% of the stock’s value at the time you make the gift, and the stock increases in value to 14% at the time the option is exercised, then the 14% value passes to the donee at a gift tax cost of only 9%. But, if the value of the stock decreases and the option is not exercised, the gift will have been wasted. The gift is still wasted even if the annual exclusion applies or if the applicable exclusion amount is used.

You need to determine whether the risk is worth the potential benefit. Assess the probability that the stock price will increase or decrease and that the option will be exercised. If the gift tax cost is low relative to the face value of the stock, less risk will be involved.

Income and Gift Tax Issues

Income taxes create another uncertainty regarding the gifting of an option because tax results will differ depending on whether the option is exercised during your life or after your death. When the option is exercised during your lifetime, appreciation of the option is removed from your estate. In addition, you can obtain further leverage because you, instead of the new owner of the option, will have to pay the taxes on the appreciation, which will further reduce your taxable estate.

The value of the option needs to be determined for gift tax purposes. An IRS revenue procedure provides a safe harbor guideline for determining an option’s value, but an independent appraisal may provide a more favorable value. Another valuation alternative is to place the option in a family limited partnership and to make gifts based on the discounted value. However, there are many uncertainties involved with this method, so great care should be used.

IRS Obstacles

In 1998 the IRS issued a Revenue Ruling stating that the gift of an option which vests only after an employee completes additional employment is not a completed gift for gift tax purposes. The problem with the IRS position is that if the value of the stock increases before the option vests, then the value of the gift has increased. In light of the IRS’s position in the ruling, gifting only vested options may be prudent, although alternatives are available.

One alternative is to conclude --  with the support of many tax experts -- that the IRS is incorrect in its position and take a contrary position. Another is to gift the option with a guarantee that the gift will be paid if the option does not vest. Or you can convince your employer to choose different restrictions, such as having the option price decrease over a period of years so that employees have an incentive to remain with the company. Similarly, you can encourage your company to choose a method that places a penalty on employees if they exercise their options and then fail to remain with the company for a specified period of time.

Overall Estate Plan