Stock Option Strategies

here was a time, and it was not that long ago, when the equities market ruled. Stock values, it seemed, only went in one direction: Up. The economy continued to expand so continuously that it wouldn't even slow down for a "soft landing." Recessions had become so…"passé."

Historians (defined as those with a memory exceeding 18 months) warned everyone that markets also go down. Analysts kept using the term "overvaluation." But in the "irrational exuberance" of the times, no one paid any attention.

Then, in the spring of 2000, the dot.com bubble burst. The market had still not recovered on September 11, 2001. Since that day, a series of shockwaves has pounded the financial markets. Whenever the markets regroup, investors are forced to retreat by major accounting scandals, insider trading scandals, and the biggest bankruptcy in American history.

For those holding employer-provided stock options, the dizzying rise and precipitous fall of the stock market in the recent past, and the wild volatility that has characterized the market even more recently, has illustrated the simple verities of planning: Be prepared for every contingency. Don't be caught with too much of one stock just because you work for that particular company. And don't take future appreciation for granted.

Where does that leave strategic planning for stock options today? Specifically, with regard to estate planning, there are more choices and variables to consider than ever. Let's examine stock options from the ground up and see what conclusions may be reached.

Stock Option Basics

A stock option is the right to purchase stock at a particular price. Companies provide such options to employees as a form of compensation. An option is carefully limited as to the amount of stock that can be purchased, who may exercise the option, and when it may be exercised.

Note: This article does not address "put" options, "call" options, or "equity collar" techniques involving such options. In addition, the discussion is focused primarily on options in publicly traded securities. Many specialized valuation considerations apply to privately issued securities.

Vesting: As with other company benefits, an employee may not have a vested right in a stock option until remaining employed for a required amount of time.

Exercise: In Europe, the exercise of a stock option has usually been limited to a specific and very limited window of time. In the United States, options typically can be exercised during a five to 10 year period of time. If not exercised within that time, the options expire. The option holder loses nothing.

Example: Tina has an option to purchase 500 shares of stock for $22 per share within ten years. At the end of 10 years, the stock is worth $20 per share. Tina allows the option to expire. She had the opportunity to see how the stock would change in value over 10 years, but she is not obligated to purchase stock for more than it is presently worth.

Note that plans may provide alternative payment methods for exercising an option. Employees may be required to pay cash by some companies while others may have cashless alternatives or allow for a swapping of existing company shares for new shares. The terms and conditions are contained in the plan documents of the company or employer which grants the options. A starting point for any planning decision is to examine the plan documents as well as the action granting a specific stock option and determine as follows:

• The number of shares that may be purchased
• The exercise price
• The date the options vest or become exercisable
• How to exercise the options
• To whom options may be transferred
• When the options expire
• How options are affected by the holder's death or disability
• How options are affected by a change in the company

Corporate executives may also be expected to maintain certain levels of stock ownership. Executives who are privy to nonpublic information must also be sensitive to the potential for insider trading charges.

Options For All: Although an increasing number of executives and employees have received stock options in recent years, the democratization of this benefit has been superficial. One study found that a majority of employees receiving stock options simply exercise their options at the first opportunity, i.e., within six months of becoming vested and 90% of those exercising options then sold the stock immediately. This does not represent much of an attempt to take full strategic advantage of the stock options.

Long-term planning is also lacking. Of those who hold onto stock options for any length of time, only a small percentage have estate plans that are designed to deal with stock options effectively. To some extent, a stock option invites every planning technique that applies to any appreciating capital asset. But stock options have specialized considerations to be aware of. Not all options are alike and significant income tax consequences must be weighed.

Types of Stock Option

Any estate-planning strategy involving stock options is going to begin by determining what type of stock option is involved. In 1996, the Securities Exchange Commission modified rules that had discouraged employers from permitting holders to make lifetime transfers of stock options. As a result, there are now two major types of stock options, ISOs and NSOs, each with very different rules on transfers. Note also the distinct income tax consequences that apply to each.

The ISO: Incentive stock options are highly restricted:

• The purchase price must be 100% of the market price at the time of the grant.
• Incentive stock options are not transferable other than at death, i.e., by will, or by descent and distribution in the event of intestacy.
• No income tax is triggered by exercising such options. Tax applies when ISOs are sold.
• Capital gains are triggered by the sale of the ISOs if held for one year from the time the option is exercised, or two years from the time of the grant of the option, or upon death.
• Unexercised options in the estate receive a stepped-up basis. Example: John received a grant of an option to purchase 1,000 shares of Acme stock at $5. At his death, the stock was worth $15. John's estate may exercise the option and purchase the stock for $5,000, yet it will have a stepped up basis of $15,000 in the property.

• The purchase price can be below the market value of the stock at the time of the grant.
• NSOs are transferable during life. Note however that the stock option plan may impose limitations on whom distributions may go to.
• NSOs can be issued to consultants who are not employees and can be made exercisable for periods exceeding 10 years.

	ISO	NSO
TRANSFERABLE DURING LIFE	NO	YES (If Plan Allows)
INCOME TAX WHEN EXERCISED	NO	YES
INCOME TAX WHEN SOLD	YES	NO
STEPPED UP BASIS	YES	n/a
BARGAIN PRICE AT GRANT	NO, 100%	YES

Valuation Issues

No two valuation experts are going to agree on the valuation of any asset and that applies to stock options as well. However, there are some accepted valuation approaches.

Safe Harbor: There is a valuation approach accepted by the IRS which applies to stock options granted by an employer as compensation, i.e., in connection with the performance of services, and which applies to publicly traded securities. This safe harbor follows standards established by the Financial Accounting Standards Board and calls for the use of an option pricing model. One widely used model, Black-Scholes, takes into account (1) the exercise price of the option, (2) the expected life of the option, (3) the current price of the underlying stock, (4) the expected volatility of the underlying stock, (5) the expected dividends on the underlying stock, and (6) the risk-free interest rate for the expected term of the option.

Note, however, the Black-Scholes model is based on the European approach to stock options where the option must be exercised at a specific time. In addition, option pricing models may not always be advantageous to the option holder. In certain instances, it may be worth the effort to claim various discounts in valuation and then defend that approach to the IRS.

Strategic Factors

Naturally, strategic importance is in the eye of the beholder. Investment advisers place more emphasis on seeking higher returns and portfolio balance while estate planners may factor in a number of other considerations:

• what is the overall risk to the estate
• what amount of liquidity is needed
• will the timing of a transfer be useful
• what is the overall tax impact on an estate or on the option holder's family

As a general strategy, holding options for a longer period of time makes sense. Most options expire after five or 10 years. The longer an option is held, the greater the opportunity for appreciation to occur without any capital contribution or risk on the part of the option holder.

Timing issues may also help identify strategic decisions. Thus, where the plan requires an option to be exercised within six months of retirement, an employee who is retiring late in the year and would be exercising the option within six months could then consider the consequences of exercising the option in the current tax year or waiting until after January 1 of the following tax year.

Exercising the option prior to retirement, when the employee is in a higher tax bracket and is already paying the maximum of withholding taxes may be preferable to an exercise after retirement that would trigger additional taxes.

The size and nature of the company must also be considered. In a closely held company, dilution of ownership may be controlled by the company retaining the right to purchase company stock upon the termination of employment. The employee of a closely held company will need some mechanism for selling stock as well.

Tax Ramifications

A major factor to consider is the income tax consequence of exercising or transferring a stock option. ISOs appear to have more complications with tax preference items, the alternative minimum tax (AMT) and income in respect of a decedent (IRD) coming into play.

There are generally no income tax consequences to either the company or the employee at the time that an incentive stock option or a nonqualified stock option is granted. Only if an option has a readily ascertainable value at the time of grant would the bargain element be immediately taxable to the employee as ordinary income. Typically, the stock must be transferable and must be actively traded on an established market to have a readily ascertainable value and in turn produce taxable income. Those conditions are typically met when the option is actually exercised.

When a nonqualified option is exercised, the difference between the purchase price and the fair market value is taxed as ordinary income to the employee. Options exercised at death would result in income reported on the decedent's final return and would not be income in respect of a decedent (IRD).

Example: Lucy exercises 1,000 nonqualified stock options to purchase XYZ stock at $20 per share. The current market price of the stock is $45 per share. Lucy pays $20,000 for stock that is worth $45,000. She is taxed as though she had received $25,000 of ordinary income in this transaction. She will have to pay Federal and state employment withholding taxes. After this transaction, Lucy holds the 1,000 shares of stock with a tax basis of $45 per share. If she sells them at that price, she will not have a capital gain.

By comparison, an incentive stock option will not create taxable income to the employee when it is granted nor when it is exercised. Only when the stock is sold will there be income and at that point it would be treated as a capital gain.

The company granting the nonqualified stock option gets a company deduction for the corresponding amount of compensation received by the employee unless the option is nontransferable and has a substantial risk of forfeiture. In that situation, the employee would be taxed and the company would get a deduction when the option becomes transferable and the risk of forfeiture ends. However, the employee could elect to treat the stock as income in the year it is transferred.

Appreciation of the stock after the option is exercised is treated as a capital gain.

Estate Planning Techniques

Strip away all the specialized rules and the stock option can be seen as an asset with great potential to appreciate in value. That immediately calls numerous techniques into play.

Gifts: The company plan determines what transfers can be made during life. Some companies permit transfers to family members and family controlled entities. If so, use of family limited partnerships, closely held corporations, or trusts can be utilized. The transfer of vested stock options is a completed gift for both gift tax purposes and charitable deduction purposes. If transferred before exercised, the value of the options can be very small for gift tax purposes and future appreciation is removed from the estate.

Sales: When permitted by the company plan, stock options can be transferred for value, i.e., sold, to a family member or family entity. Sales can be structured as installment sales.

Valuation Discounts: As discussed above, a safe harbor approach is desirable for convenience sake in avoiding the time and effort of battling the IRS. That convenience goes right out the window when such an approach causes the estate to forfeit valuable discounts. A transfer of nonqualified stock options can be a very effective estate planning strategy but establishing valuation will be an important consideration.

Charitable Gifts: Highly appreciated assets make excellent gifts to charity because all capital gains tax that would otherwise have resulted would be avoided. In addition, the gift of assets to charity will qualify a donor for an immediate income tax deduction. This deduction is based on the current value of the gift.

Note that a fiduciary should be authorized to exercise any stock options owned by an employee at the time of his or her death and that such exercise may take place even though it increases the nondiversified holding of the estate. In the context of a closely held corporation, a stock redemption arrangement can establish a price for stock, avoid lack of diversification in the estate, and provide the estate with liquidity.

Where Section 303 stock redemption arrangements are contemplated, meeting the requirement that stocks comprise at least 35% of the decedent's estate may require advance planning and the lifetime transfer of other assets.

Putting It All Together

Although there are many options for stock options, there is no simple way to select the best course of action. There are too many variables involved. A stock may appreciate a lot, or a little, or get wiped out entirely. Estate planning goals may well be overshadowed by income tax concerns, particularly as the estate tax is phased out. Context is critical as well. Every family has potential goals and needs that are unique.

TECHNICAL REFERENCES

Gotthardt, "An Integrated Approach to Estate Planning for Employee Stock Options", Journal of Practical Estate Planning, CCH (2002).

Markstein and Pressgrove, "New Developments Create Opportunities Via Gifts of Stock Options, 24 Estate Planning 9, p. 403 (WG&L)(Nov., 1997).

The safe harbor for valuation of stock options is covered in Rev. Proc. 98-34, 1998-1CB 983.

© K.S. 2002