Gifting compensatory stock options.

• Author: Harrison, Robert E.

Taxpayers fortunate enough to have been granted compensatory stock options have a unique opportunity to use these options to transfer the anticipated appreciation to future generations at little or no gift/estate tax cost. Unfortunately, a recent IRS ruling casts a cloud over the ability of taxpayers whose compensatory options are not yet exercisable (i.e., not vested) to make a gift of their options at a minimal transfer tax cost.

Income Tax Consequences

The income tax consequences of nonqualified options that do not have a readily ascertainable fair market value (FMV) at the time of grant are generally set forth in Regs. Sec. 1.421-7. Unless the specific nonqualified option is actively traded on an established market, it will almost always be considered as not having a readily ascertainable FMV for income tax purposes. The grant of such a nonqualified option does not cause income recognition. If the option is exercised by the grantee or otherwise disposed of in an arm's-length transaction, the grantee will have ordinary compensation income in the following amount:

1. If the option is exercised, the excess of the FMV of the stock received over the exercise price; or

2. If the option is transferred in an arm's-length transaction, the amount or FMV of the consideration received.

   In the case of exercise, the grantee's holding period for the stock received begins on the date of exercise; the stock's basis is its FMV at that date.

   If the option is transferred in a transaction not regarded as arm's-length, no income is recognized until the transferee either exercises the option or disposes of it in an arm's-length transaction. At that point, the transferor (the service provider) is deemed to recognize taxable income. If the transferee exercises the option, the transferor's taxable income would be the excess of the FMV of the stock received over the exercise price. The transferee does not incur an income tax liability as a result of exercise, even though the transferee's basis in the stock would be its FMV at the time of exercise. The transferee's holding period for the stock commences on the option's exercise date. Similarly, if the transferee disposes of the option in an arm's-length transaction, the transferor (service provider) would recognize taxable income equal to the amount or FMV of the consideration received by the transferee.

   Gift Tax Consequences

   The gift of nonqualified, compensatory stock options to children and grandchildren, either...