Intrafamily installment sales of nonqualified stock options.

• Author: Hamill, James R.

Today's employees of dot-com companies are fast becoming tomorrow's millionaires. Every day, Internet companies are going public; their initial public offerings are making their workers wealthy, often via the use of nonqualified stock options (NQSOs).

This article suggests that these noveau riche clients sell their NQSOs on an installment basis to a family-controlled entity, thereby deferring taxes and converting ordinary income to capital gain.

Everyone is talking about the equity markets. Companies want to go public or be acquired at outlandish multiples, the media is consumed with dot-coms and e-commerce is the rage. Initial public offerings (IPOs) and stock options are now a part of everyone's vocabulary. Tremendous wealth has been created, but unlike past generations, it is being shared with employees through stock options.

How much wealth has been generated? Exhibit 1 below lists 10 IPOs with large one-day gains. Employees holding stock options at these companies saw their wealth increase three to seven times in a single day.

Exhibit 1: Recent IPOs Ticker Offer Rank Company symbol IPO date price 1 VA linux Systems LNUX 12/99 $30 2 TheGlobe.Com TGLO 11/98 9 3 Foundry Networks FDRY 9/99 25 4 FreeMarkets FMKT 12/99 48 5 Cobalt Networks COBT 11/99 22 6 MarketWatch.com MKTW 1/99 17 7 Akamai Technologies AKAM 10/99 26 8 CacheFlow CFLO 11/99 24 9 Sycamore Networks SCMR 10/99 38 10 Ask Jeeves ASKJ 7/99 14 Percent Company First-day close change VA linux Systems $250.00 733 TheGlobe.Com 63.50 606 Foundry Networks 156.25 525 FreeMarkets 280.00 483 Cobalt Networks 128.13 482 MarketWatch.com 97.50 474 Akamai Technologies 145.19 458 CacheFlow 126.38 427 Sycamore Networks 184.75 386 Ask Jeeves 64.94 364 Source: Hoover's, as reprinted in Red Herring 248 (March 2000).

This unprecedented growth in the value of the equity markets, and the increasing use of equity-based compensation, means that many employees have significant wealth in unexercised incentive stock options (ISOs) or nonqualified stock options (NQSOs). Under Sec. 422(b)(5), an ISO, by its terms, is not transferable by an employee. To create the proper incentives for equity-based compensation, many NQSOs are also nontransferable. However, in response to employee demands, many employers have amended their NQSO plans to permit transfers to the option holder's family members (inch]ding trusts or partnerships established for their benefit.

The IRS has ruled that a gift of NQSOs is a completed transfer for gift tax purposes and has suggested a safe harbor for transfer tax valuations of such options.(1) When an option is exercised by the transferee, however, the employee is required to recognize the compensation income resulting therefrom.(2)

An alternative to a gift of an NQSO is a sale to a partnership or trust controlled by the employee's family. Such a sale must be permitted by the employer's plan; however, employee demand to sell an option position to family members, rather than to transfer by gift, may induce employers to agree to plan modifications permitting a sale to designated parties similar to those permitted to acquire unexercised options by gift. The dot-coms grant equity-based compensation through their many e-commerce ventures. These companies are particularly well-suited to the option sale strategies suggested in this article, because they anticipate significant appreciation in the value of their stock and are likely to be more flexible in designing or modifying stock option plan terms.

This article analyzes the benefits of a sale of NQSOs to an entity controlled by the option holder's family. If a sale is structured to qualify for installment reporting of the intrinsic gain on the sale date, the employee may be able to achieve both (1) gain deferral and (2) conversion (from compensation income to capital gain) of gains realized by the family-controlled entity (FCE) after the date of sale and through the date of option exercise. This analysis includes the income tax consequences of such a sale, including the availability of installment reporting and valuation issues. Because the installment sale strategy necessarily depends on an employer's willingness to permit such a sale, the effects of such a sale on the employer's tax situation and on the, incentive aspects of the stock option. plan are also discussed.

NQSO Income Timing

Sec. 83 governs the tax treatment of a transfer of property in exchange for the performance of services. Generally under Sec. 83(a), the service provider includes in income the excess of the fair market value (FMV) of the property transferred over the amount (if any) paid for the property.(3) If, however, the property is subject to a substantial risk of forfeiture and is not freely transferable, the taxable event is deferred until the risk of forfeiture lapses or the property becomes freely transferable. A substantial risk of forfeiture generally exists under Sec. 83(c)(1) if an employee must perform substantial future services to retain the property; property is not freely transferable unless it can be transferred free of forfeiture risk. In the unlikely event the employee can locate a buyer who will take the property subject to the forfeiture risk, he is taxed when the property is transferred for value; otherwise, the taxable event is the date of lapse of the forfeiture restriction.

Sec. 83 is the statutory authority for the taxation of NQSOs, even though Sec. 83(e)(3) states that Sec. 83 does not apply to the transfer of an option without a readily ascertainable FMV.(4) The Sec. 83 regulations govern whether an option has a readily ascertainable FMV and is, therefore, subject to Sec. 83 at the date of grant of the right. To understand why an NQSO does not have a readily ascertainable FMV, one must first review the economic aspects of an option.

Option Basics

An option gives a holder a right (but not an obligation) to acquire the property subject to the option right by paying the designated exercise price within the period specified in the option contract. An employee holding an NQSO will not exercise that option and acquire the stock unless the option is "in the money" (i.e., the FMV of the stock exceeds the exercise price). The value of an option to acquire stock has three elements. First, the intrinsic value of an option refers to the excess (if any) of the stock's value over the exercise price. This is the value that would be realized on an immediate exercise of the option right; it increases as the value of the stock subject to the option right increases.

Second, the option has leverage value, because it allows an employee to maintain a long position in employer stock without having to commit capital or pay taxes until option exercise. This value may be thought of as the return that an employee could earn on funds otherwise used to acquire the stock subject to the option right. This leverage value is similar to an interest-free loan; the leverage value decreases as the time to maturity of the option decreases and with the appropriate discount rate.(5)

Third, because an option holder would never exercise an out-of-the-money option, he suffers no economic loss for a decline in the stock's value below the option exercise price. Thus, although stock returns tend to be distributed evenly, with possible positive and negative returns, an option has a "kinked" or "stacked" distribution, in which any probability associated with stock price movements below the exercise price is associated with a zero payoff. Thus, an option offers price protection (i.e., insurance) value for stock price movements...