Transfer of nonqualified stock options to charity.

• Author: Dunn, Bill

In Letter Ruling 9737014, the IRS explained two methods of making a non-arm's-length transfer of nonqualified stock options that will not trigger income recognition until the options are subsequently exercised. In both cases, the options were substantially vested and the employee-optionee-donor retained control over the timing of exercise during his lifetime. This resulted in the Service finding that no completed gift had been made.

In the first case, to remain anonymous, a donor transferred stock options to a combined custody and brokerage account held on behalf o the employee by a financial intermediary and subject to the terms of a gift administration agreement. Under the agreement, the intermediary was required to exercise the options on a specified date, which the donor retained the ability to change. On exercise, the intermediary was to sell the shares immediately, and deposit the net proceeds in the account from which a wire transfer would be made to the specified charities. The letter ruling explained that the net proceeds of the sale meant the gross proceeds less the exercise price, withholding taxes and costs relating to the option's exercise and its transfer. (It was assumed that the intermediary paid the exercise price and withholding taxes to the donor's employer directly.)

In the second case, an optionee irrevocably donated options to a charity, but retained the power to veto the charity's proposed exercise of the options during his life and to designate the withholding tax rate and the spread on exercise. The charity had two methods by which it would be able to exercise the options. It could either pay the exercise price and all applicable taxes to the donor's employer and then receive the shares, or it could arrange for a same-day sale with a broker who would deliver the exercise price and taxes to the donor's employer.

In both cases, once the donor died, the charities were free to exercise the options at any time.

The IRS ruled that the donors will not recognize income or gain on the transfer of the options, but will recognize compensatory income when the options are exercised. The amount of this income is equal to the excess of the optioned shares' fair market value on the date of exercise over the option's exercise price.

The Service also ruled that when the exercise occurs during an optionee's lifetime, his recognized income is wages for Federal income tax withholding purposes under Sec. 3401, not the result if the...