How to value gifts of employee stock options.

• Author: Franz, Diana R.

For employees fortunate enough to possess stock options, the IRS has cracked down on the transfer tax benefits of gifts of such options. Rev. Rul. 98-21 provides that a completed gift exists when the options vest, even if not exercisable; Rev. Proc. 98-34 explains how to value the gift. This article uses detailed examples to analyze both pronouncements.

The Service has launched a two-pronged attack on a popular transfer tax planning technique--gifts of employee stock options (ESOs). A tax benefit exists because most ESOs granted by publicly traded companies have been valued for gift tax purposes at relatively small amounts (frequently, zero). Two recent IRS pronouncements, Rev. Rul. 98-21(1) and Rev. Proc. 98-34,(2) are designed to curtail this advantage. This article describes the tax planning technique involving gifts of ESOs and discusses the implications of the IRS pronouncements.

Gifts of ESOs

An opportunity to generate significant transfer tax savings was created in 1996 by a change in the securities laws that allowed recipients of ESOs to transfer them to family members or to trusts for their benefit. This ability created the need to value ESOs for gift tax purposes. However, very little IRS guidance existed; the only pronouncement was a 45-year-old ruling(3) holding that the value of a stock option for estate tax purposes was the difference between the fair market value (FMV) of the employer's stock and the option's exercise price. This difference is known as the option's "intrinsic value."(4) Intrinsic value considers the value of an option only if it is exercised immediately; it disregards the portion of the option's value attributable to the potential future appreciation of the underlying stock.

Example 1: T, an executive of publicly traded Z Corp., was granted 500,000 ESOs on June 1, 1997. The options grant T the right to purchase 500,000 shares of Z for $10 per share at any time from June 1, 1998 until June 1, 2007. The options are not generally transferable, but may be transferred to an immediate family member or to a trust for his benefit. The option contract further provides that, if T's employment with g terminates within the first year after the options are granted for any reason other than death or disability, the options will be forfeited. At the date the options were granted, the FMV of Z's stock was $10 per share. One year later, T's rights to the options became fully vested; on that date, Z shares were worth $12 each.

If T remains with Z and holds his options until their June 1, 2007 expiration date, when Z stock has risen to $40 per share, the options would be worth $15,000,000 (($40 - $10) X 500,000); T would certainly exercise them. If T is in the 39.6% Federal income tax bracket at that time, he will pay $5,940,000 in Federal income tax; his wealth will increase by a net amount of $9,060,000.

However, if T transferred his options to his daughter, G, on the grant date, the intrinsic value of the options would have been zero, because the stock's FMV would have equaled the ESO's exercise price. Based on then-existing IRS guidance, the intrinsic value would have been the value used for gift tax purposes; thus, no gift tax would have been due. If the options are exercised in 2007, G will pay the $5,000,000 ($10 x 500,000) exercise price and receive $20,000,000 of stock ($40 x 500,000). The $15,000,000 of income from the exercise of tile options would still be included in T's gross income,(5) so he would still be liable for the $5,940,000 income tax. However, as a result of the 1997 gift, $15,000,000 of wealth will have been transferred from T to G tax-free.

The IRS's Response

Due to the clear advantages, many taxpayers have used gifts of ESOs as a leveraged wealth transfer technique. In response, the IRS has issued two pronouncements that will reduce taxpayers' ability to use ESOs to make wealth transfers without incurring transfer tax. The Service's two-pronged approach attacks when the gift of ESOs is deemed to have occurred and how the value is computed.

When a Gift of ESOs Is Completed

Rev. Rul. 98-21 deals exclusively with gifts of ESOs and clarifies when such gifts are deemed completed if the options are conditioned on the performance of services by the donor-employee. The ruling states that, before the employee performs the services, the options do not comprise a set of enforceable rights that can be transferred as a gift for Federal gift tax purposes; a gift occurs only after the services have been performed and the option contract has become binding. Therefore, according to Rev. Rul. 98-21, the gift is completed on the later of the date (1) of the transfer or (2) that all of the services have been performed.

In Example 1, above, the options granted on June 1, 1997 were conditioned on T's continued employment with Z until June 1, 1998. Rev. Rul. 98-21 would have applied to this transfer; thus, the gift of the options to G would not be deemed completed on June 1, 1997. Instead, the valuation date used for gift tax purposes is June 1, 1998, the date when the options became fully vested; at that date, Z stock had risen from $10 to $12 per share. Thus, the intrinsic value of the options was $2 per share ($1 million for 500,000 options). The one-year delay in the valuation date caused T's transfer to G to become a $1 million taxable gift.

The Rev. Proc. 98-34 Safe Harbor

Rev. Proc. 98-34 outlines a safe-harbor method for valuing ESOs for gift, estate or generation-skipping transfer tax purposes. The procedure applies only to nonpublicly traded options on publicly traded stock. The valuation method suggested in Rev. Proc. 98-34 is based on the Black-Scholes option pricing model,(6) which takes into account both an option's intrinsic value and the value derived from the potential appreciation of the underlying stock. By endorsing the Black-Scholes model as a safe-harbor valuation method, the IRS appears to be distancing itself from its prior acceptance of...