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Thursday, May 2, 2024
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Case Studies |
Spicy Options for Restauranteur, Part 8
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Case:
Roger Garcia is CEO of The Enchilada Factory, a chain of upscale restaurants that serves Mexican food geared toward health conscious patrons. Roger opened his first restaurant 30 years ago. With initial table space for a mere 12 people, Roger never could have imagined that this company would grow to over 150 locations with revenue of $800 million per year. Not surprisingly, magazines and trade journals frequently request interviews with Roger and write about his amazing journey to the top.
However, it has not always been a smooth ride. The restaurant business is very competitive and there have been many difficult times over the years. For instance, about seven years ago, the company was on the verge of bankruptcy. Costs were soaring and customer service was abysmal. In need of new direction and new blood, Roger hired David Guerrero as President of the company. Not only did David have an amazing reputation for turning companies around, he had a restaurant business background. As expected, David pumped new life into The Enchilada Factory. He got costs under control, improved customer service and revamped the menu. In just two years, the company turned around and has never looked back.
This wonderful turnaround didn't come cheap, however. In order to acquire David, Roger gave him a substantial six figure salary and a plethora of incentive stock options (ISOs) - 10,000 ISOs to be exact. Given the current profitability and growth of the company, the stock price has skyrocketed in the past seven years. Accordingly, David's ISOs are worth a fortune.
After a thorough review of the characteristics of ISOs (see Parts 1-6), David asks about non-qualified stock options (NSOs). In particular, his wife Debra owns many NSOs at her company. Therefore, David wonders how they are similar and different from his ISOs.
Question:
Can Debra make a charitable transfer of her NSOs? If so, what are the tax consequences of such a gift?
Solution:
Unlike ISOs, the tax code does not prohibit the transfer of NSOs. With that hurdle cleared, the next step is to review the company plan. This is an instrumental step, because some companies do not allow NSOs to be transferred or assigned. In such a case, an employee will be bound by the company plan rules. However, if the company plan allows for the transfer of NSOs, then an employee may transfer his or her NSOs.
As a general rule, NSOs may not be transferred without the recognition of ordinary income. This rule makes lifetime transfers of NSOs unattractive to most employees. Despite this general rule, Debra will not have any immediate taxable income in the event she transfers NSOs to charity. A transfer by gift is not considered a disposition, because it is not at arm's length. See PLR 9616035 and PLR 9349004. In essence, the taxable event is deferred until the NSOs are exercised by the charity.
While Debra will not realize income when she transfers the NSOs to charity, she will realize income when the charity exercises the NSOs. Specifically, Debra will realize ordinary income equal to the difference between the exercise price and the fair market value of the stock on the date of exercise. Thus, Debra cannot avoid the ordinary income tax recognition related to the NSOs.
Instead of gifting the NSOs, there is a strategy that Debra should consider as an alternative. Many employees, like Debra, hold company stock that they acquired during previous years with the company. The basic strategy is to create a 5% remainder unitrust and transfer the oldest and, thus, most highly appreciated stock into the unitrust. At the same time Debra transfers her oldest stock to the unitrust, she exercises her NSOs. The charitable income tax deduction available for the contribution to the unitrust will partially offset the ordinary income recognized upon exercise of the NSOs. Debra loves this strategy and enthusiastically contacts her attorney to implement the plan.
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