|
Sunday, May 5, 2024
 |
Case Studies |
An Option for Stock Options
|
Case:
Patricia Weldon is Vice President of operations for a major manufacturing company. She is 55 years old, single and has now been with the company over 25 years. As part of her compensation package, two years ago she was granted an option to purchase 5,000 shares of company stock at a per-share price of $20. The stock is now trading on the New York Stock Exchange at $50 per share.
The type of option granted to Ms. Weldon is categorized as a nonstatutory (i.e., nonqualified) option. This type of option is governed by Internal Revenue Code Sec. 83. Generally, these kinds of options are not taxable to the employee when granted unless they have readily ascertainable values, which means they are actively traded on an established market at the time of the grant. However, compensation will be realized when the option is exercised or otherwise disposed of under Reg. 1.83-7. In Ms. Weldon's case, if she were to exercise the option to purchase the 5,000 shares, she would have to recognize the difference between the exercise price ($20 per share) and the fair market value of the stock ($50 per share) as ordinary income. Therefore, she would be required to recognize income of $150,000.
Because of the performance of the company over the past year and the future projected earnings growth of the company, the stock recently reached an all-time high of $50 per share and, in Ms. Weldon's mind, may be overvalued. Due to this fact, she is concerned about a possible drop in the stock's value and would like to exercise the option in the near future. However, she is also concerned that she will have to recognize additional ordinary income of $150,000 for tax purposes. Since she is in the top income tax bracket, the additional income tax due on the recognition of this income is over $50,000.
Throughout her career with the company, Ms. Weldon has been granted a number of options to purchase stock and has exercised each of those options except the 5,000-share option she currently holds. As a result of exercising previous options, she has accumulated a portfolio of 10,000 shares in company stock, the value of which is now $500,000. She has an overall basis in this stock of $100,000 and has not sold it due to the capital gains tax implications. Because of her concern that the stock may be overvalued and also due to her lack of diversification, she is considering selling a portion of her current holdings.
Ms. Weldon has been an active philanthropist over the years and the primary charity she has benefited is a local retirement center. She currently serves on the board, and in a recent board meeting, the decision was made to embark on a $5.5 million capital campaign to build a much-needed center across town. She was challenged to make a major contribution to the endowment phase of this campaign.
Question:
Is there a way to couple a gift to the capital campaign and minimize the tax bite on exercising the option to purchase the 5,000 shares?
Solution:
In consultation with the Director of Gift Planning at the retirement center, Ms. Weldon decided to use her current holdings, i.e., $500,000 stock portfolio, to fund a 5.5% one-life charitable remainder unitrust. She then would exercise her 5,000-share option. The four primary benefits of the charitable trust are as follows: 1) The capital gains tax on the gain of $400,000 would be bypassed. 2) Since the current dividend on the stock is only 2%, she would increase her income $20,000+ per year. 3) The trust would generate a tax deduction of $155,915. This tax deduction would completely offset the income of $150,000 that she would be required to report upon exercising the 5,000-share option. 4) She is able to fulfill her desire to make a major contribution to the capital campaign.
Caveat: The question often arises, "Why not transfer the option to the charitable trust and let the trust exercise the option?" The answer to this question is that ordinary income will be realized when the option is exercised or otherwise disposed of under Reg. Sec. 1.83-7. Therefore, the transfer of an unexercised nonqualified stock option to a charitable trust will not protect the employee from realization of income.
|
|
|
|
