|
Thursday, May 2, 2024
 |
Case Studies |
Testamentary Stock Options
|
Case:
Randall Jacobson, age 60, is recently retired. He is married, his spouse Avery is age 50 and they have no children. For the last 25 years, Randall had been employed by a successful engineering firm on the East Coast. During his tenure with the company, he was granted a number of nonstatutory (many times referred to as "nonqualified") stock options as part of his compensation package. He now holds options to purchase 10,000 shares of the company stock at the price of $20 per share. The underlying company stock is currently trading at $100 per share. Because of the nature of nonstatutory options, Randall would have to recognize compensation income on the difference between the fair market value of the stock at the time of exercise and the exercise price when the options are exercised. Therefore, should he choose to exercise the options, he would have to recognize $800,000 of ordinary income representing the difference between the fair market value of the stock of $1,000,000 and the exercise price of $200,000.
Randall and Avery have been involved with a number of local charities over the years and would like to consider making a substantial gift to those charities. They recently attended a financial and estate planning seminar sponsored by one of the charities they support and were impressed with the discussion on charitable remainder trusts. As a result, they decided to arrange a meeting with the Director of Major Gifts, Kathryn Miller of that particular charity to talk about how a charitable trust could be utilized in making their desired gift. During that meeting, Randall asked the question as to whether or not the options on his company stock could be transferred to a charitable trust. By doing so, Randall thought he could avoid recognition of the $800,000 of compensation income because the charitable trust, which is tax-exempt, would in turn exercise the options and the income would be allocable to the trust. Ms. Miller stated that this was an excellent question, but that the recognition of the income by Randall could not be avoided. She stated that according to Reg. Sec. 1.83-7, Randall would recognize income when the options are exercised or "otherwise disposed of." By transferring the options into the charitable trust with subsequent exercise of the options by the trust, Randall would still be required to report the $800,000 of ordinary income.
Question:
Randall and Avery wonder if there is any tax-wise method to use the options to fund a charitable trust for the benefit of their favorite charities. They are very interested in any strategies that would not require recognition of ordinary income by Randall upon exercising of the nonstatutory options.
Solution:
The Director of Major Gifts, Ms. Miller, stated that there is one strategy that could work very well in Randall's situation. If Randall were to transfer the options to a charitable remainder trust upon his death, the trust could then exercise the options and the income would be "trapped" inside the charitable trust. They learn that this is very similar to transferring a pension plan or IRA account to a charitable trust upon death. Because of the tax-exempt nature of the trust, the trust would not pay tax on the ordinary income recognized upon the exercising of the options. The charitable trust would be payable to Avery for life and then the assets of the trust would be transferred to their favorite charities.
There is only one complication to this strategy in that the charitable trust must have cash of $200,000 to exercise the options. Ms. Miller stated that there are a couple of ways to handle this complication. First, Randall and Avery could fund a two-life inter vivos charitable trust now and transfer at least $200,000 of property into the trust. Then, when Randall passes away, the trust assets could be converted to cash, which in turn would be used to exercise the options. Secondly, Randall and Avery could draft a testamentary trust into their estate plan which would receive the options. An additional $200,000 in cash or property would also be used to fund the testamentary trust which would be used to exercise the options.
Since Randall and Avery have a portfolio of highly appreciated stock, they made the decision to fund an inter vivos two-life charitable remainder trust with $200,000 of this stock. By doing so, they take advantage of the benefits of a charitable trust including a current charitable income tax deduction, bypass of capital gains on the sale of the stock within the trust, and lifetime income. After Randall passes away, the options will be transferred into and then exercised by the trust. The fair market value of the trust will then be $1,000,000 as a result of the trust exercising the options. Avery will then receive lifetime income from the million-dollar trust and upon her passing, the trust assets will be distributed to the named charities.
Randall and Avery are very pleased with the results of this scenario. The ordinary income recognition on the options is avoided and they are able to achieve their objectives of benefiting their favorite charities.
|
|
|
|
