Friday April 19, 2024

4.13.2 Non-Qualified Stock Options

Non-Qualified Stock Options

NSO:  There are many ways that corporations compensate, motivate and reward key executives and officers.

Granting the Option:  Similar to ISOs, there are generally no tax consequences to an employee when the NSO is granted.

Exercising the Option:  When an employee exercises or otherwise disposes of a NSO, it is a taxable event (unlike with an ISO).

Transfer Limitations, Charitable or Otherwise:  Unlike ISOs, the tax code does not prohibit the transfer of NSOs.

The Super Retirement Unitrust:  There is a strategy that can be considered and used by executives with NSOs.

NSO
There are many ways that corporations compensate, motivate and reward key executives and officers. Corporations may provide performance-based bonuses, preferential working environments and corporate perks such as tickets to sporting events or use of the corporate jet.

Stock options are another popular way to attract and retain key personnel. These options generally come in two types - incentive stock options (ISO) and non-qualified stock options (NSO). In many cases, NSOs are favored, because they are not subject to the numerous requirements of ISOs. Thus, corporations may more easily reward key executives and officers.

Granting the Option
Similar to ISOs, there are generally no tax consequences to an employee when the NSO is granted. See Sec. 83. This allows a company to provide current benefits without an accompanying tax liability to the employee. However, if the NSO has a readily ascertainable value, then the employee may have taxable income immediately upon grant.

In some cases, an employee may elect to report the compensation at the time the options are granted. See Sec. 83(b). The taxable income realized will equal the value of the stock options. With such an election, however, the employee will not report ordinary income upon later exercise of the option. This is not a common election because most employees do not want to increase their taxable income prematurely.

Exercising the Option
When an employee exercises or otherwise disposes of a NSO, it is a taxable event (unlike with an ISO). Specifically, the employee will realize ordinary income (not capital gain) equal to the difference between the exercise price and the fair market value of the stock. After the exercise of the options, many employees will sell a portion of the company stock in order to pay the tax liability triggered by the exercise. Since there is no favorable re-characterization of the company stock (from ordinary income to capital gain), there is no holding period requirement similar to ISOs.

Example 4.13.2A

Edward Employee is COO of Widgets, Inc. Three years ago, Widgets granted Edward non-qualified stock options. The granting of the NSO was not a taxable event. The NSOs allow Edward to purchase company stock for $10 per share. The stock is currently valued at $50 per share, and Edward, not surprisingly, wants to exercise his options. Therefore, when Edward exercises his options for 1,000 shares, he will have $40,000 of ordinary income to realize. The $40,000 of ordinary income (not capital gain) represents the difference between the option price and the stock price ($50,000 - $10,000).

Edward will owe income tax. Thus, Edward decides to sell some of his company stock to cover the tax liability.

Transfer Limitations, Charitable or Otherwise
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 transferable or assignable. 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 NSO. As a general rule, NSOs may not be transferred without recognition of ordinary income. Reg. 1.83-7. This rule makes lifetime transfers of NSOs unattractive to most employees.

In the event an employee transfers an NSO to charity, the employee will not have any immediate taxable income. 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 NSO is exercised by the charity.

As stated above, however, the employee will realize income when the charity exercises the NSO. Specifically, the employee 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. Unfortunately, there is more bad news.

The timing and amount of the charitable deduction is subject to many complex technical rules. See PLR 9737014, PLR 9737015 and PLR 9737016. For instance, under the reduction rules, an employee must reduce his or her charitable deduction by the ordinary income element associated with the contributed property. In this case, the entire amount between the exercise price and the stock value is arguably an ordinary income item. Thus, the IRS may argue that an employee receives no charitable deduction for that value. Although the employee may argue a charitable deduction is permissible, there is no direct authority for such a position. Accordingly, employees should proceed with caution.

Finally, the employee may want to claim a charitable deduction for the value of the NSO, not taking into account the ordinary income element. In that case, the employee's charitable deduction will equal his cost basis in the NSO. However, this is likely zero since the employee did not purchase the NSO or realize ordinary income when acquiring the NSO.

In the end, the contribution of the NSO is not very favorable to the employee. In short, the employee will have taxable ordinary income when the charity exercises and will have no charitable deduction to offset the ordinary income. On the other hand, the charity benefits from the increased value of the stock after exercise.

The Super Retirement Unitrust
There is a strategy that can be considered and used by executives with NSOs. Although there is no method to avoid the ordinary income, many executives hold stock that they acquired in previous years. In this case, the basic strategy is to create a 5% remainder unitrust and transfer the oldest and thus most highly appreciated stock into the remainder trust. At the same time the executive transfers his oldest stock to the unitrust, he exercises new options. The charitable income tax deduction available for the contribution to the unitrust will partially offset the ordinary income recognized upon exercise of the stock options.

In states that have passed the Uniform Principal and Income Act, a trustee of many trusts may be given the power to allocate capital gains to distributable income or to principal. However, effective Jan. 2, 2004, a charitable remainder unitrust under Reg. 1.664-3(a)(1)(i)(b)(3) is precluded from permitting the trustee to have a purely discretionary power to allocate capital gain. The unitrust drafter may now allocate all recognized capital gain to income, no recognized capital gain to income or a fixed fractional part of gain to income. An alternative to permit discretionary distribution of capital gain is to place the unitrust assets in a partnership or single-member LLC. When a trust payout is desired, recognized capital gains are distributed from the partnership or LLC to the unitrust, and then to the income recipients.

After retirement, the trustee distributes gains from the partnership to the unitrust and pays out low-tax income. This strategy allows the executive to bypass capital gain when his or her stock is sold, has the benefit of tax-free growth prior to retirement, and at retirement can receive 5% unitrust distributions.

The Super Retirement Unitrust has a 5% payout so that the most substantial income tax deduction is available at the time of contributions to the trust. For example, an executive and spouse both age 55 would be entitled to a deduction of approximately 25% of the value contributed.

The end result of this plan is that executives are able to exercise their NSOs in a tax-efficient way. A Super Retirement Unitrust and NSO option is desirable because an NSO holder is able to cut their current income tax bill and diversify their holdings tax free in the NIMCRUT.

Example 4.13.2B


Ella Executive earns approximately $400,000 per year and also receives NSOs. She has exercised her NSOs consistently in previous years and has a substantial portfolio of appreciated stock. This year, Ella plans to exercise NSOs that will enable her to purchase stock with a current fair market value of $110,000 for $10,000. When Ella exercises her NSOs this year, she must recognize $100,000 of ordinary income.

When Ella exercises her NSOs, she forms a 5% payout net income with makeup charitable remainder trust (NIMCRUT). She will contribute $200,000 of existing long-term-gain stock and receive a $68,000 deduction which is available to offset the $100,000 of ordinary income from the exercise of the NSOs.

Because Ella's NIMCRUT is invested for growth, all of the sold and diversified stock in the trust grows tax free each year and does not increase her income. When she is ready to retire, the NIMCRUT invests for income and provides her with substantial retirement income.

Case Studies on Non-Qualified Stock Options

The Super Retirement Unitrust:   Dale and Darlene Sullivan, both age 55, are executives who have been employed over the years by a number of high tech and internet based companies. They are known throughout the industry as marketing gurus who have been involved in taking a number of companies public. Instead of taking a salary at these various companies, they have opted to take their compensation in the form of nonqualified or nonstatutory options. These are the kinds of options that when exercised create reportable ordinary income for the difference between the exercise price and the fair market value of the stock at the time of exercise. For example, if Dale and Darlene are holders of a nonqualified option in which they can purchase a share of stock currently valued at $50 for an exercise price of $10, then they are required to report ordinary income of $40 on their tax return.

Extreme Makeovers for the Grantor Charitable Lead Trust, Part 6 - Bear Market Exercises:   Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly represents class action lawsuits against large, multinational corporations. As a result of the high stakes and high dollar amounts involved, it is not uncommon for a jury to award a judgment of over $100 million.

Spicy Options for Restauranteur, Part 7:   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.

Spicy Options for Restauranteur, Part 8:   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.

Private Letter Rulings

PLR 200111051 Corporate Pledge of Stock Options to PF is not Self-Dealing:   Corporation C recently pledged to Private Foundation X an option to purchase shares of its common stock. C's business purpose for the pledge is to further the charitable purposes of X and other charitable organizations. The options pledged are transferable by X only to charities described in Sections 170(c) and 501(c)(3). However, these charities must not be related to X or be controlled by a disqualified person under Sec. 4946. Of importance is the fact that C is a substantial contributor to X and therefore is a disqualified person with respect to X.

PLR 200141018 Transfer of Stock Options to Charity Produces Charitable Deduction:   X is a for-profit corporation, and Y is a private foundation. X pledged to Y an option to acquire common stock of X at a specified price, which represented the fair market value of the stock on the date the option was pledged. Under the terms of the option, Y can exercise the option by delivering written notice and payment to X.

PLR 200202034 Pledged Stock Options Produce Charitable Deduction when Exercised by Charity:   Corporation is a publicly held company that has its common stock listed on an established securities market. Recently, Corporation pledged options to Private Foundation. Private Foundation is a non-profit corporation that is a tax-exempt Sec. 501(c)(3) organization.

Related Topics on Non-Qualified Stock Options

4.13.1  Incentive Stock Options:    There are many ways that corporations compensate, motivate and reward key executives and officers. Corporations may provide performance-based bonuses, preferential working environments and corporate perks, such as tickets to sporting events or use of the corporate jet.

4.13.3  Bequest of Options:    IRD, or income in respect of a decedent, is generally the result of assets that have untaxed ordinary income or capital gain at the time of the decedent's death. However, unlike other assets, IRD assets do not receive a stepped-up basis. In fact, when a beneficiary receives an IRD asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation. See Sec. 691.

4.13.4  Testamentary CRT:    IRD, or income in respect of a decedent, is generally the result of assets owned by the decedent that has untaxed ordinary income or capital gain at the time of the decedent's death. However, unlike other assets, IRD assets do not receive a step up in basis at death. In fact, when a beneficiary receives an IRD asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation. See Sec. 691.

      Quiz-Basic



© Copyright 1999-2024 Crescendo Interactive, Inc.