Wednesday April 24, 2024

4.13.3 Bequest of Options

Bequest of Options

Income in Respect of a Decedent:  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.

Bequest of Options:  While stock options are a very desirable asset for an employee, many beneficiaries would far prefer to receive a capital asset than an IRD asset.

Beneficiary Designation and Stock Options:  For bequests of stock options, it is vital that an employee designates a qualified charity as the beneficiary.

Income in Respect of a Decedent
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.

ISOs and NSOs are classic examples of IRD assets. Accordingly, the beneficiary of an ISO or NSO will have IRD, since the employee would have been subject to tax on the options during life. The taxable IRD effectively reduces the beneficiary's inheritance.

Other common IRD assets include IRAs and pension plans, the ordinary income element within a commercial annuity, the gain in installment notes and the ordinary income element within U.S. savings bonds.

Bequest of Options
While stock options are a very desirable asset for an employee, many beneficiaries would far prefer to receive a capital asset than an IRD asset. Specifically, the capital asset receives a stepped-up basis and the heir may convert the capital asset to cash with no recognition of capital gain. However, an IRD beneficiary will be subject to ordinary income tax or capital gains tax with respect to the stock options. Thus, it is logical to transfer capital assets such as stock or land to noncharitable beneficiaries and bequeath IRD assets to charitable beneficiaries.

Accordingly, stock options are an excellent asset to bequeath to charity. When the option is transferred to charity, the estate will receive a charitable estate tax deduction equal to the value of the option. See Sec. 2055. Moreover, when the charity exercises or disposes of the option, it will not be subject to income tax. In fact, the IRD asset is a passive asset and, thus, generates no unrelated business taxable income to the charity. See Sec. 512. As a result, the maximum value of the option is transferred to charity without any reduction for income or estate taxes.

Example 4.13.3A

Brian Bequest owns $100,000 of non-qualified stock options. In compliance with Brian's company plan, he named Doing Good Work Charity as the designated beneficiary of the NSOs. Brian died this year without ever exercising the NSOs. Charity received the options pursuant to the beneficiary designation. As a result, Brian's estate claimed a $100,000 charitable estate tax deduction for the value of the NSOs.

Subsequently, Charity exercised the NSOs for $40,000. The exercise resulted in $60,000 of IRD to Charity. However, Charity is exempt from income taxes. Therefore, Charity does not have to pay any income tax with respect to the $60,000. Accordingly, Charity owns $100,000 of company stock. The following day Charity sold the stock and used the $100,000 proceeds for charitable purposes.

Beneficiary Designation and Stock Options
For bequests of stock options, it is vital that an employee designates a qualified charity as the beneficiary. Stock options, like many IRD assets, are frequently transferred through a beneficiary designation. Once the employee passes away, the transfer of the options is completed first in accordance with the beneficiary designation. In the event there is no such designation, the options will usually transfer to the employee's estate, and the executor will exercise the options. Unfortunately, this may result in income tax consequences to the estate, i.e. IRD.

The beneficiary designation possibilities and limitations are generally governed by the plan of the company that issued the options. The company plan usually sets forth any transfer restrictions and the procedure for naming a beneficiary. The best course of action is for the employee to contact the company administrator for a copy of the plan and to follow its procedures meticulously.

The tax code is much more flexible when dealing with the transfer of options at death. For example, ISOs generally may not be transferred during life. However, the ISO rules are less restrictive after the employee passes away. In that case, the employee's designated beneficiary may receive and exercise the ISO.

It is also possible for the employee's estate to be the beneficiary of the stock options. In that case, the executor receives the stock options after the employee's death. If the employee made a bequest to charity of the stock options, then it is very beneficial to have an allocation provision that permits the executor to use the IRD assets in satisfaction of the charitable bequest. This helps the executor avoid the IRD associated with the stock options. However, caution should be exercised not to require use of IRD assets for pecuniary bequests, since satisfying a pecuniary bequest with IRD could trigger recognition of taxable income at the estate level.

Case Studies on Bequest of Options

Spicy Options for Restauranteur, Part 5:   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 200002011 Unqualified Deferred Comp and Options Bequeathed to Charity:   Taxpayer has accrued a right to three different types of unqualified deferred compensation. He has compensation that has been payable but has been deferred, non-statutory stock options that he may exercise and a right of his estate to receive an additional amount of nonqualified deferred compensation.

PLR 200012076 Bequest of Nonqualified Options IRD to Charity:   Senior officers of technology companies and other corporations frequently receive stock options as part of their compensation. The taxpayer in this ruling is the retired chairman of Company X and holds vested nonqualified stock options that will expire in 15 years.

Related Topics on Bequest of Options

3.2.3  Bequests of IRAs and Other IRD Assets:    Some assets transferred to heirs do not receive a stepped-up basis. This "income in respect of a decedent" (IRD) is defined as gross income "not properly includable in computing [decedent's] taxable income for the taxable year ending with the date of his death." Reg. 1.691(a)-1(b). IRD assets are those in which there is either untaxed ordinary income or a deferral of capital gain. When the beneficiary receives the asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation if he or she had recognized the income or gain.

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.

4.13.2  Non-Qualified 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.

      Quiz-Basic



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