Friday April 26, 2024
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4.13.4 Testamentary CRT
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Testamentary CRT
Income in Respect of a Decedent: 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.
Testamentary CRT Funded with Options: Because of the IRD aspect of stock options, it is logical to transfer stock options at death to a testamentary charitable remainder trust (CRT).
Beneficiary Designation and Stock Options: For testamentary CRT planning purposes, it is vital that an employee designates his or her testamentary CRT as the beneficiary of the IRD assets.
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Income in Respect of a Decedent
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.
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.
Testamentary CRT Funded with Options
Because of the IRD aspect of stock options, it is logical to transfer stock options at death to a testamentary charitable remainder trust (CRT). When the option is transferred to the CRT, the estate will receive a charitable estate tax deduction equal to present value of the remainder interest. See Sec. 2055. Moreover, when the CRT exercises or disposes of the option, it will not be subject to tax. Specifically, the IRD asset is a passive asset and, thus, generates no unrelated business taxable income to the CRT. See Sec. 512. The CRT will merely account for the IRD pursuant to the four-tier accounting structure, i.e. tier one or tier two. The ultimate benefits of the testamentary CRT are a minimization of estate and income taxes, a term of years or lifetime income stream, and an eventual gift to charity.
Example 4.13.4A
Charlie Crut owns $100,000 of non-qualified stock options. In compliance to Charlie's company plan, he named The Charlie Crut CRT as the designated beneficiary of the NSOs. Charlie died this year without ever exercising the NSOs. The CRT received the options pursuant to the beneficiary designation. The CRT pays for the lifetime of Charlie's son, Adam. Consequently, Charlie's estate claimed a $15,000 charitable estate tax deduction for the present value of the remainder interest.
Subsequently, the CRT exercised the NSOs and purchased $100,000 in stock for $50,000. The exercise resulted in $50,000 of IRD to the CRT. However, the CRT is exempt from income taxes. Therefore, the CRT does not have to pay any income tax with respect to the $50,000. The CRT now owns $100,000 of company stock and immediately proceeded to sell and diversify its holdings. As a result of the sale, the CRT reports the $50,000 of IRD as tier one income. In taxable estate situations, the $50,000 of tier one may be reduced for any estate taxes paid attributable to the IRD. See Sec. 691(c).
Beneficiary Designation and Stock Options
For testamentary CRT planning purposes, it is vital that an employee designates his or her testamentary CRT as the beneficiary of the IRD assets. 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 in accordance with the beneficiary designation, rather than under the terms of the employee's will.
The beneficiary designation possibilities and limitations will be governed greatly by the company plan. The company plan usually provides 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.
As for the tax code, it 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.
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Case Studies on Testamentary CRT
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.
Spicy Options for Restauranteur, Part 6:
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.
Testamentary Stock Options:
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.
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