Tax Planning for Stock Options

Stock exchange collectibles. Old stock share certificates from 1950s-1970s (United States). Vintage scripophily objects (obsolete). -GETTY

Stock options, that is the contractual right to buy the stock of an employer by an employee at a discount price, remains a popular way for companies to compensate employees without incurring an immediate financial cost, and for employees to receive some participation in the equity of the company without incurring immediate income taxes. Planning for owners of stock options, and their beneficiaries require care to maximize these financial benefits.

There are two types of stock options -Qualified and Non-Qualified options Qualified stock options include Employee Stock Purchase Plans and Incentive Stock Options, which comply with the IRS rules. All other stock options are non-Qualified stock option plans. There are tax advantages to a Qualified Stock Option Plan, but such options are not transferrable. Non-Qualified Stock Option Plans do not get the same favorable tax treatment, but they are more flexible and often can be transferrable from an employee to a beneficiary or a Trust. Generally, the option is not considered to be income at the time of the grant but may be when the option is exercised, and the employee has the right to buy the stock at below market value.

Stock options, that is the contractual right to buy the stock of an employer by an employee at a discount price, remains a popular way for companies to compensate employees without incurring an immediate financial cost, and for employees to receive some participation in the equity of the company without incurring immediate income taxes. Planning for owners of stock options, and their beneficiaries requires care to maximize these financial benefits.

There are two types of stock options -Qualified and Non-Qualified options Qualified stock options include Employee Stock Purchase Plans and Incentive Stock Options, which comply with the IRS rules. All other stock options are non-Qualified stock option plans. There are tax advantages to a Qualified Stock Option Plan, but such options are not transferrable. Non-Qualified Stock Option Plans do not get the same favorable tax treatment, but they are more flexible and often can be transferrable from an employee to a beneficiary or a Trust. Generally, the option is not considered to be income at the time of the grant but may be when the option is exercised, and the employee has the right to buy the stock at below market value.

For those options which will not lapse at death, you also need to consider what is the difference between the option price and the fair market value. If the option is for a price higher than the current value, then the option is valueless. An option that allows the purchase of stock as a discount to the current value may have significant value either as a gift or in an estate. Also, the date when your exercise the options, how the beneficiary will pay for the exercise of the option, and the marketability of both the options and the option stock are factors in planning.

If you are going to hold options after your death, you must consider to whom does the option go to? If the options are going through your estate, then your will should include specific powers for the Personal Representative to exercise the options. Placing options in an estate is not the most efficient way of handling options, as there is significant income tax incurred when options are exercised and the stock sold. The better tactic is to have the options in a trust, so avoiding the possible delays of going through probate. Again, the trust should have specific provisions to allow the trustee to hold or exercise the options without violating the fiduciary duty to diversify investments.

Finally, but most importantly, planning for a source of funds to either pay the estate tax on the options or to pay for the exercise of the options is a prime consideration. Liquidity can be through the proceeds of a life insurance policy or a source of funds other than the sale of the options or the option stock. Lending to a trust or estate to finance the exercise of options is possible but only under restricted conditions. Another consideration is whether, in the case of a closely held company, the estate can elect to defer the payment of estate taxes under section 6166 or section 303.

With the decline in the value of stocks, especially in technology companies, there may be an opportunity to make some gifts of options with little or no gift tax consequences, if they are transferrable.

So, if you have stock options, whether Qualified or Non-Quantified, is important to consider not only when you might exercise the options during your lifetime, but also how you might hold the options after your death.