Stock Options
A question was asked in our Q&A session today about stock options. Let me give you a brief overview of qualifed and non-qualified stock options and their use in charitable planning.
Qualified Stock Options
While there is a good deal of discretion with respect to exercising ISOs, there are many restrictions regarding who can exercise ISOs. In particular, the employee is the only person who can exercise the ISO during his or her lifetime. Moreover, ISOs are generally not transferable during the employee’s life. See Sec. 422(b)(5). Therefore, an employee may not transfer an ISO to charity or a planned gift, e.g. CRT, CGA or CLT. This limitation effectively removes any gift possibilities with ISOs.
Once the ISO is exercised and the stock holding period is met, an employee has a great deal of flexibility. Simply put, the employee now owns long-term capital gain property. In this way, the stock is similar to other types of highly appreciated stock.
Thus, the employee may transfer the stock outright to charity or to a CRT or CGA. Accordingly, the tax rules applicable to gifts of appreciated long-term capital gain property willapply, e.g. 30% AGI limitation.
Non-qualified Stock Options
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.
I hope this helps.
Randy
