Click here for a discussion of conventional and employer stock options.

83(b) Election

For additional analysis of this important tax savings device, click here.

Tax Preparation Pointers

• An investment portfolio can reflect ESPP shares, ISOs and NonQuals exercised on different dates at different prices.  Good records are vital. 

• Always reconcile the employee's option schedule and brokerage statements to the wages shown on the W-2.   Every once in a while, there is a difference. Perhaps the employee exercised the options or sold the stock after leaving the employer.

• Employers do not always identifying disqualifying dispositions and it therefore falls to the tax preparer to review the holding periods for each disposition. Ordinary income from a disqualifying disposition goes on line 21 of the federal return if the employer did not include this income on the W-2.

• There will usually be a small Schedule D gain or loss on a same day sale because the sale price seldom matches the market price assumed in the employer's calculations.

Planning Considerations

• It is imperative to plan the exercise/sale of options and the payment of state tax, especially when you have both ISOs and NonQuals.  It is usually possible to delay the tax and it is sometimes possible to save tax or to maximize the AMT credit carryover but the best scenario is seldom obvious. Planning an option exercise and/or transfer requires the explicit calculation of tax effects since rules of thumb can provide misleading or erroneous results.  Advice from a knowlegable professional should be considered.

• Delaying and reducing tax is not the only planning consideration. If the value of the employer's stock dominates the employee's net worth and it is prudent to sell some of this stock to diversify the portfolio. The Enron debacle in the fall of 2001 demonstrated this truth yet again. You have an insider's view of your company's potential and you can time your option exercise, and stock sales, accordingly. (If you really are an insider, there are SEC restrictions on when you can sell company stock.)

• Markets do not always go up.  It may be possible to salvage a situation where ISO stock depreciated after exercise by a disqualifying disposition in the same tax year.  To learn more about this, click here.

• Older employees who are charitably inclined can diversify, obtain income and benefit a charity by donating low basis stock to a CRAT or CRUT.  (The law was changed a few years ago such that the tax benefits are no longer attractive for younger employees.)

• Gifting appreciated stock after any holding periods expire can be an attractive.  The donor's heirs receive more money after gift tax than they would after estate tax because the estate tax is an inclusive tax while the gift tax is an exclusive tax. (That is, estate tax is  assessed on the value of a bequest plus the associated tax but the gift tax is assessed on the value of the gift alone.) But remember that  gifted stock does not receive a step-up in basis on your death.   The loss of stepped-up basis partially offsets the estate tax savings.

Warning: Since current law repeals the estate tax in 2010, think twice before making gifts large enough to trigger the actual payment of gift tax!.

• Another estate planning technique is to gift vested options. (NonQuals only please; one cannot gift ISOs or ESPP options.)  When the options are exercised, the donor rather than the recipient recognizes income and employment taxes.  Although the beneficiaries are benefited by the payment of this tax, the gift tax is an obligation of the donor.  Therefore, paying the gift tax is not considered to be a taxable gift, much as paying income tax on a defective grantor trust is not considered a taxable gift.

• For estate tax purposes, NonQuals are valued at the difference between the fair market value of the underlying stock on the date of death and the exercise price. If the options were exercised before death, the estate tax liability would be lower because of the income tax liability upon exercise reduces the taxable estate.  Thus more estate tax is paid on unexercised options.   A similar situation occurs with IRAs and pension accounts.  Section 691(c) includes a provision to rebate the extra estate tax when the option is exercised but this adjustment is imperfect and the repayment might be delayed for several years. This is not a consideration if the recipient is a charity. Thus, when there is charitable intent, it is worth running the numbers to quantify the benefit from giving NonQuals to charity and other assets to non charitable beneficiaries.

• There are a variety of planning techniques involving charitable trusts and life insurance.

• Valuation is a big issue with gifted options.  See Rev. Proc 98-34 for suggestions on valuation methodologies.   Be sure to file a gift tax return with full disclosure to start the statue and to preclude the IRS from revaluing your gift at a later date.

• On death, ESPPs and ISOs are stepped-up in value and the stock can be transferred before the holding period restrictions run without triggering a disqualifying disposition.  An option with a $10 exercise price is valued at $5 for federal estate tax purposes if the fair market value of the stock is $15 on the date of death.  The stock purchased by exercising this option will have a $15 basis. Since the stock was not acquired from the decedent but is the result of exercising an option acquired from the decedent, the holding period probably begins on the date of exercise rather than being automatically long term. 

For additional information see Reg. 1.423-2(k)(3) and Carol Cantrell "Living and Dying with the Complex Rules of Incentive Stock Options" Journal of Taxation 87(2), August 1997.

David Hardesty's site (and e-mail update service) deals mostly with e-commerce.  Seach on "ISO" to find a half dozen interesting and well written articles.

Estate planning for stock options—What to give, when, and to whom, by Sanford J. Schlesinger and Dana L. Mark, 92 JTAX 301, May 2000.

Web Sites

Kathleen Pender (San Francisco Chronicle, June 23,2000) suggests www.mystockoptions.com and www.optionwealth.com.  The latter site is only semifunctional due to numerous broken links as of this writing.

December 30, 2001