When Eugene Isenberg, chief executive at Houston oil company Nabors Industries, was awarded 2.25 million stock options, he wanted to keep as much of the wealth in the family--and away from the Internal Revenue Service--as possible. If his heirs inherited the options upon his death, a 55% estate tax would gobble much of their potential value. So he transferred the options, immediately after receiving them, to a trust created for his kids. By sweeping the options out of his estate while the share price was still low, Isenberg, 67, headed off the millions of dollars in estate taxes his heirs would have owed on the options' future appreciation.
RUSH. Thanks to recent IRS and Securities & Exchange Commission rulings permitting the transfer of unexercised, nonqualified options, more executives like Isenberg will rush to take advantage of this new estate planning strategy. With nonqualified options, any appreciation above the grant price is taxed as ordinary income, payable at the time of exercise. Using this tool, the executive may pay gift tax on the value of the options when the gift is made. And whenever the heirs exercise the options, the executive will also owe income tax on the spread--the gain in share price from the time of grant to the time of exercise. But these options could be a tax time bomb, since the tax burden stays with the executive, who could be socked should the shares soar. The result: The kids keep more money than if they received the options through the estate after the executive died. If the executive dies before the options are exercised, his estate is responsible for the income tax, says Robert Salwen, president of New York-based consulting firm Executive Compensation Corp.
Until last year, most companies strictly forbid the transfer of stock options. But following a 1996 SEC ruling that liberalized restrictions, a growing number of companies, including McDonald's, Time Warner, and H.J. Heinz, have revised their executive compensation plans to allow options transfers. And more are expected to follow, Salwen says. So if you have accumulated a significant amount of nonqualified options as part of your compensation, consider using this time-sensitive strategy before the options' value grows.
To employ this technique, you must work for a publicly traded company with an option plan that specifically permits the transfer of nonqualified stock options. Tax-favored incentive stock options--where any gain realized from the time of grant to the time of sale is taxed as capital gains--can never be transferred. The best candidates to consider transfers are individuals with estates worth more than $600,000, the level at which estate taxes take effect.
If you believe the share price will increase, transfer the unexercised options as soon as they are granted, either to a trust or directly to your heir, says Jonathan Dubitzky, a partner with the Boston law firm Sullivan & Worcester. "The sooner the gift is made, the sooner the wealth can build up in the kids' hands free of gift and estate tax," he says.
GIFT TAX. While this strategy allows you to avoid some taxes, you can't escape them all. You can make annual tax-free gifts of up to $10,000 worth of options per heir. Anything above that is subject to gift tax of up to 55%, depending upon the size of your estate and the value of the options at the time of transfer. According to the IRS, gift tax on transferred options is based on their value the day they were transferred. While the IRS has not stated its position on the taxation of unvested options, experts suggest valuing them the same way.
Like any other financial planning strategy, transferring stock options involves risk. If the stock tanks and the options become worthless, you cannot go back to the IRS and reclaim the gift tax. Yet Dubitzky says: "Even if the stock only grows modestly, the increase in the kids' wealth will be much larger for every dollar of gift tax you paid than if you gave them cash or stock."
Once the options are transferred, your heirs have somewhere between five and ten years--depending upon the terms of the grant--to exercise them. At that time--because the options originally were granted as part of your compensation--you will owe income tax on the spread. Should your stock turn out to be the next Microsoft, the future tax hit could be onerous. "As ironic as it may sound, it's much better for the executive to pay the income tax than the kids because it preserves wealth for the next generation," Dubitzky says. So if you have the means to pay the income tax and can do without the related income, this could be one of the most valuable gifts you'll ever give.