Print This Page

Date:   Mon, 26 Apr 2010
From:   Shawn

Mike,

What are the tax implications of making gifts of nonqualified stock options to family members? Is the donee liable for the tax on the difference between the fair market value of the stock at exercise and the option price?

Thanks.

Answer

Date:   7 May 2010

Hello Shawn,

This is actually a fairly loaded question, and my answer probably won't be complete.

Since non-qualified stock options don't have the requirements of incentive stock options that they be held by employees, gifts are apparently permitted. With recent favorable rulings by the IRS, more employers are permitting gifts of NQSOs.

According to Revenue Ruling 98-21, the gift won't be completed until the shares are vested. The IRS issued guidance in Revenue Procedure 98-34 to value the options using the Black Scholes model or an accepted version of the binomial model. The details are beyond the scope of this explanation. If a gift is made of unvested shares, the valuation is done and the gift reported when the shares vest.

There is no taxable income to the donor when the gift is made. When the donee exercises the option, taxable income is reported by the donor-employee for the excess of the fair market value of the stock over the option price. The donee adds the income reported by the donor to the tax basis of the stock, so it will be the fair market value on the date of exercise. (Letter Ruling 199952012.)

From an estate planning perspective, the employee receives two "benefits" of making lifetime gifts of NQSOs. If the stock value goes up after the gift, the appreciation is shifted from the employee's estate. In addition, the employee's estate is reduced by the income taxes related to the exercise. Since the income taxes are a personal liability of the employee, the payment of income taxes should not be a taxable gift.

The employee is taking a risk that the stock could appreciate so much that paying the income tax when the option is exercised could create a financial hardship.

Some transfers of non-qualified stock options can be reportable or listed transactions, so proceed with caution.

Good luck!

Mike Gray

For more information about non-qualified stock options, request our free report, Non-Qualified Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.