Does it make sense to transfer a qualified incentive stock option to a Family Limited Partnership? What are the transfer tax implications?
June 25, 2001
It doesn’t make sense to transfer an ISO to a Family Limited Partnership. In order to qualify as an ISO, the option may not be transferable except by will or under the laws of descent and distribution. (Internal Revenue Code Section 422(b)(5).)
Now that I’ve answered your question, what about transfers of stock acquired by exercising an incentive stock option?
After an option has been exercised, the stock may be transferred. Depending on the circumstances, gift tax may apply. If the transfer is of a minority limited partnership interest in a family limited partnership, valuation adjustments may apply for lack of control, lack of marketability, lack of transferability. If you are contemplating such a transfer, you really should get professional advice, including involving a competent tax attorney and a good business appraiser.
If the stock is transferred before the holding period requirements are met (more than one year after exercise, more than two years after grant), the transfer is taxable. Ordinary income is reported with respect to the transfer. The amount of ordinary income is the lesser of the fair market value at exercise over the option price or the fair market value on the transfer date over the option price. If the transfer is made after the year of exercise, the regular tax will be partially offset by a minimum tax credit carryforward from the date of exercise. In the process of computing the alternative minimum tax for the year of transfer, a subtraction is made for the preference reported in the year of exercise.
If the stock is transferred after the holding period requirements are met and the other rules for non-taxable transfers to partnerships are met, there may be no income tax for the transfer. However, the potential gain for the stock on the date of transfer might have to be allocated to the transferee partner when the stock is ultimately sold. (Only future appreciation is shifted to the other partners.) The AMT preference adjustment should follow that capital gain.
Special rules apply for corporate insiders or other restricted stock. Be sure to get tax help in this situation.
Just reading this explanation should convince you that planning for transactions with incentive stock options is highly complex and getting competent tax advice for these is essential.
For more information about incentive stock options, ask for a free copy of our report, Incentive Stock Options – Executive Tax and Financial Planning Strategies.