Is it best to exercise incentive stock options before or after death?
October 17, 2011
Date: Mon, 17 Sep 2007
I have a client who is terminally ill (life expectancy less than 6 months). My client has about $1.5 million in ISOs, with an option price of about $300,000 and an unrealized gain of $1.2 million.
What are the tax implications of exercising the ISOs before death and selling the resulting shares after death, assuming all of this is accomplished during 2007? My client lives in Texas, a community property state.
Would it be better to exercise the ISOs after death?
Thanks for any insight into this taxing question.
Date: 16 Oct 2007
For ISO’s that are unexercised at death, the holding period requirements and the requirement that the holder be an employee within three months after leaving employment are eliminated. (Internal Revenue Code Section 421(c)(1)(A).) The employee must have met the employment requirement as of the date of death. (Treasury Regulations Section 1.421-2(c)(1).)
Therefore, for regular tax reporting, any gain with respect to any stock received from exercising an ISO after death will be a capital gain. Whether the capital gain is short-term or long-term will depend on the holding period of the stock after exercising the option.
The basis of shares acquired from exercising an ISO after death equals the estate tax value of the option plus the option price.
For AMT reporting, ISO’s are taxed like NQOs. When an ISO is exercised, there will still be an AMT adjustment for ordinary income, resulting in an item of income with respect of a decedent. The AMT basis of the ISO stock will be the option price plus the ordinary income reported for AMT.
When the ISO is exercised before death, a transfer of the stock by bequest or inheritance is not a disqualifying disposition. (Internal Revenue Code Section 424(c)(1)(A).)
Exercising the option before death will result in an AMT, and the AMT credit will disappear at the death of the employee.
The holding period requirement is waived with respect to stock sold after the death of the employee. (Treasury Regulations Section 1.421-2(d).) Therefore, a sale of the stock will not result in a disqualifying disposition.
Under the rules relating to inherited property, the tax basis for the stock will be the fair market value as of the date of death or the alternate valuation date (Internal Revenue Code Section 1014(a), and the gain with respect to the sale of the stock will be a long-term capital gain (Internal Revenue Code Section 1223(11).) For stock held as community property, the basis adjustment and new holding period applies to 100% of the stock, regardless of which spouse is first deceased (Internal Revenue Code Section 1014(b)(7).) (These basis adjustment rules could change if the repeal of the estate tax becomes effective in 2010.)
Determining the “correct” answer to your question involves unknowns, including changes in the price of the stock on the date of exercise, the date of death and the date of sale. A “rule of thumb” answer is it’s probably better to exercise before death, because the AMT will be deductible when computing the estate tax and getting a “fresh start” basis adjustment and long-term holding period after death. This decision could also have an impact on the amount to be allocated to trusts after death.
I recommend that your client consult with a tax advisor and an attorney about this matter before making a final decision.