I occasionally get asked whether it is possible to transfer a stock option. Listed below are relevant considerations.
Does the plan allow for it?
Carefully read the stock option plan and agreement to see if there are any restrictions on option transfer. There generally will be. Most plans allow transfer on the optionee’s death pursuant to the will and the laws of distribution. Fewer plans allow transfer of an option during the optionee’s lifetime, and when they do, they frequently require board approval and/or limit such transfers to those pursuant to the terms of a divorce or separation agreement.
Will the transfer cause disqualification?
If the option is an incentive stock option (ISO), any transfer made prior to the death of the optionee will disqualify the option. To preserve ISO status, ex-spouses sometimes instead enter into an agreement to split the underlying economics of the option without transferring the option.
What is the tax treatment of such a transfer?
If the option is being gifted, the transfer will be subject to the gift tax rules. Generally, the recipient of a gift is not subject to tax, but the giver is once certain thresholds are exceeded.
Currently, each taxpayer may gift up to $17,000 per year ($34,000 for spouses splitting gifts) to an indefinite number of recipients. In addition, each taxpayer has a lifetime unified credit of $12.92 million until 2025, after which it is set to go down to $6.46 million. Amounts gifted in excess of the annual threshold reduce the taxpayer’s unified transfer credit, and only once that is exceeded will the giver have gift tax.
Generally, an option transferred to a family member for no consideration will be considered a gift. However, an option put into a revocable grantor trust may not be a gift because the transfer can be revoked, and thus the gift is not yet considered complete. Also, to my knowledge the IRS has not yet provided guidance as to whether the transfer of unvested options results in a completed gift for gift tax purposes.
The exercise of the gifted option will cause the giver (i.e., the service provider) ordinary income equal to the fair market value of the shares on the date of exercise, minus the exercise price.[1] The recipient of the gifted option will have no income on exercise and after exercise, will have a tax basis in the shares equal the sum of (i) the option exercise price and (ii) the ordinary income recognized by the giver in connection with the option exercise.[2]
Any optionee considering an option transfer should be advised to discuss the potential tax consequences with his or her tax advisor.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] I am assuming for this purpose a regular exercise, i.e., an exercise with respect to vested shares.
[2] See PLR 9421013.