Employee stock options often represent a significant portion of an executive's net worth. This may be particularly true for executives working for technology or other emerging growth companies, due to the prevalence of stock options in these companies and their potential for significant appreciation in value. A transfer of employee stock options, however, involves consideration of various estate, gift and income tax rules. This article examines the transferable estate, gift and income tax consequences of option transfers by an employee and addresses certain related securities laws issues. As this article points out, employers and employees who are interested in pursuing an option transfer should proceed with caution. Employers commonly grant stock options to employees, either in the form of "incentive stock options" "ISOs" or "nonqualified stock options" "NSOs". ISOs offer employees certain tax benefits and are subject to qualification requirements under the Internal Revenue Code. Even though NSOs are not subject to the ISO nontransferability limitation, many stock option plans contain restrictions on transfer similar to those that apply to ISOs. Employers that do allow employees to transfer their options generally do so on a restricted basis by, for example, limiting option transfers to the employee's family members or to a family trust. If an employee dies holding unexercised employee stock options, the value of the option at the time of death i. In either case, the income tax consequences upon exercise after the employee's death depend on whether the option is an ISO or an NSO. In the case of an ISO, exercise will not generate taxable income and the purchased shares will have a tax basis that "steps up" to their fair market value at the time of the executive's death. In the case of NSOs, exercise will trigger ordinary income measured as the difference between the fair market value of the shares at the time of exercise and the option exercise price, subject to a deduction for any estate tax paid with respect to the NSO. There is no step up in the tax basis as the result of the employee's death. As mentioned above, however, ISOs are not transferable during the employee's lifetime. Since ISOs do not present the same estate planning opportunities as NSOs, this discussion is limited to the transferability of NSOs including ISOs that become NSOs as a result of an amendment to permit transferability or as a result of an actual option transfer. A transfer of employee stock options out of the employee's estate i. At death, estate taxes are computed on the basis of the decedent's gross estate prior to the payment of taxes. In other words, estate tax is paid on the portion of the estate that is used to pay estate taxes. By removing from the decedent's taxable estate assets that will otherwise be used to pay the tax, only the "net" value of the decedent's estate is taxed at death. If the employee transfers options and incurs gift and later income taxes as a result discussed belowthe ultimate estate tax burden is reduced. A transfer of property by way of gift is subject to the gift tax rules. These rules apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. When an option is transferred by way of gift, the amount of the gift is the value of the option at the time of transfer. The gift tax regulations provide that the value of property for gift tax purposes is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both being reasonably knowledgeable of the relevant facts. Applying this standard to NSOs is particularly challenging given their unique characteristics. Moreover, there does not appear to be any IRS precedent for valuing Google for gift tax purposes, and it is not clear how the IRS would value an NSO upon audit. While recent refinements to option valuation methodology for SEC disclosure and financial accounting purposes might be helpful, 10 an employee who wishes to transfer an NSO should be prepared to defend the option valuation used for gift tax purposes and should consider obtaining an independent valuation. To be an effective transfer, the gift must be complete. The IRS has addressed the gift and income tax consequences of an employee's transfer of an NSO in a series of private letter rulings beginning in However, in four of these rulings the options involved were fully vested and exercisable at the time of transfer. The IRS has yet to specifically determine whether a transfer of unvested options results in a completed gift for gift tax purposes. Typically, the exercisability of unvested options is based upon the employee's continued employment with the employer, and it is possible that the IRS will not consider the gift to be complete until the option becomes exercisable. This could significantly undermine the intended estate planning benefits since the value of the option could be much higher at the time of vesting than at the time of grant. Under different circumstances the IRS previously concluded that where an employee-donor could defeat a transfer by terminating his employment, the transfer was an incomplete gift. Nevertheless, transferable long as options employee does not retain rights in the option, the transfer of an option should be considered complete even though the option is not then exercisable and will expire upon the employee's termination of employment. In PLRs and the IRS noted that while the exercise of the transferred option might be google upon the employee's retirement, disability or death, these events were acts of independent significance, and their resulting affect on the exercisability of the transferred option should be considered collateral or incidental to termination of employment. The annual exclusion is not available, however, in connection with gifts of future interests, relating generally to gifts the enjoyment and possession of which options postponed to a future date. The IRS might view the transfer of an unexercisable NSO as a gift of a future interest, which would not qualify for the annual exclusion. Even if the option is not considered a future interest, a transfer of an NSO, other than by outright transfer, may not qualify for the annual exclusion unless the transfer meets the requirements of Internal Revenue Code Section c relating to transfer to minorsor, in the case of transfers to options irrevocable trust, the trust includes so-called "Crummey" provisions relating to the right of beneficiaries to demand a portion of the trust corpus. The federal income tax consequences resulting from a gift of NSOs are more predictable than the gift tax consequences described above. In general, the transfer itself should not have any income tax consequences to the employee or the donee, although the employee or the employee's estate remains taxable on any gain realized in connection with the option exercise. NSOs are not taxed at grant unless they have a "readily ascertainable fair market value" within the meaning of Treasury Stock. The employee will not recognize any income or gain upon the transfer of an option. Nor will the donee recognize any taxable income as a result of the transfer. If the donee exercises the options before the employee's death, any income taxes paid by the employee escape estate tax transferable the employee's death. Thus, in effect, the employee has made a tax free gift to the donee in the amount of the income taxes paid as a result of the exercise. If the purchased shares are subject to a "substantial risk of forfeiture," the date of taxation and measurement of ordinary income in connection with the option exercise may be deferred unless the employee makes an election under Section 83 b of the Internal Revenue Code. The employer is entitled to a corresponding deduction. The donee incurs no liability in connection with the option transfer or its exercise. After exercising the option, the donee's tax basis in the purchased shares is equal to the sum of i the option exercise price and ii the ordinary income recognized by the donor in connection with the option exercise. Transferable options held by employees of public companies raise google number of issues under federal securities laws. In addition, private companies must be sensitive to applicable state securities laws. Rule 16b3 offers insiders broad exemptions from Section 16 with respect to compensatory transactions. Effective November 1,options no longer have to be nontransferable to enjoy exemption under Rule 16b3. As a result, under the New Rules the grant of a transferable NSO or an amendment to an existing option to permit transferability should not be considered a "purchase" under Section 16 that can be "matched" with a sale of employer securities during the six months before and after the option grant. Moreover, in the case of an option transfer by an insider to a family member living in the same household as the insider, the option will be considered indirectly owned by the insider and will remain subject to continuing reporting under Section 16 a of the Securities Exchange Act of A plan amendment permitting option transfers does not generally require shareholder approval. Form S-8 is the standard SEC registration form for public company securities to be issued to employees under employee equity plans. In essence, registration on Form S8 ensures that the shares employees receive under such plans will be freely tradeable on the open market. Unfortunately, Form S8 is generally limited to share issuances to employees and does not extend to shares issued in connection with an option transferred by the employee-donor during his or her lifetime. Although the SEC is considering changing this limitation, under current law option shares issued to the donee of an option will not be freely traded but will instead be considered "restricted" i. As a result, shares issued to the donee will be subject to the holding period requirement under Rule Under limited circumstances, Form S3 may be available to cover resale of option shares by the recipient. Companies considering amending options to permit transfers should also be sensitive to the financial accounting consequences of such an amendment. In particular, companies should consult their auditors to determine whether such an amendment triggers a new measurement date. Amending an option to permit transfers to the employee's family or family entities e. If a new measurement date is triggered, the company would be required to recognize compensation expense based on the difference between the option exercise price and the value of the option shares at the time of the amendment. The consequences of option transfers can be uncertain. Stock cannot be transferred and continue to qualify as ISOs, but NSOs may be transferred if the option plan permits it. Nevertheless, in certain situations the estate planning benefits of an option transfer can be substantial stock may still outweigh these disadvantages. SEC Releasefn. FindLaw For Legal Professionals Not a Legal Professional? Edit Your Profile Log Out. FindLaw Corporate Counsel Business Operations Transferable Employee Stock Options. SUMMARY The consequences of option transfers can be uncertain. Endnotes 1 Code '