This article is reprinted with permission from the
August 31, 1994
edition of
New York Law Journal.
1994 NLP IP Company.


Developments Affecting Stock Options

By Joseph E. Bachelder.


RECENT DEVELOPMENTS affecting stock options include a notice of proposed rule-making by the Securities and Exchange Commission that would affect, among other things, the status of stock options under Rule 16b-3 pursuant to 16 of the Securities Exchange Act of 1934 (Exchange Act). Other developments discussed include the subject of transferring stock options to family members for estate planning purposes and the project on accounting for stock compensation programs being conducted by the Financial Accounting Standards Board (FASB).

SEC Proposals

On Aug. 10, the SEC issued a notice of proposed rule-making under the heading "Ownership Reports and Trading by Officers, Directors and Principal Security Holders." 1 Included in the proposals are several that directly involve stock options and Rule 16b-3.

One of the proposals would eliminate restrictions under Rule 16b-3 on the transferability of options. This would be accomplished by deleting current Rule 16b-3(a)(2). Among transactions that would be affected by this proposal would be the gifting of stock options for estate planning purposes. (The tax-planning features of gifting stock options to family members is discussed in a separate section of this column below. 2)

This proposal would change the result in the Time Warner Inc. no-action letter dated Dec. 18, 1992. In that letter the staff of the SEC held that a plan previously approved by shareholders could be amended (without shareholder approval) to permit transfers by gift from a participant to a family member, family trust or family partnership without disqualifying, under Rule 16b-3, options that were subject to the required restrictions on transferability. Under the no-action letter, the grant of options that contain such provision would not be exempt under Rule 16b-3. Options that are amended to permit such transfer likewise would not be exempt under Rule 16b-3 and would be deemed regranted on the date of such amendment.

The Aug. 10 proposal would permit options to be transferable without losing their status under Rule 16b-3. There would be no limitation on the type of transfer. In its discussion of the proposals, the SEC staff indicates a concern as to the implications of permitting transfers without any limitation on the type of transfer and raises a number of questions in this regard. (For this discussion, see 59 Fed. Reg. 42,454.)

A second proposal, concerning the six-month holding period currently required by Rule 16b-3, dovetails, in part, with the first. It provides "that compliance with this paragraph (c)(1) is not required with respect to a disposition by a plan participant that is exempted by rule from 16(b) of the Act." Proposed Rule 16b-3(c)(1) (59 Fed. Reg. 42,461). The discussion includes the comment "that securities obtained in an exempt grant may be disposed of within six months if the disposition is a gift or otherwise exempt from short-swing profit recovery." In connection with this observation the staff asks for comment on the question "should the rules provide that the six-month holding period continue to run in the hands of the transferee?"

A third proposal would provide that the right to have securities withheld, upon the exercise of a stock option, for purposes of payment of (a) withholding taxes or (b) the exercise price is not itself a derivative security to which it relates. Accordingly, the exercise of such withholding right no longer will have to comply with the provisions of Rule 16b-3 relating to the exercise of a stock appreciation right in order to be exempt. Several provisions in Rule 16b-3 would be affected by this proposal. 3

A fourth proposal would liberalize the exemption for the cash settlement of a stock appreciation right for new publicly traded companies. Under the current rule a publicly traded company must have been subject to the reporting requirements of 13(a) of the Exchange Act for at least one year prior to the transaction and have filed all reports and statements thereby required. Under the proposal, the required filing of reports and statements would apply "for at least a year prior to the transaction or such shorter time as the issuer has been subject to [13(a) of the Exchange Act]." Proposed Rule 16b-3(e) (59 Fed. Reg. 42,461).

A fifth proposal would provide that "a director's fee," not just "an annual retainer fee" as provided under the current rule, may be elected in the form of securities or cash without disqualifying the status of the director as a "disinterested person" for purposes of Rule 16b-3(c)(2)(i). Thus a meeting fee or other director's fee could be included in the fees subject to the election. The requirement that the securities selected represent "an equivalent amount" in cash also would be deleted. Proposed Rule 16b-3(c)(2)(i)(C) (59 Fed. Reg. 42,461).

Estate Planning

Until about two years ago there was little reason for an executive to consider making a gift of a stock option for estate planning purposes. This was so because of technical tax and securities law obstacles.

In December 1992, in the Time Warner no-action letter discussed above, the SEC opened the door to permitting transferability of a stock option without disqualifying the plan involved under Rule 16b-3. As also discussed above, the proposed rule changes issued by the SEC on Aug. 10 would open the door still further to transferable options.

In 1993, the Internal Revenue Service addressed some of the tax concerns that faced the transferability of options. In June 1993 the IRS issued PLR 9349004 concerning a proposal by an executive to transfer stock options to a trust for the benefit of his descendants. The IRS ruled that:

1. The transfer of the options to the trust would not result in taxable income to the executive making the transfer.

2. Upon exercise of the options by the trustee, the executive (or his estate if he was then deceased) would be taxable under Code 83(a) and the employer would be entitled to a deduction under Code 83(h).

3. The basis of the stock acquired by the trustee upon exercise of an option would be the exercise price plus the amount of taxable income to the executive (or his estate) under Code 83(a) attributable to the exercise.

(In PLR 9421013 the IRS confirmed that the same result would apply if an executive transferred stock options to a son.)

In September 1993 the IRS issued PLR 9350016, which addressed gift and estate tax aspects of the transfer of a stock option. In the circumstances addressed by the ruling the taxpayer proposed to transfer stock options to an irrevocable trust for the benefit of his descendants. Each option carried an exercise price that was 110 to 115 percent of the market price on the date of grant. Each option had a five-year term and was not conditioned on continued employment. The ruling's discussion of the trust arrangement is sparse. It notes that the trustee is to have certain powers and that the executive "is not the trustee and cannot be appointed trustee of Trust."

The IRS held that:

1. Under Code 2501 the transfer of the stock options to the trustee constituted a completed gift.

2. The provisions of Code 2701(a), applicable to certain transfers of interests in a corporation or a partnership to a family member, did not apply.

3. The provisions of Code 2703(a), which provide for the disregard of certain options and other rights, did not apply.

4. The assets of the trust, including the stock options, would not be includible in the estate of the taxpayer for estate tax purposes.

The ruling concluded that it reached this result "because the options will have been irrevocably transferred, and A [the executive] has not retained any power or control over the Trust that would cause inclusion in A's gross estate under any provision of the Code."

Opportunity to Plan

With the favorable IRS rulings and with the SEC Time Warner no-action letter and proposed changes in Rule 16b-3, there is reason to look carefully at the estate planning opportunities associated with the gifting of a stock option to a family member, or to a trust for the same purpose.

Assuming a low value, or possibly no value, associated with the option at the time of gift, future growth in value of the stock may be taken out of the executive's estate with little, or no, gift tax (or, if applicable, use of the lifetime credit or the annual exclusion).

At the current marginal estate tax rate of 55 percent this benefit could be very valuable. If the executive pays the income tax on the exercise, thus eliminating from the estate the amount paid in respect of the income tax, a further economic benefit has been realized. However, before making such a gift an executive should have in mind the following:

1. The stock options covered by PLR 9350016 were exercisable in all events starting six months after grant and were not conditioned on continued employment. Would the IRS conclude that there had been a completed gift at the time the option was transferred if future exercise was conditioned on continued employment of the executive? In such a case would the gift be deemed to be completed, instead, at the time the option vested, or, if different, at the time it became exercisable? (Ordinarily, vesting and exercisability occur on the same date, or dates.) Or, in such a case, might the gift be considered incomplete until the option is exercised or employment is terminated with a fixed period left to exercise the option? What if the continued exercisability of the option after termination of employment is conditioned on the executive's not competing with his former employer? Even if the foregoing scenarios do not prevent a completed gift in connection with the original transfer, do they raise the possibility of future transfers of future increments in value being deemed transferred on the later date, or dates, on which the applicable conditions are satisfied?

2. PLR 9350016 does not address problems of valuation. At the present time, valuation of a stock option grant is an issue for accounting purposes (see discussion in next section). Methods of option valuation, such as the Black-Scholes model, can place significant value on a stock option at time of grant. There is very limited precedent in IRS rulings for the valuation of a stock option for gift and estate tax purposes4. While gift and estate tax precedent suggests that valuation of an option be limited to the "spread" (the amount by which the fair market value of the stock exceeds the exercise price of the option), it is possible that the IRS may review this issue. If the IRS did assert an option value in addition to the spread, if any, at time of option grant, the executive would face the possibility of incurring a gift tax (or use of a lifetime credit) at time of transfer of the option for which no, or little, benefit was obtained (i.e., if there was no significant future growth in the stock value).

The FASB Project

The status of the FASB project on accounting for stock compensation has been reported in prior columns.5 On June 30, 1993, the FASB issued an "Exposure Draft" proposing to recognize the "fair value" of an option on the date of grant as a compensation expense.

The Exposure Draft has been the subject of much controversy. Among more recent developments, public hearings were held by the FASB in March at which substantial criticism was directed at the proposal. In April, the FASB held a meeting with compensation and financial experts on the issue of determining a stock option's "fair value." Diverse opinions were expressed as to whether (and if so, how) stock options can be valued.

In May, the United States Senate voted 88-9 to adopt a non-binding sense-of-the-Senate resolution expressing opposition to the proposal.6 In June, as reported in his column on June 30, the FASB announced a delay in implementation of part of its proposal, specifically its pro forma disclosure requirement for 1994 financial statements.

On June 22 the FASB met and discussed issues relating to methods for measuring the value of a stock option. At its meeting on July 6, the FASB addressed the subject of measurement date. The Exposure Draft had proposed a "modified grant date" as the measurement date, an approach that uses the stock price on the date of grant but allows subsequent adjustments for service and performance-related factors that occur after grant date but before vesting date. By the end of the discussion, a number of the board members indicated interest in pursuing, as the measurement date, the vesting date as perhaps a better choice than the grant date.

At its meeting on July 27, the FASB continued discussing the issue of measurement date, and focused on vesting date measurement. The staff presented the concept of a "short-term option" method. This method would ignore the actual term of the option and deem the option term to be some short-term period, such as 90 days, after the vesting date. For example, using a 90-day short-term period, if a 10-year option were granted on Jan. 1, 1995, and vests 100 percent Jan. 1, 1996, the option would be valued as of Jan. 1, 1996, on the assumption that it would expire on March 31, 1996, even though the option is exercisable for nine more years. It is uncertain whether value would be measured by an option pricing methodology such as Black-Scholes or whether value would simply equal the intrinsic value of the option at vesting date (i.e., the spread) plus some amount representing time value.

In addition to a meeting held on Aug. 24, at which the measurement date and associated issues were further discussed, the FASB is planning to hold two meetings in September. Any tentative decisions made by the board as to the measurement method and date would be discussed at a "Task Force" meeting scheduled for Oct. 25.


1 Securities and Exchange Commission Release Nos. 34-34514, 35-26100, IC-20467, 59 Fed. Reg. 42,449 (Aug. 17, 1994) (the Proposing Release).

2 Note that restrictions outside of Rule 16b-3 may prevent a plan from permitting the gifting of a stock option. For example, an incentive stock option, under 422 of the Internal Revenue Code (Code), must be subject to transfer restrictions. Code 422(b)(5) states that an option will be treated as an incentive stock option only if, among other requirements, "such option by its terms is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him." However, most stock option plans provide for the grant of both incentive stock options and nonqualified stock options. The rules of Code 422 do not prevent a plan, whether or not it contains provisions for the granting of incentive stock options, from providing for the transferability of nonqualified stock options.

3 The Proposing Release would (i) add to Rule 16b-3(f)(2) a provision allowing withholding of shares by the issuer in order to pay the exercise price (in addition to the surrender or delivery to the issuer of shares in order to pay the exercise price) and (ii) add a new Rule 16b-3(f)(3) to allow the surrender or delivery to the issuer, or the withholding by the issuer, of an equity security to satisfy the tax withholding consequences of either the receipt or vesting of the equity security or the exercise of a derivative security related to the equity security. 59 Fed. Reg. 42,461. Moreover, Rule 16a-1(c) would be amended to expressly exclude from the definition of "derivative securities" the right or obligation to surrender a security, or to have a security withheld, upon exercise of a derivative security or vesting of restricted shares to satisfy the exercise price or tax withholding consequences of exercise or vesting. 59 Fed. Reg. 42,460.

4 In a 1953 ruling the IRS held that the difference between the exercise price of an option and the market price of the optioned stock subject to it, determined as of the applicable valuation date, was includible in the deceased employee's estate. There is no suggestion that the IRS considered the possibility of any value associated with the option right and there is no indication of the length of the period following death during which the estate could exercise its right. Rev. Rul. 196, 1953-2 C.B. 178.

5 See this column, New York Law Journal, March 29, 1993; June 30, 1993, and June 30, 1994.

6 There is currently pending legislation that would effectively overrule the proposal if adopted. Equity Expansion Act of 1993, S. 1175, H.R. 2759, 103d Cong., 1st Sess. (1993).