Stock options are a source of significant wealth — both the options themselves and the stock acquired upon the exercise of the option can be valuable assets. But stock options do not always lend themselves to effective charitable giving. They’re subject to complex taxation rules and, to a lesser extent, rules under the Securities Exchange Act of 1934. It’s important to understand when and to what extent these assets make effective charitable gifts.
Stock options are the right to acquire shares of stock at a set price (the “strike price”) for a specified period of time. For instance: An employer might grant an employee the right to acquire 100 shares of stock at $10 a share for a five-year period. If the price of the stock goes up to $25 per share during this five-year period, the value of the right to purchase a share of stock at $10 also increases.
There are two types of stock options: incentive stock options and non-qualified stock options. ISOs have income tax advantages to the owner of the stock option, which NQSOs are not afforded. On the other hand, NQSOs are not subject to certain limitations that apply to ISOs. NQSOs also provide the employer with a deduction, which ISOs generally do not.
The ins and outs of income tax
When an employer grants an ISO to an employee, no income tax is recognized at that time. The exercise of the ISO by the employee is not an income tax event for the regular income tax either. However, the spread between the strike price and fair market value of the stock at the date of exercise is a tax preference item for alternative minimum tax purposes and can create an alternative minimum tax liability. If the alternative minimum tax does not apply, and the ISO holding period rules are met, only when the employee sells the stock acquired by the exercise of the ISO will an income tax be triggered. The tax will be on the difference between the strike price and the sale price. An example of the ISO rules is as follows.
On Jan. 1, 2004, X Corp. grants Rachel, an employee of the company, an ISO under which she can purchase 100 shares of X stock at $10 per share over a 10-year period. On July 10, 2004, when the fair market value of X stock is $20 per share, Rachel exercises the option to purchase all 100 shares by paying $1,000 for stock that has a fair market value at the time of $2,000. Rachel recognizes no income tax consequences upon the grant or exercise of the ISO.
Three years later on Nov. 30, 2007, Rachel sells the 100 shares of X stock for $25 per share. The difference between the $2,500 sale price and the $1,000 tax basis is long-term capital gain because Rachel held X stock for more than one year after the exercise of the ISO. But as noted in the next section, simply holding the stock for one year is no guarantee of capital gain treatment; ISOs cannot be transferred by the employee to any other individual or to a charity other than by a will, or pursuant to the laws of descent and distribution. Thus ISOs cannot be used to make lifetime charitable gifts. An ISO that passes at the death of the employee continues to be treated as an ISO in the hands of the beneficiary, including if the beneficiary is a charity. However, because a charitable beneficiary is a tax-exempt entity, the income tax advantages of an ISO could be lost. For this reason, donors may be well advised to use ISOs for non-charitable purposes and fund charitable gifts with other assets.
Transferral of stock
While ISOs cannot be transferred during the owner’s lifetime, the stock acquired through the exercise of the ISO is not subject to the same restrictions. Care should be taken to ensure that the gift of stock will not be treated as a disqualifying disposition. If the stock is donated to a charitable organization within one year of the exercise of the ISO, or within two years of the date the employee was awarded the ISO, the donor will realize ordinary income at the time of the donation equal to the difference between the fair market value of the stock on the date of transfer and the strike price. In addition, if the disqualifying distribution results from the contribution being made within one year of ISO exercise, the charitable income tax deduction will be limited to the donor’s tax basis in the contributed stock.
In the earlier example, had Rachel sold the 100 shares of X stock on Nov. 10, 2004, the sale would constitute a disqualifying disposition (because the sale occurred within two years following the grant of the ISO). Accordingly, Rachel must recognize ordinary income equal to $1,000, which is the excess of the $2,000 fair market value of X stock upon exercise over the $1,000 strike price. Only the difference between the $2,500 sale price and the $2,000 fair market value upon exercise will be treated as capital gain.
Taxing the NQSO
As upon the grant of an ISO, an employee does not recognize income upon the grant of a NQSO. However, when the NQSO is exercised, the employee will recognize ordinary income equal to the difference between the fair market value of the stock when the NQSO is exercised over the strike price.
The transfer of a NQSO to a charitable organization is not a taxable event to the employee. However, the exercise of the NQSO by the charity will create a taxable event to the employee. This is because the employee will recognize income when the NQSO is exercised, even though the employee no longer owns the NQSO and doesn’t receive the stock. When the charitable organization exercises the NQSO, the employee will recognize ordinary income equal to the fair market value of the stock when the NQSO is exercised over the strike price. Unlike the transfer of other types of appreciated assets, in which a transfer to charity will enable the donor to avoid paying tax on the appreciation, the transfer of an NQSO requires the donor to pay the tax even though the stock is held by a charity. To add insult to injury, the charitable income tax deduction appears to be limited to the employee’s tax basis in the NQSO. Because the employee does not recognize income when the NQSO is granted, the tax basis is, as a rule, zero.
Transfer to charity
Unlike an ISO, stock acquired through the exercise of a NQSO is not subject to the disqualifying disposition rules and may be transferred to charity at any time. If the transfer occurs within one year after acquisition, the employee will be entitled to a charitable deduction equal to the lower of the fair market value of the stock on the date of contribution to the charitable organization or the fair market value of the stock on the date the option was exercised.
If the transfer occurs more than one year after acquisition, the employee will then be entitled to a deduction equal to the fair market value on the contribution date.
Finally, tax considerations aside, the employer plans that govern the particular stock option plan should be reviewed to ensure that a transfer is not barred by the plan itself.
Clearly, the gift of an ISO or a NQSO to a charitable organization or the gift of stock acquired through the exercise of these options benefits the organization. The difficulty arises in the fact that these sorts of gifts might not be as advantageous to the donor.
Kathleen A. Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa B. Petkun is a partner in the Tax Department of Pepper Hamilton.