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Financial Planning > Trusts and Estates > Estate Planning

A few good reasons why stock options belong in estate plans

By Tom Nawrocki

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Assets that are expected to appreciate in value are always a good thing to include in an estate plan, which is one reason stock options have become an increasingly popular option. Stock options did not figure prominently in an executive’s estate planning until 1996. At that point, the Securities and Exchange Commission amended its rules that required most options to be non-transferable in order to take advantage of the exemption from liability.

Not surprisingly, that change resulted in stock options becoming much more desirable to executives and their heirs. In recent years, stock options have become more and more common — a recent report by the investment firm Sanford C. Bernstein Co. estimates that 45 percent of employee compensation is distributed in the form of stock options. And more and more estate planners are using these assets in the plans they’re setting up.

Here’s why stock options can be so useful to an estate plan: Say a client receives an option to buy 10,000 shares at $50 per share, on a stock that is currently trading at $40. The client doesn’t have to pay any tax upon being granted those options. It’s not until those options are exercised and the stock is purchased, that a taxable event happens. That transaction generates taxable income equal to the difference between the stock price set by the option and the market price of the stock. So if the client transfers the option to an heir or to a trust, the taxable value of the gift will be relatively low, and the gift tax will be minimal.

In the best-case scenario, those shares will appreciate greatly over a long period of time. If we assume that the market price of those shares has reached $100 when the option is exercised, the heir will own shares worth $1 million. There won’t be any tax due on the appreciation until the heir or the trust sells those shares.

That’s the point at which income must be recognized — when the stock option is exercised. The difference between the exercise price and the stock’s fair market value is treated as ordinary income, and the income tax falls on the individual who received the option as compensation, even if the option has been transferred to an heir. That can be a double advantage: Payment of the income tax decreases the client’s eventual estate tax obligation, but it increases the basis of the stock for the heir, reducing their eventual tax burden.

But there are some common pitfalls that estate planners need to be aware of:

  • In most cases, it is advantageous for the client to move very quickly. It’s important to transfer the options to the heirs or to a trust when their value is low as possible. The most valuable way to address the issue of options isn’t to wait until the estate plan is created and then evaluate whether it makes sense to put options into them. Rather, the client is usually better off looking into an estate plan as a vehicle for the stock options as soon as they are granted.

  • The immediate tax consequences of a grant of stock options can be significant. The client should be prepared to satisfy a potentially large withholding income tax obligation as soon as the options are granted.

  • Some companies have grown concerned that the ability to transfer stock options diminishes them as an incentive. As a result, some corporations have imposed restrictions on exactly who the options may be transferred to, such as limiting it to immediate family members, or have begun requiring transfers to be approved by a corporation’s compensation committee. The client should make sure these restrictions are satisfied (or are nonexistent) before making use of the option in his or her estate plan.

  • Any compensation in unexercised, restricted stock that remains unreported upon the client’s death is to be considered “income in respect to a decedent,” and is treated the same as any balances remaining in qualified retirement plans and IRAs. There can be significant income and estate tax consequences as a result. 

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