Strategies for Charitable Giving of Employee Stock Options

Due to the widespread use of stock options today, advisors should have a basic understanding of the rules governing contributions of employee stock options to charity.

A stock option is a contractual right given by a corporation to an employee (or independent contractor) to purchase the corporation’s stock. This right extends for a stipulated period of time and gives the holder the right to buy the stock at a fixed price. This price is usually the fair market value of the stock at the time the option is granted. The employee’s ability to exercise (purchase stock at the option price) is deferred into the future and may be contingent on continued employment.

There are two types of stock options: Incentive Stock Options (ISO), also referred to as “statutory options,” which meet requirements for favorable federal income tax treatment; and Non-Statutory Stock Options (NSO), also called “non-qualified” options. NSOs are generally more flexible than ISOs, but their tax treatment is less favorable. The majority of existing stock options today are NSOs because the number of ISOs that can be issued to an employee is limited.

When considering a charitable contribution of stock options, donors must first evaluate what type of options they own and how long they have held the options. Additionally, they need to review the terms of the stock option plan or agreement to determine whether a transfer of the option is possible.

Incentive Stock Options (ISO)

A donor cannot directly donate incentive stock options (ISOs) during his or her lifetime.[1] However, he or she may exercise the ISOs and give the actual shares as a gift, just like any other shares.

If a donor has held the shares for the mandatory holding period and exercises the ISO, he or she can claim a fair market value deduction and avoid recognition of any capital gain. Neither the granting nor the exercise of an ISO will trigger income tax if the employee holds the shares for a minimum holding period and does not exercise more than three months after leaving employment. Therefore, ISOs are very attractive because the employee does not recognize income until he or she finally sells the shares of stock received from the exercise. To achieve the best tax outcome, the employee must hold the shares: 1) for at least two years from the date the option was granted; and 2) one year from the date the option was exercised.[2] Then, the shares can be gifted to charity as “long-term gain” property.

Example:  Harold Thompson is a Vice President of Good Food Inc., which gave Harold the option to purchase company stock for $100 per share. The options are qualified as ISOs. The granting of the options does not trigger a taxable event.

When Good Food, Inc. stock is valued at $500 per share, Harold decides to exercise his option. Harold pays $100 per share. The exercise of the ISO does not trigger any income tax consequence, but if Harold is subject to Alternative Minimum Tax (AMT), he will have $400 of ordinary income per share. With ISOs, AMT concerns may arise upon exercise, and a donor should assess his or her individual tax situation to determine whether the AMT will apply.

If Harold holds the shares for more than a year, his stock becomes long-term capital gain property. After two years of holding the stock, Harold sells the shares for $900 each. As a result, he realizes $800 of long-term capital gain ($900 – $100). If Harold donates any of the shares of Good Food Inc., to a public charity, he avoids the capital gains taxes and is able to deduct the gift valued at $900 per share. Therefore, the “cost” of making this gift for Harold is low. 

Bequest of ISOs and ISO Shares

If the plan allows, the same tax treatment is applicable to the exercise of an ISO and not lost upon the death of the employee. The ISO plan may allow the ISO to be exercised by the employee’s estate. Thus, bequeathing an ISO to charity will generate a charitable deduction for the estate.

Non-Statutory Stock Options (NSO)

NSOs are considered compensation received by the employee in exchange for services and are includable in the employee’s gross income.[3] NSOs are subject to taxation as income upon either: 1) the initial grant to the employee if the option has a readily ascertainable value; or 2) when the NSO is exercised.[4]

Unlike ISOs, when an employee exercises an NSO, it becomes a taxable event. The employee realizes ordinary income equal to the difference between the exercise price and the current fair market value of the stock. Since the income is taxed immediately, there is no minimum holding requirement.

NSOs do not offer the possibility of avoiding tax on the gain inherent in the options. Therefore, gifting the NSOs to charity during a donor’s lifetime has a less favorable tax treatment. The employee will recognize tax as ordinary income when the charity exercises the NSO and to make matters worse, the donor may not have a charitable deduction to offset the ordinary income.

On the other hand, if the employee donates the shares received from exercising an NSO, he or she will receive a charitable deduction that can be used to offset the income recognized at exercise.[5]

Tip: Since the donor must recognize the income upon exercise, it is often a better strategy for a donor to use a different asset (such as highly appreciated stock or real estate) to make a gift that will create a significant deduction to offset the income generated from exercising the NSOs. 

Funding a Charitable Remainder Trust (CRT) with NSOs

Although there is no method to avoid the ordinary income recognized from exercising NSOs, many employees hold employer stock that they acquired in previous years. In this case, the basic strategy is to create a Charitable Remainder Trust (CRT) and transfer the oldest and most highly appreciated stock into the CRT. If the employee plans to work a number of years and does not currently need income, he or she can establish a Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT).

At the time the employee transfers the oldest stock to the unitrust, he or she exercises new options. The charitable income tax deduction available for the contribution to the unitrust will partially offset the ordinary income recognized upon exercise of the stock options.

Example: Harold Thompson earns approximately $500,000 per year and receives NSOs. Harold has exercised his NSOs regularly in previous years and has large holdings of appreciated stock in his company, Good Food, Inc. This year, Harold plans to exercise NSOs that will enable him to purchase stock with a current fair market value of $1,000,000 for $100,000. When Harold exercises his NSOs this year, he must recognize $900,000 of ordinary income.

Harold exercises his NSOs and establishes a NIMCRUT. He contributes $1,000,000 of other long-term-gain shares of Good Food, Inc. to the unitrust and receives a $680,000 deduction to help offset the $900,000 of ordinary income from the exercise of the NSOs.

Harold’s NIMCRUT is invested for growth with very low income and dividends, so all of the sold and diversified stock in the trust grows tax-free each year and does not increase Harold’s income. When Harold retires, the NIMCRUT can pivot and invest for income, or a FLIP triggering event could be used to convert it into a standard CRUT.

Bequest of NSOs

Although a lifetime gift of NSOs is not particularly advantageous, a testamentary transfer of NSOs to charity may provide some real benefits to the donor. Like retirement plan assets, stock options do not receive a stepped-up basis at death. All gains recognized upon the subsequent exercise of the NSOs will be deemed “income in respect of a decedent” (IRD) and included in the gross income of the person or entity that receives and exercises the option.[6] Since a qualified charity is tax exempt, it does not owe IRD.

In conclusion, while the tax code does not favor the donation of stock options, these strategies may provide tax benefits that advisors should consider.

---

[1] IRC 422(b)(5)
[2] IRC § 422(a)(1)
[3] Treas. Regs. §§ 1.61-15, 1.421-6.
[4] IRC § 83(a)-(b); Treas. Regs. § 1.83-7
[5] The deduction will be equal to either the donor’s basis in the shares if the shares are transferred within 12 months of the exercise date, or fair market value if the donor transfers the shares after 12 months
[6] IRC § 691(1)(C); Treas. Reg. § 1.83-1(d) also review PLR 200002011 that allowed a donor’s estate to avoid income by transferring to charity