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.
