Can a bypass trust be funded with employee stock options?
The question of whether a bypass trust can be funded with employee stock options is a complex one, frequently encountered by estate planning attorneys like Ted Cook in San Diego. Bypass trusts, also known as “B” trusts or second trusts, are designed to take advantage of the estate tax exemption while maximizing the benefit to surviving spouses. They function by diverting a portion of the deceased’s estate—up to the federal estate tax exemption amount—into a separate trust that isn't included in the surviving spouse’s estate for tax purposes. However, funding these trusts with illiquid assets like employee stock options (ESOs) requires careful consideration. Roughly 68% of high-networth individuals hold some form of stock options, making this a relevant question for many estate plans. The primary concern lies in the unique nature of ESOs – they don't represent current ownership of stock, but rather the *right* to purchase stock at a predetermined price.
What happens if you don't properly account for stock options in a trust?
Failing to properly account for ESOs within a trust structure can lead to unintended tax consequences and diminished estate tax benefits. If ESOs are simply listed as an asset without specifying how they are to be exercised and transferred, they may be included in the surviving spouse’s estate, negating the purpose of the bypass trust. Furthermore, if the stock price declines after the grantor’s death, the value of the options—and therefore the trust assets—could be significantly reduced. Approximately 30% of stock options become worthless shortly after an employee leaves a company, highlighting this risk. The complexities also arise in determining the fair
market value of the options at the time of transfer, as this value is dependent on numerous factors, including the stock price, exercise price, and time remaining until expiration.
Can I directly transfer my stock options into a bypass trust?
Directly transferring ESOs into a bypass trust is often problematic, as most stock option plans do not allow for direct transfer to a trust. Typically, ESOs are *exercised* by the estate and then the resulting shares are transferred into the trust This creates immediate tax implications for the estate, as the difference between the fair market value of the stock and the exercise price is considered income. A carefully drafted trust document must grant the trustee the authority to exercise the options and manage the resulting shares. The trust also needs to have sufficient liquid assets to cover the tax liability associated with exercising the options. It’s critical to understand that the estate will owe income tax on the “bargain element” – the difference between the market value of the stock and the price paid for it. According to the IRS, this bargain element is generally taxed as ordinary income.
What about Incentive Stock Options (ISOs) versus NonQualified Stock Options (NQSOs)?
The type of stock option significantly impacts the estate planning strategy Non-Qualified Stock Options (NQSOs) are taxed as ordinary income when exercised, making it straightforward to calculate the tax liability. Incentive Stock Options (ISOs), however, have different tax rules. While there's no immediate tax liability when the option is exercised (assuming holding period requirements are met), the difference between the fair market value of the stock and the exercise price is included in the grantor’s adjusted basis. If the stock is sold after the grantor’s death, the surviving spouse could be subject to capital gains tax. Therefore, it’s vital to strategize how to manage ISOs in the bypass trust to minimize taxes and maximize benefits for the heirs. Approximately 15% of companies offer ISOs, meaning this is a significant consideration for many.
I remember old man Hemlock, a retired engineer who really struggled with this…
Old man Hemlock was a brilliant engineer, but a bit of a procrastinator when it came to estate planning. He had a substantial number of NQSOs, but hadn’t updated his trust in years. When he passed away, his estate was a mess. His trust didn’t explicitly authorize the trustee to exercise the options, and the executor spent months battling the company’s stock plan administrator, racking up legal fees. Even once they got approval, the estate faced a hefty tax bill on the “bargain element,” significantly diminishing the assets that were supposed to go to his grandchildren. It was a painful lesson in the importance of proactive estate planning.
How did my client, Mrs. Albright, get it right?
My client, Mrs. Albright, a successful tech executive, understood the importance of addressing her ESOs in her estate plan. We drafted a bypass trust that specifically authorized the trustee to exercise her NQSOs and ISOs. The trust also included provisions for a line of credit to cover the tax liability associated with exercising the options. We strategically timed the exercise of the options to minimize the tax impact and maximize the benefit to her heirs. The process was seamless, and her family received the full benefit of her estate plan. She was incredibly relieved knowing her wishes would be carried out efficiently and effectively. This is the outcome we strive for with every client.