STOCK OPTIONS

Practical Charitable Planning for Employee Stock Options

Author: RICHARD L. FOX, ATTORNEY

RICHARD L. FOX is an attorney and a partner in the law firm of Dilworth Paxson LLP, in Philadelphia (www.dilworthlaw.com), where he heads the Philanthropic and Nonprofit Practice Group. Mr. Fox's practice areas include income taxation, charitable giving, private foundations, family planning, and trusts and estates. He is also a member of the editorial board of Estate Planning and the author of the treatise Charitable Giving and Solicitation, a Warren, Gorham & Lamont/RIA publication. He may be contacted at rfox@dilworthlaw.com.

Because of the complex rules governing the taxation of stock options, careful planning is essential when considering a charitable contribution of stock options or of stock acquired through the exercise of stock options.

Employee stock options have traditionally been one of the most popular forms of deferred compensation used by corporations. In light of the enactment of the American Jobs Creation Act of 2004 (“AJCA”), which places substantial restrictions on other forms of deferred compensation, stock options are likely to become even more widely used as a means of compensating employees. ¹ Given the substantial wealth often associated with employee stock options and the stock acquired upon the exercise of such options, both planners and charities should be aware of the potential adverse tax ramifications when donors are contemplating using inherently valuable stock options to further their philanthropic giving. This article explores issues to consider in this context, including the potential traps that exist for an unwary donor who contributes to a charity employee stock options or stock acquired upon exercise of the options, without fully analyzing or planning for the resulting tax consequences. ²

Background on employee stock options

An employee stock option provides a corporate employee with a contractual right to purchase stock from the corporation at a specific price, typically referred to as the “strike price,” over a stated period of time. ³ Because the strike price remains fixed, an employee stock option becomes inherently more valuable as the fair market value (“FMV”) of the stock subject to the option increases over the term of the option.

The Internal Revenue Code generally creates two categories of employee stock options: incentive stock options (“ISOs”) and nonqualified stock options (“NQSOs”). ⁴ ISOs provide certain income tax advantages that are not available to NQSOs, although, in return for such favorable treatment, ISOs are subject to certain conditions and limitations not applicable to NQSOs. ⁵

In addition to the rules applicable under the Internal Revenue Code, ISOs and NQSOs are subject to the terms and conditions of their respective underlying plan documents. These plan documents generally include provisions aimed at furthering the underlying purpose of granting employee stock options, which is to provide the employee with an incentive to contribute to the continued growth of the corporation's value over the long term. For this reason, plan documents often impose vesting requirements before the options can be exercised, and may prevent the employee from transferring the options during life, including transfers to charity. ⁶ It is of the utmost importance, therefore, when planning for the use of stock options to consider carefully the specific terms and conditions of the applicable plan documents.

ISOs, by their terms, may not be transferred by an employee during life, thereby preventing the possibility of an inter vivos transfer of these options to any transferee, including a charity. ISOs may be transferred by a testamentary disposition, however. Although ISOs cannot be contributed to a charity during life, the stock acquired upon the exercise of an ISO can be contributed, subject to certain holding period requirements in order to avoid triggering negative income tax consequences.

While a plan document may permit inter vivos transfers of NQSOs to various permitted transferees (including charities), or the plan may be amended to provide for such transfers, the income tax consequences associated with NQSOs cannot be transferred, so the employee remains liable for the income tax associated with the exercise of an NQSO—no matter when the options are exercised or by whom. ⁷ This may produce a favorable result if an NQSO is transferred to a child or other family member the employee intends to benefit. ⁸ On the other hand, this could lead to a disastrous and presumably unanticipated result for an unwary donor who contributes NQSOs to his favorite charity, only to learn subsequently that he is personally liable for substantial income taxes resulting from the charity's later exercise of the options.

Moreover, unless the employee retains control over the exercise of the NQSOs after their contribution, it appears that any available charitable income tax deduction attributable to the contribution of an NQSO is limited to the employee's tax basis (which is likely to be zero), despite the ordinary income required to be recognized by the employee upon exercise by the charity. For this reason, NQSOs are generally not good candidates for lifetime charitable giving, although they are an ideal asset for testamentary charitable planning. Nevertheless, it is possible to combine other charitable giving techniques with the exercise of NQSOs during an employee's lifetime, so as to further an employee's philanthropic intentions while sheltering the income tax liability otherwise triggered upon the exercise of the NQSOs.

ISOs

Income tax consequences generally. An ISO is an option granted pursuant to a plan adopted by an employer that meets all the statutory requirements imposed under Section 422 . ⁹ No income tax consequences result when an ISO is granted to the employee. Similarly, there are no income tax consequences to the employee upon the exercise of an ISO, even though the FMV of the stock acquired upon exercise may be substantially greater than the strike price paid for the stock. ¹⁰ Instead, only a subsequent disposition of the stock triggers income tax consequences, and the income realized from such disposition generally is characterized as capital gain.

If the employee disposes of the stock within two years from the date of the grant of the option or within one year after the stock is acquired upon exercise of the option, a “disqualifying disposition” results. In that case, the employee must recognize ordinary income ¹¹ in the year when the disqualifying disposition occurs, in an amount equal to the excess of the FMV of the stock at the time the ISO was exercised over the strike price paid for the stock. ¹² This income, which is added to the tax basis of the stock acquired on exercise, ¹³ is equal to the bargain element of the stock purchase.

Example 1. On 1/1/05, the ABC Corporation grants Henry, an employee of the company, an ISO under which Henry can purchase 1,000 shares of ABC stock at $10 per share over a ten-year period. On 6/30/05, when the FMV of the ABC stock is $20 per share, Henry exercises the option to purchase all 1,000 shares by paying $10,000 for stock having an FMV at that time of $20,000. Henry recognizes no income tax consequences upon the grant of the option or upon the exercise of the option. ¹⁴

Example 2. The facts are the same as in Example 1, except that Henry sells all 1,000 shares of the ABC stock on 11/30/06 for $25 per share. Because the sale of the ABC stock occurs within two years following the grant of the option, the sale constitutes a “disqualifying disposition.” Accordingly, for the taxable year 2006, Henry must recognize ordinary income equal to $10,000—i.e., the excess of the $20,000 FMV of the ABC stock upon exercise over the $10,000 strike price; the $20,000 FMV represents Henry's tax basis in the 1,000 shares of stock acquired upon exercise of the option. The difference between the $25,000 sale price and the $20,000 tax basis is long-term capital gain because Henry held the ABC stock for more than one year after the exercise of the ISO.

Example 3. Assume the same facts as in Example 1, except that Henry sells all 1,000 shares of the ABC stock on 1/1/09 for $35 per share. In this case, Henry has held the stock for a sufficient period of time (i.e., more than two years after the grant of the ISO and more than one year after the acquisition of the stock upon exercise of the ISO) to avoid causing the sale to constitute a “disqualifying disposition.” Accordingly, for the taxable year 2009, Henry recognizes long-term capital gain on the sale of the stock equal to $25,000—i.e., the excess of the $35,000 sale price over the $10,000 strike price paid by Henry. Henry recognizes no ordinary income.

Prohibitions on lifetime transfers of ISOs to charity. An ISO is not transferable by the individual holding the option other “than by will or the laws of descent and distribution,” thereby foreclosing the possibility of lifetime transfers of ISOs to charity. ¹⁵ If an employee dies while holding an ISO that is transferable by will or the laws of descent and distribution, the option retains its status as an ISO. Consequently, the same favorable ISO rules apply to the estate of the employee or anyone who has acquired the ISO as a result of a bequest or inheritance or otherwise by reason of the death of the employee, subject to two exceptions which liberalize the rules otherwise applicable to an employee. ¹⁶

Under the first exception, the option need not be exercised within three months of the termination of the employment of the deceased employee. ¹⁷ Second, the estate or other person acquiring the ISO is not subject to the holding period requirements otherwise applicable in order to be accorded ISO tax treatment. ¹⁸ Provided the plan otherwise permits, an ISO may be used as a funding source for a charitable bequest, although the retention of ISO tax benefits is not particularly relevant to a charity, which is exempt from tax under Section 501(a) . ¹⁹ Stock previously acquired upon the exercise of an ISO can be bequeathed to charity upon an employee's death without resulting in a disqualifying disposition, no matter how long the employee held the stock following the exercise of the ISO. ²⁰

Contributions of stock acquired pursuant to exercise of ISOs. Although an ISO cannot be transferred to a charity during an employee's lifetime, the stock acquired pursuant to the exercise of an ISO can be contributed to charity as an inter vivos gift. In determining whether a “disqualifying disposition” occurs, however, a “disposition” is broadly defined to include “a sale, exchange, gift, or a transfer of legal title.” ²¹ Although certain transactions are excepted from the meaning of “disqualifying distribution” under Section 424(c)(1) , a contribution to charity is not one of the enumerated exceptions. Accordingly, a charitable contribution of stock results in a disposition for this purpose. ²²

Stock acquired pursuant to an exercise of an ISO, which is subsequently contributed to a charity within two years from the date the option was granted or within one year after the stock was acquired, therefore, results in a disqualifying disposition. If a disqualifying disposition occurs as a result of a charitable contribution of stock acquired through exercise of an ISO, the income tax consequences are as follows:

• The employee is required to recognize ordinary income in the taxable year of the contribution in an amount equal to the excess of the FMV of the stock at the time the ISO is exercised over the strike price.
• If the stock contributed to charity was held for more than one year following the exercise of the option, the available charitable income tax deduction may be based on the FMV of the stock at the time of the contribution, ²³ even though a disqualifying disposition occurs.
• If the stock contributed to charity was held for one year or less following the exercise of the option, the maximum charitable income tax deduction is the FMV of the stock at the time the stock option is exercised, because any subsequent appreciation from the date of exercise through the date of the contribution would be subject to the reduction rules of Section 170(e)(1)(A) . ²⁴

Because a disqualifying distribution can result upon a charitable contribution of stock acquired pursuant to an ISO, such stock should generally be held for more than two years from the date of the grant and one year from the date of the exercise before it is contributed. ²⁵ Otherwise, the donor will recognize ordinary income upon the contribution of the stock. In addition, if a disqualifying distribution results from the contribution occurring within one year of the exercise of the ISO (as opposed to resulting from the contribution being made within two years of the date of the grant of the ISO), the amount of the charitable income tax deduction will be limited to tax basis, notwithstanding that the FMV of the stock may be significantly greater. ²⁶

The above rules apply to transfers to charitable split-interest trusts as well. For example, in Ltr. Rul. 9308021 , the taxpayer proposed to transfer to a charitable remainder trust (“CRT”) stock acquired pursuant to the exercise of an ISO. Where the stock to be contributed would not meet the requisite holding period, the IRS ruled that the “Taxpayer must include in gross income the difference between the fair market value of the stock at the date the options were exercised and the exercise price.” The IRS also found that this “amount will be includible in the Taxpayer's gross income for the taxable year in which the stock is transferred to the trust.” Where the ISO requisite holding period would be met, the IRS ruled that "no income will be recognized by the Taxpayer” upon the transfer to the CRT.

NQSOs

NQSOs may be transferred during an employee's lifetime because, unlike ISOs, there is no prohibition on lifetime transfers under the Internal Revenue Code. Nevertheless, the specific terms of the stock option plan govern the permissibility of transfers of stock options issued under the plan and, therefore, such terms should be reviewed prior to any contemplated transfer. For example, the terms of the plan may allow transfers only to family members or to legal entities established for the benefit of family members, thereby preventing transfers of the stock options to charity. Alternatively, the terms of the plan may permit charitable transfers, but only with the consent of the board of directors or a committee of the board.

Unlike an ISO, the income tax consequences of which are governed by Sections 421 and 422 , the income tax consequences with respect to NQSOs are governed by Section 83 . Under Section 83 , an employee generally does not recognize taxable income upon the grant of a nonqualified stock option. An exception to this general rule exists where the stock option has a readily ascertainable value, which requires that it be actively traded on an established securities market or meet all the following four conditions: (1) the option is transferable; (2) the option is exercisable immediately in full; (3) the option or the property subject to the option is not subject to any restriction or condition (other than a lien or other condition to secure the payment of the purchase price) which has a significant effect on the FMV of the option; and (4) the FMV of the option privilege is readily ascertainable. ²⁷

As a general rule, NQSOs granted to employees are not the type of options that are actively traded on an established securities market and will fail one or more of the above four requirements. Hence, in the usual situation, no taxable income will be recognized by an employee upon receipt of an NQSO. Unlike in the case of an ISO, when an employee subsequently exercises an NQSO, ordinary income must be recognized in an amount equal to the excess of the FMV of the stock at the time of exercise over the strike price. ²⁸

As further discussed below, although NQSOs are not attractive for lifetime charitable giving, they are excellent candidates for testamentary bequests to charity. Moreover, the stock acquired on the exercise of an NQSO can be an ideal asset for charitable giving. Even if such stock is not held for a one-year period prior to its contribution to charity, the income tax charitable contribution deduction will equal the FMV of the stock on the exercise (or the FMV of the stock at the time of the contribution, if lower). ²⁹ If the stock is held for one year following exercise, the deduction will be based on the FMV of the stock on the date of the contribution, thereby allowing any appreciation realized subsequent to exercise to be deducted.

Consequences of inter vivos transfer of nonqualified stock options to charity. The Regulations under Section 83 address only the tax effects of a sale or other disposition of an NQSO “in an arm's length transaction.” ³⁰ Neither Section 83 nor the accompanying Regulations address the tax consequences of a transfer of an NQSO in the context of a non-arm's-length transaction, such as a contribution to charity. ³¹ The IRS has ruled, however, that a contribution of an NQSO to charity does not trigger the immediate recognition of income to the employee, although the employee continues to be subject to Section 83 when the option is ultimately exercised by the charity. ³²

Thus, although the contribution of the NQSO will not result in immediate recognition of income, the employee will not avoid recognition of the ordinary income associated with the exercise of an NQSO by contributing it to charity, even though the charity—rather than the employee—will subsequently exercise the option on its own behalf. ³³ Instead, when the charity ultimately exercises the option, the employee must recognize ordinary income (as compensation) equal to the excess of the FMV of the stock at the time of exercise over the exercise price in the taxable year of exercise.

Because the contribution of NQSOs does not allow an employee to escape taxation upon the exercise of the options, NQSOs do not offer the tax benefits associated with contributions of other types of property, where the donor avoids tax on the built-in gain attributable to contributed property. Further, if NQSOs—which have been held for over a year—are then contributed to charity, the available charitable income tax deduction nonetheless appears to be limited to the tax basis of the options, given that the Section 170(e)(1)(A) reduction rules should be applicable. ³⁴

Assuming that the NQSO was not taxed to the employee upon its grant (the usual case), the employee will generally have no tax basis in the stock options, thereby reducing the charitable deduction to zero (notwithstanding that the NQSOs might otherwise have substantial value on the date of the contribution). Moreover, when the NQSOs are actually exercised and the employee recognizes ordinary income equal to the excess of the FMV over the strike price paid by the charity, a charitable income tax deduction would not appear to be available to the employee at such time, either for the amount of the income recognized by the employee or the tax required to be paid. ³⁵

The inability of the employee to take a charitable deduction upon the exercise of the option by the charity is inconsistent with the application of the Section 170(e)(1)(A) reduction rules upon the contribution of the NQSO. Furthermore, from a policy standpoint, the employee should be entitled to a charitable deduction equal to the compensation recognized by the employee upon the exercise of the option by the charity. ³⁶ From a technical standpoint, however, where the employee has, in fact, previously transferred all rights and title to the NQSOs to the charity, so that the transfer is fully complete for income tax purposes, no additional charitable deduction would appear to be available upon the subsequent exercise of the options by the charity, even though the income is required to be recognized by the employee upon the subsequent exercise of the options by the charity. ³⁷

Although there is no clear authority on these issues, the likely result of contributing an NQSO to charity is that the donor is eligible only for a charitable income tax deduction in the year of the contribution limited to the tax basis of the options (presumably zero). This result is coupled with the fact that the donor recognizes ordinary income in the year in which the charity exercises the options, with no offsetting charitable deduction in that year. These negative consequences obviously make an NQSO a rather unattractive candidate for charitable giving. ³⁸

One alternative for avoiding such consequences is set forth in Ltr. Rul. 9737016 . There, NQSOs were transferred to a charity, but the transfer was not complete for income tax purposes because the employee retained a continuing inter vivos right to veto any proposed exercise of the options by the charity. ³⁹ The employee also compelled the charity to pay the applicable withholding taxes attributable to the taxable income required to be recognized by the employee on the exercise of the options by the charity. ⁴⁰

Because the transfer was not complete for income tax purposes, no charitable deduction was available on the transfer of the NQSOs to the charity. ⁴¹ The IRS ruled, however, that the gift of the options was complete when the charity exercised the options. At that time, said the IRS, the employee was entitled to a charitable deduction based on the FMV of the stock, without reduction under Section 170(e)(1)(A) , given that the employee recognized income at the same time he was considered to have made a completed transfer of the options to the charity. ⁴² Thus, although the employee was taxed on the excess of the FMV of the stock on the exercise of the options by the charity, an offsetting charitable deduction based on FMV was available. The actual allowable deduction was equal to the FMV of the stock upon the exercise of the NQSO less the strike price paid by the charity, and was further reduced by the amount of the withholding taxes paid by the charity for which the employee would otherwise have been responsible.

The resulting tax consequences in Ltr. Rul. 9737016 are presumably more favorable than where an employee makes a completed gift of NQSOs prior to their exercise by the charity. The tax consequences in Ltr. Rul. 9737016 are the same as where the employee retains the NQSOs, exercises them, and then immediately transfers to the charity the stock acquired on exercise or the sale proceeds thereon, less the required tax withholding, rather than making a transfer of the NQSOs to the charity. ⁴³ The technique used in Ltr. Rul. 9737106 , however, gives absolute assurance to the charity that it will ultimately receive the value associated with the options (although subject to lifetime veto rights by the employee), including the value of the options upon the employee's death, without the charity facing the possibility that the employee might transfer the options to some other charity, either as an inter vivos or testamentary disposition.

Using other charitable giving techniques in conjunction with exercise of NQSOs. Although the income associated with the exercise of NQSOs cannot be assigned by contributing the options to charity, other charitable giving planning techniques may be used in conjunction with NQSOs so as to shelter the income required to be recognized by the employee upon the exercise of the options. Often, employees with NQSOs already own substantially appreciated stock in the company issuing the NQSOs which has been held for over a year. This stock can be an excellent tool to shelter the income realized on the exercise of the NQSOs.

In this situation, consideration should be given, for example, to the employee contributing such stock directly to a charity, to a CRT, a pooled income fund, or a grantor charitable lead trust. The charitable income tax deduction, which would be based on the FMV of the contributed stock, would then be available to offset the taxable income the donor recognizes upon the exercise of the NQSOs, subject to the applicable gross income percentage limitations imposed under Section 170 .

Testamentary bequests of NQSOs. In the context of a testamentary bequest of an NQSO, the IRS has ruled that the same treatment accorded nonvested property under Reg. 1.83-1(d) should apply when the charity exercises the option after the death of the employee. ⁴⁴ As a result, an employee's bequest of NQSOs to a charity will result in income in respect of a decedent (“IRD”) under Section 691 to the charity when the options are exercised, and not to the employee's estate or to the heirs or devisees of the estate. ⁴⁵

Because the IRD should not be considered unrelated business taxable income (“UBTI”) under Section 512 , the income recognized by the charity should be fully exempt from tax under Section 501(a) . Because the exercise of an NQSO will result in income to the charity, rather than to the employee's estate, ⁴⁶ a testamentary disposition of NQSOs produces a particularly attractive result, thereby making a bequest of an NQSO an excellent vehicle for testamentary charitable planning.

Conclusion

The substantial wealth often associated with employee stock options and the stock acquired upon exercise may prove a useful source of charitable giving, although the tax rules associated with employee stock options are highly complex. Planners and charities should be aware of and fully consider the potential adverse tax consequences when donors are contemplating using employee stock options to further their philanthropic giving. In addition, the parties must be particularly careful to avoid the potential traps that exist for an unwary donor considering the contribution of either stock options or stock acquired upon exercise of such options.

PRACTICE NOTES

An employee may wish to bequeath NQSOs to charity. Because the exercise of such NQSOs will result in income to the charity, rather than to the employee's estate, a testamentary disposition of NQSOs produces a particularly attractive result.

¹

  The American Jobs Creation Act of 2004 (“AJCA”) imposes substantial restrictions on the ability to defer the recognition of taxable income on deferred compensation. Section 409A. AJCA excludes incentive stock options (“ISOs”) from these restrictions, and provides a specific exclusion from FICA and FUTA wages with respect to the transfer of stock on the exercise of an ISO or any subsequent sale of that stock. All other stock option arrangements where the exercise price is at least equal to the fair market value of the stock on the date of the grant are also not subject to the restrictions imposed on deferred compensation under AJCA.

²

  The same considerations and risks would apply to contributions of options, or stock acquired on the exercise of options, to split-interest charitable trusts, such as charitable remainder trusts and charitable lead trusts, as well as to pooled income funds.

³

  For the definition of an “option,” as provided under the Regulations, see Reg. 1.421-1(a)(1) .

⁴

  ISOs are also referred to as statutory or qualified options, and NQSOs are also referred to as nonstatutory or nonqualified stock options.

⁵

  In addition, the employer generally cannot take any compensation deduction on the issuance or the exercise of an ISO.

⁶

  Most stock options granted to employees of publicly traded corporations historically were not transferable, generally so as to comply with the exemption requirements of Rule 16b-3 of the Securities Exchange Act of 1934. In 1996, however, Rule 16b-3 was amended, so that nontransferability was no longer required as a condition of qualifying for the available exemptions. Prior to the transfer of stock options or stock involving a publicly traded corporation, securities law aspects of such a transfer should be fully considered. In any event, as discussed below, ISOs, by their very terms, are not transferable during life.

⁷

  As discussed below, however, if the NQSO is exercised following the death of the employee, the income that is triggered upon exercise is considered “income in respect of a decedent,” taxable to the person exercising the option. If the charity exercises an NQSO after the employee's death, the income recognized upon the exercise is sheltered from tax because of the charity's tax-exempt status under Section 501(a) .

⁸

  The transfer of NQSOs to children or other family members allows the future appreciation potential to be transferred free of estate and gift tax, and the income tax liability associated with the exercise of the NQSOs remains with the employee—another advantage from an estate and gift tax planning standpoint. The IRS's position is that the gift of such options is not complete for gift tax purposes until the later of the transfer or the time when the donee's right to exercise the option is no longer conditioned on the performance of services. Rev. Rul. 98-21, 1998-1 CB 975 . Unlike noncharitable transfers, where the goal is to transfer property at its lowest value, the goal of a charitable transfer (for which both charitable income tax and gift tax deductions are available) is to transfer property at its highest value, so as to maximize the available charitable income tax deduction.

⁹

  For example, to qualify for ISO treatment, the individual holding the option must remain an employee of the issuing corporation (or a parent or subsidiary of that corporation) at all times during the period beginning on the date the option is granted and ending on the day three months before the date of exercise. Section 422(a)(2) . The ISO plan may, but need not, prohibit the exercise of the option more than three months following the termination of employment; however, an exercise after such three-month period would not be accorded ISO treatment. The specific plan requirements for ISO treatment are found in Section 422(b) .

¹⁰

   Section 421(a)(1) . The spread between the FMV of the stock upon the exercise of the option and the strike price paid is a tax preference item for purposes of determining the alternative minimum taxable income. Section 56(b)(3) . Thus, although the exercise of an ISO does not cause the recognition of regular taxable income, the alternative minimum tax (“AMT”) consequences must be carefully considered prior to exercise of an ISO or the use of stock acquired via exercise of an ISO.

¹¹

  Such ordinary income is taxed as compensation and, accordingly, is subject to employer withholding requirements.

¹²

  See Prop. Reg. 1.421-2(b) .

¹³

   Reg. 1.424-1(c)(4), Example 9 .

¹⁴

  As indicated in note 10 supra, however, the excess of the $20,000 FMV over the $10,000 strike price is a tax preference item for AMT purposes.

¹⁵

   Section 422(b)(5) .

¹⁶

   Section 421(c)(1)(A) .

¹⁷

  Id.

¹⁸

  Id.

¹⁹

  Because a charity is tax-exempt, its exercise of the ISO or its sale of stock acquired upon exercise of the ISO is sheltered from tax under Section 501(a) , since any such income should not be considered unrelated business taxable income (“UBTI”) under Section 512 . Given the favorable income tax treatment accorded a testamentary disposition of an ISO, a bequest of an ISO may be more suitable to noncharitable beneficiaries, depending on the decedent's other assets.

²⁰

   Section 424(c)(1)(A) (the term “disposition” does not include a transfer from a decedent to an estate or a transfer by bequest or inheritance).

²¹

   Section 424(c)(1) .

²²

  A testamentary transfer to a charity is an enumerated exception, however. See note 20 supra.

²³

  Any deduction based on FMV is subject to the reduction rules of Section 170(e) .

²⁴

  In such a situation, given that the holder of the option obtains a step-up in basis upon the exercise of the option equal to the FMV of the stock on the date of exercise, any appreciation in value from the date of the grant until the date of the exercise would not reduce the available charitable income tax deduction under Section 170(e)(1)(A) (because such appreciation is included as income and therefore increases the basis of the stock).

²⁵

  As in the case of any stock that continues to be held over a period of time, the employee is subject to the risk that the value of the stock acquired upon the exercise of the ISO will decline in value. In situations where, for whatever reason, it is anticipated that the stock acquired pursuant to the exercise of an ISO will substantially decline in value, a sale or contribution of that stock prior to the expiration of the applicable holding period should be considered, despite the consequences resulting from a disqualifying disposition.

²⁶

  The deduction is limited to basis in such a situation because if the stock were sold, it would not produce long-term capital gain. As a result, Section 170(e)(1)(A) would limit the deduction to the basis of the stock contributed, which would likely be equal to the strike price paid upon exercise.

²⁷

   Reg. 1.83-7(b) .

²⁸

   Reg. 1.83-7(a) .

²⁹

  The reason is that the basis of the stock acquired upon exercise is stepped up to its FMV as a result of the employee recognizing income at such time. Thus, even if the Section 170(e)(1)(A) reduction rules apply on the contribution of the stock (because any gain realized on the sale would not produce long-term capital gain), the minimum deduction would be based on the basis of the stock. In no event can the charitable deduction exceed the FMV of the stock on the date of the contribution, no matter what the basis. (Where basis exceeds the value, it is generally better to sell the stock, recognize the taxable loss, and contribute the sale proceeds to charity.)

³⁰

  In such a case, the receipt of money or other property upon such sale or disposition is taxed under Section 83 in the same manner as if the option had actually been exercised. The employee recognizes ordinary income (as compensation) as a result of the disposition, and Section 83 ceases to apply. The ordinary income is equal to the excess of the money or other property received upon the disposition over the employee's basis in the option (which is generally zero).

³¹

  See, e.g., Ltr. Rul. 200012076 (“section 1.83-7 is silent regarding the transfer of a nonstatutory option in a non-arm's length transaction”).

³²

  See, e.g., Ltr. Ruls. 9737015

and 9737016 . The IRS has similarly ruled that a transfer of NQSOs to family members does not cause the recognition of taxable income to the employee, even though the gift is complete for gift tax purposes. See, e.g., Ltr. Ruls. 199952012