Nonqualified stock options and incentive stock options (ISOs) can be used to shift income to children at capital gain rates. By making lifetime gifts of nonqualified stock options before the market value has appreciated, an employee may remove a potential high-growth asset from an estate, at a low gift tax value. By permitting an employee to transfer nonqualified stock options to children (or grandchildren), a company may confer a substantial benefit without additional compensation expense and the employee will have an appreciated asset to gift to his children. The children will sell the stock to pay for college and will be taxed at capital gain rates.
Example: An employee receives an ISO on 7-1-17 to buy 3,000 shares of XYZ Inc. stock at $10 per share (its fair market value at the time). The employee exercises the option on 8-2-018 when the fair market value of the stock is $21 per share. The employee receives 3,000 shares of XYZ Inc. at $10 per share. On 9-3-19 the employee gifts (joint with her husband) 750 shares of the stock to the child when the fair market value is at $30. The employee continues to do this for the next three years that the child is in college as well. The employee has satisfied her ISO holding requirement of holding her stock for two years after the grant date and one year after the exercise date. The child will realize $15,000 of long term capital gain for each of 4 years ($30/share x 750 shares) less ($10/share basis x 750 shares).
If you are in a combined (federal, self-employment, and state) tax bracket of 20%, you could reduce your taxes up to $200 for every $1,000 of income reduction by shifting nonqualified stock options or incentive stock options (ISOs) to your children.