¹See Hurlbut W. Smith, 318 US 176 (1943); Regs. Sec. 25.2511-1(e); Sec. 7520. See IRS Letter Rulings 9514017 (1/9/95) and 9952012 (1/3/00) for the transfer tax consequences of an option gift; see Rev. Proc. 98-34, IRB 1998-18, 15, for the IRS safe-harbor valuation methods, which are based on the Black-Scholes option pricing model and discussed in Franz, Crawford and Campbell, "How to Value Gifts of Employee Stock Options," 29 The Tax Adviser 848 (December 1998).

²The employee recognizes the income, even though he has not exercised the option, to ensure that income from services is taxed to the party who earned it, under Lucas v. Earl, 281 US 111 (1930), rev'g 30 F2d 898 (9th Cir. 1929). This is a further benefit for sales or gifts to family limited partnerships or defective trusts, because the employee must pay the tax, further reducing his estate.

³According to Regs. Sec. 1.83-1(a)(1), services can be performed as an employee or independent contractor.

⁴Under Regs. Sec. 1.83-7(b), an option has a readily ascertainable FMV if (1) it is traded on an established market or (2) it is transferable, exercisable immediately, not subject to a restriction that has an effect on FMV and has an option privilege with a readily ascertainable FMV.

⁵Sec. 83(c). In the Black-Scholes model, the discount rate is the risk-free rate, because the option holder may form a riskless hedge by trading in the option and the underlying stock. Employee stock options cannot not be traded on an established market, so that it may not be possible to form a riskless hedge; thus, a risk-adjusted discount rate may be appropriate to value the leverage component.

⁶An employer who issues NQSOs may also have market-traded options. However, the options received by its employees are not traded on an established market. Also, there are fundamental differences between the terms of market-traded options and employment-based options. These differences make it difficult to use the market price for traded options to establish the value of employment-based options.

⁷IRS Letter Ruling 9533008 (5/9/95).

⁸IRS Letter Ruling (FSA) 200005006 (11/1/99).

⁹These benefits are similar to those available when a Sec. 83(b) election is made for a restricted property transfer. Because an option is not property for Sec. 83 purposes, the Tax Court has ruled, in Richard A. Cramer, 101 TC 225 (1993), that a Sec. 83(b) election will not accelerate the taxable event for an option transfer. The sale strategy proposed in this article thus provides the best means to accelerate the income from an NQSO.

¹⁰NQSOs are typically granted "at-the-money"; thus, the intrinsic value tends to increase over time.

¹¹See Rev. Ruls. 72-135, 1972-1 CB 200, and 72-350, 1972-2 CB 394.

¹²See Rev. Proc. 2000-3, IRB 2000-1, 103 and IRS Letter Ruling 9502027 (10/13/94).

¹³See IRS Letter Rulings 9803009 (10/14/97), 9803021 (10/20/97) and 9803022 (10/20/97).

¹⁴Rev. Rul. 58-384, 1958-2 CB 410.

¹⁵See FSA 200005006, note 8 supra, and Regs. Sec. 1.83-1(b)(1).

¹⁶Rev. Proc. 98-34, note 1 supra.

¹⁷In addition to Black-Scholes, other well-regarded models have been developed by Merton, Cox and Rubenstein, Shelton, and Kassouf.

¹⁸Select employees may be subject to lock-up restrictions or SEC insider trading rules, which would need to be considered before any sale.