Studies indicate stock options have contributed significantly to the sharp rise in the number of households worth $25 million and more. That means there's a growing number of executives who qualify as clients for the services of top-flight wealth management advisors. So it behooves those advisors to know that life insurance might help executives' families cover the cost of exercising the qualified incentive stock options (ISO) they inherit. Insurance also may help heirs cover the taxes on those options.
Carola Frydman, assistant finance professor at the Massachusetts Institute of Technology's Sloan School of Management, surveyed 77 chief executive officers in 1989 and 102 CEOs in 2004. Back in 1989, only 31 percent had a firm-related net worth of more than $25 million. By 2004, that number had jumped to 75 percent. At the same time, she found, lower level executives' firm-related wealth doubled.
One reason for this rapid rise, says Frydman, is that executives' stock option grants have increased (firm-related wealth takes into account salaries, current and deferred bonuses, as well as the value of stock option grants and the executives' holdings of company stock). "The growth of the stock market has increased the value of many executives' wealth due to stock options and their company stock holdings," says Professor Frydman.
This means more executives and their beneficiaries are facing the problems associated with the exercise of stock options. It's particularly important to plan in case an executive dies before exercising his ISOs. Absent adequate liquidity, the executive's survivors may not be able to take full advantage of those options. But life insurance can sometimes help, says Lina Storm, financial planner with the John Hancock Financial Service's Advanced Market Group, Boston.
Storm offers this hypothetical example of a highly compensated 55-year-old executive: Stock options are a significant portion of his compensation. Let's say he has options for 15,000 shares. The option price is $80 per share. Because the options need to be exercised within 10 years, the executive, who's married, wants to ensure that his wife and children do not lose the full value of the options should he die before they're exercised.
This executive could consider buying enough life insurance to allow his family to exercise the inherited options, hold the stock for the required holding period for capital gains treatment, and, ideally, pay the estate taxes associated with the inclusion of the stock in the estate of the executive or the executive's spouse.
The cash required to exercise the options is $1.2 million (15,000 shares at $80 per share). The market price of the stock in the executive's assumed year of death is projected to be $188 per share, for a market value of $2.82 million. The projected estate taxes connected with the stock, based on an estate tax of 50 percent, is $1.41 million. Therefore, the full liquidity need is projected to be $2.61 million.
Assuming the executive has as the owner of this policy an irrevocable life insurance trust (ILIT) for the benefit of his spouse and children, the ILIT's trustee would purchase a cash-value insurance policy for $2.61 million for an annual premium of $28,038.
The options are assumed to transfer to the executive's widow. She then can exercise the options using the $1.2 million distribution from the ILIT's life insurance proceeds made to her as a spousal beneficiary of the trust. By exercising the stock options, the executive's widow can achieve tax-deferred appreciation of $1.6 million ($1.2 million paid for fair market value of $2.82 million). Remaining in the trust would be $1.41 million of death proceeds to cover projected estate taxes at the widow's subsequent death, assumed to immediately follow the executive.
The options may provide the widow with the $1.62 million built-in gain, whether insurance is used or not, Storm says. But this gain may be lost if the widow lacks the liquidity to exercise the options and hold the stock for the required holding period. Even if the widow could liquidate assets to exercise the options, she would have to pay taxes on the liquidation. "The full value of the stock option benefit can be realized at a discounted cost through the use of life insurance." Storm says.
Of course, it is highly unlikely that the executive's wife will die immediately after her husband dies. And, if she uses one or more planning techniques to transfer all or part of the stock out of her estate, the liquidity need at her death could be substantially reduced. Still, the insurance, particularly a life insurance trust, would give the executive's family far more flexibility than they would otherwise have for long-term planning with the stock.
Alan Lavine is co-author with his wife, Gail Liberman, of "Quick Steps to Financial Stability (Que/Penquin Group)."
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