What Is Revenue Procedure 2000-37?

The transfer of compensatory stock options to family members is a financial planning strategy that involves specific tax rules. The Internal Revenue Service (IRS) has provided guidance that clarifies the tax treatment for these transactions, establishing when a gift is considered complete for tax purposes and how it should be valued.

While some may look for this information under Revenue Procedure 2000-37, that particular procedure provides a safe harbor for like-kind exchanges of real estate and does not apply to compensatory options. The primary guidance for gifting stock options is found in other IRS publications, specifically Revenue Ruling 98-21 and Revenue Procedure 98-34. These documents outline the framework for the gift and income tax consequences associated with transferring these assets for estate planning purposes.

Scope of the Revenue Procedure

The IRS guidance on gifting compensatory awards applies specifically to nonstatutory stock options (NSOs). An NSO is a type of employee stock option that does not qualify for the special tax treatment afforded to incentive stock options (ISOs). When an NSO is exercised, the difference between the fair market value of the stock at exercise and the exercise price is treated as ordinary income for the employee.

The guidance also covers stock appreciation rights (SARs), which give an employee the right to the monetary equivalent of the increase in the value of a specified number of shares over a specified period. The transferor in these situations must be the service provider—the employee, director, or independent contractor who originally received the options or SARs as compensation. The transfer itself must be made to a person who would be considered a “natural object of the service provider’s bounty.”

This term generally refers to immediate family members, such as a spouse, children, or grandchildren, or a trust established for their benefit. The core purpose of allowing these transfers is to facilitate estate planning, permitting the service provider to move potential future appreciation of the company’s stock out of their taxable estate.

Conditions for the Safe Harbor

For the transfer of a nonstatutory stock option to a family member to be treated as a completed gift under the IRS safe harbor, several specific conditions must be met. A primary requirement from Revenue Ruling 98-21 is that the option must be legally binding and enforceable, and its exercise cannot be conditioned on the employee performing additional future services. This means the option must be fully vested and exercisable at the moment it is transferred. If the option is not yet vested, the gift is not considered complete until the vesting requirements are satisfied.

Another condition is that the transfer must be made for no consideration, meaning the family member cannot pay the service provider for the option. The transfer must be permitted under the terms of the stock option plan and the specific option agreement. Many company plans historically prohibited transfers, but modifications have become more common to allow for these estate planning transactions.

The service provider must also agree to remain responsible for the income tax consequences that arise when the family member eventually exercises the option. The employer must concur with this arrangement and agree to report the compensation income on the service provider’s Form W-2 or Form 1099-MISC in the year the option is exercised. Finally, the option’s terms must be fixed and determinable at the grant date, including an exercise price at least equal to the stock’s fair market value on that date.

Valuation Method for Gift Tax Purposes

Once it is established that the transfer of a nonstatutory stock option qualifies as a completed gift, the next step is to determine its value for gift tax purposes. Revenue Procedure 98-34 provides a specific safe harbor methodology for this valuation. This guidance is intended to create a consistent and reliable way to value compensatory stock options that are not traded on a public market. The valuation must be performed as of the date the completed gift occurs.

Revenue Procedure 98-34 requires that the option’s value be determined by using a generally recognized option-pricing model, such as the Black-Scholes model or an accepted version of the binomial model. To comply with the safe harbor, the valuation must be conducted by a person or firm that is qualified to perform such appraisals. The valuation must take into account:

• The option’s exercise price
• The fair market value of the underlying stock on the valuation date
• The expected volatility of the underlying stock
• The expected dividends on the stock
• The risk-free interest rate
• The remaining contractual life of the option

The procedure also states that no discount can be applied to the valuation for lack of transferability or for the fact that the option is not vested at the time of grant.

Tax Consequences of the Transfer and Exercise

The tax consequences of gifting a nonstatutory stock option are split between the gift event and the later exercise of the option. For the service provider, or transferor, the transfer of a vested option to a family member is a completed gift. This means the transferor may be required to file a federal gift tax return, Form 709, if the value of the option exceeds the annual gift tax exclusion. For 2025, this amount is $19,000 per recipient, and a married couple can combine their exclusions to give up to $38,000 to any single individual without filing a gift tax return. No income is recognized by the transferor at the time of the gift.

The significant income tax event for the transferor occurs when the family member, or transferee, exercises the option. At that point, the transferor must recognize compensation income. The amount of this income is the difference between the fair market value of the stock on the date of exercise and the option’s exercise price. This income is subject to ordinary income tax rates and applicable employment taxes, and the employer will report it on the transferor’s Form W-2 or Form 1099-MISC.

For the family member who received and exercised the option, there are no income tax consequences at the time of exercise. The transferee’s tax basis in the stock they acquire is equal to the fair market value of the stock on the date of exercise. This basis is calculated as the exercise price they paid plus the amount of compensation income that was recognized by the transferor. This higher basis is important for determining the capital gain or loss when the transferee eventually sells the stock.