rp-98-34.pdf

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Part III
Administrative, Procedural, and Miscellaneous
26 CFR 601.105: Examination of returns and claims for refund,
credit or abatement; determination of correct tax liability.
(Also Part I, § 2512; § 25.2512-1.)
Rev. Proc. 98-34
SECTION 1. PURPOSE
This revenue procedure sets forth a methodology to value for
gift, estate, and generation-skipping transfer tax ("transfer
tax") purposes certain compensatory stock options described in
Section 3 of this revenue procedure. Taxpayers relying on this
revenue procedure may use an option pricing model that takes into
account on the valuation date specific factors that are similar
to those established by the Financial Accounting Standards Board
in Accounting for Stock-Based Compensation, Statement of
Financial Accounting Standards No. 123, (Fin. Accounting
Standards Bd. 1995), (FAS 123). The Internal Revenue Service
will treat the value of a compensatory stock option as properly
determined for transfer tax purposes, provided that the
requirements of this revenue procedure are met.
SECTION 2. BACKGROUND

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Section 2512(a) of the Internal Revenue Code provides that,
if a gift is made in property, the value of the property at the
date of the gift is the amount of the gift.
Section 25.2512-1 of the Gift Tax Regulations provides that
for gift tax purposes the value of property is the price at which
the property would change hands between a willing buyer and a
willing seller, neither being under any compulsion to buy or to
sell and both having reasonable knowledge of relevant facts.
Section 2031(a) provides that the value of the gross estate
is determined by including the value at the time of the
decedent’s death of all property, real or personal, tangible or
intangible, wherever situated.
Section 20.2031-1(b) of the Estate Tax Regulations provides
that the value of every item of property includible in a
decedent’s gross estate is its fair market value at the time of
the decedent’s death.
Section 2032(a) provides that the executor may elect to use
an alternate valuation date. Under this election, the value of
all property included in the gross estate generally is determined
as of 6 months after the decedent’s death. However, property
distributed, sold, exchanged, or otherwise disposed of within 6
months after death must be valued as of the date of sale,
exchange, or other disposition.
Section 2624(a) provides that, except as otherwise provided
in Chapter 13, property is valued at the time of the generation-

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skipping transfer.
FAS 123 establishes financial accounting and reporting
standards for stock-based employee compensation plans. Under FAS
123, the fair value of a stock option granted by a public entity
is estimated using an option pricing model (for example, the
Black-Scholes model or a binomial model) that takes into account
as of the option grant date: (1) the exercise price of the
option; (2) the expected life of the option; (3) the current
price of the underlying stock; (4) the expected volatility of the
underlying stock; (5) the expected dividends on the underlying
stock; and (6) the risk-free interest rate for the expected term
of the option.
FAS 123 generally requires a public entity to disclose in
its financial statements for each year beginning after December
15, 1994, a description of the method and significant assumptions
used during the year to estimate the fair value of stock options
granted during the year, including the following weighted-average
information: (1) expected life of the options; (2) expected
volatility; (3) expected dividends; and (4) risk-free interest
rate. (The foregoing is not a complete list of the disclosures
required by FAS 123. For example, FAS 123 also requires
financial statement disclosure of the weighted-average exercise
prices of options granted during the year.)
SECTION 3. SCOPE
This revenue procedure applies only to the valuation for
transfer tax purposes of nonpublicly traded compensatory stock

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options (that is, stock options that are granted in connection
with the performance of services, including stock options that
are subject to the provisions of § 421), on stock that, on the
valuation date, is publicly traded on an established securities
market. The options to which this revenue procedure applies are
referred to herein as "Compensatory Stock Options."
SECTION 4. APPLICATION
.01 Taxpayers may determine the value of Compensatory Stock
Options for transfer tax purposes by using a generally recognized
option pricing model (for example, the Black-Scholes model or an
accepted version of the binomial model) that takes into account
as of the valuation date the following factors: (1) the exercise
price of the option; (2) the expected life of the option; (3) the
current trading price of the underlying stock; (4) the expected
volatility of the underlying stock; (5) the expected dividends on
the underlying stock; and (6) the risk-free interest rate over
the remaining option term.
.02 In order to rely on this revenue procedure: (1) the
taxpayer must use the factors determined in section 4.03 through
4.07 of this revenue procedure; (2) each of the factors used in
applying the option pricing model must be reasonable (for this
purpose, the use of the factors in section 4.03 through 4.07 of
this revenue procedure will be deemed reasonable); (3) the option
pricing model must be properly applied; (4) the company that
granted the option must be subject to FAS 123 in preparing its
financial statements for the fiscal year of the company that

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includes the valuation date; (5) the underlying stock must be
common stock and must be the same stock for which the expected
volatility and expected dividends were estimated by the company
for purposes of FAS 123; and (6) no discount can be applied to
the valuation produced by the option pricing model (for example,
no discount can be taken due to lack of transferability or due to
the termination of the option within a specified number of days
following termination of employment).
.03 Except as provided in section 4.04 of this revenue
procedure, in determining the factor for the expected life of the
option, taxpayers must use either (1) the maximum remaining term
of the option on the valuation date (Maximum Remaining Term), or
(2) the expected life of the option on the valuation date
computed in accordance with this section (Computed Expected
Life). The Maximum Remaining Term is the number of years rounded
down to the nearest 1/10th of a year from the valuation date
until the option’s expiration date (assuming no condition or
event occurs that would shorten the life of the option).
The Computed Expected Life is determined in the following
manner:
Step one: Obtain the weighted-average expected life of
options granted by the publicly traded company that, for purposes
of complying with FAS 123, is disclosed in its financial
statements for the fiscal year that includes the valuation date.
(If, instead of disclosing a weighted-average expected life for
options granted during the fiscal year, the company disclosed a

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method for computing the expected life of the options granted
during the fiscal year, the taxpayer must compute the weighted-
average expected life for the taxpayer’s option using the method
disclosed by the company.)
Step two: Divide the weighted-average expected life
determined in step one by the number of years, rounded up to the
nearest 1/10th of a year, from the date the option was granted
(without regard to the application of § 424(h)(1)) until the
option's expiration date (assuming no condition or event occurs
that would shorten the life of the option).
Step three: Multiply the quotient obtained in step two by
the Maximum Remaining Term. The resulting number rounded down to
the nearest 1/10th is the Computed Expected Life expressed in
years.
This calculation can be demonstrated by the following
example. Assume that on September 1, 1998, A is granted a stock
option from Company that will terminate on the earlier of the
date 10 years from the date of grant or the date 90 days after
the termination of A's employment with Company. The option
becomes fully exercisable 3 years from the date of grant. For
the fiscal year that includes September 1, 2001, Company
discloses in a footnote to its financial statements, in
accordance with FAS 123, that the weighted-average expected life
of stock options granted by the Company during the fiscal year is
6 years. On September 1, 2001, when A's option becomes fully
exercisable, A makes a gift of a portion of the option. On

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September 1, 2001, A’s option qualifies as a Compensatory Stock
Option. For purposes of step one, the weighted-average expected
life is 6 years, as disclosed by Company for purposes of
complying with FAS 123 for the fiscal year that includes the
valuation date. For purposes of step two, the weighted-average
expected life of 6 years is divided by 10 years, the maximum term
of A’s option on the date the option was granted by Company. The
resulting quotient is 0.6 (6 years divided by 10 years equals
0.6). For purposes of step three, the quotient in step two is
multiplied by the Maximum Remaining Term to determine the
Computed Expected Life. The result is 4.2 years (0.6 times 7
years equals 4.2 years).
.04 Taxpayers must use the Maximum Remaining Term (and may
not use the Computed Expected Life) as the expected life of the
option on the valuation date if one (or more) of the following
conditions is present:
(1) the transferor of the option (or the decedent, in the
case of a transfer at death) is not the person to whom the option
being valued was granted by the company;
(2) except in the case of a transfer at death, the
transferor is not an employee or director of the company on the
valuation date;
(3) except in the case of the death or disability (within
the meaning of § 22(e)(3)) of the transferor, the option being
valued does not terminate within 6 months of termination of
employment (or service as a director) of the transferor with the

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company;
(4) the terms of the option being valued permit the option
to be transferred to, or for the benefit of, one or more persons
other than either persons who are the natural objects of the
transferor’s bounty or a charitable organization;
(5) except in the case of the death of the transferor, the
option being valued has an exercise price that is not fixed on
the valuation date. The option does not have a fixed exercise
price if, for example, the exercise price is determined by a
formula the results of which might change after the valuation
date. In addition, an option will be deemed not to have a fixed
exercise price if the company issuing the option has repriced
options (that is, directly or indirectly lowered the exercise
price of outstanding compensatory stock options) within the
3-year period ending on the valuation date;
(6) except in the case of the death of the transferor, the
option being valued has terms and conditions such that if all the
options granted in the fiscal year of the company that includes
the valuation date had the same terms and conditions, the
weighted-average expected life for the year would have been more
than 120% of the weighted-average expected life actually reported
for the year; or
(7) the company is not required by FAS 123 to disclose an
expected life of the options granted in the fiscal year of the
company that includes the valuation date.
.05 In determining the factor for the expected volatility

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of the underlying stock, taxpayers must use the expected
volatility of the underlying stock that, for purposes of
complying with FAS 123, is disclosed in the financial statements
of the publicly traded company for the fiscal year of the company
that includes the valuation date.
.06 In determining the factor for the expected dividends on
the underlying stock, taxpayers must use the expected dividends
on the underlying stock that, for purposes of complying with FAS
123, is disclosed in the financial statements of the publicly
traded company for the fiscal year of the company that includes
the valuation date.
.07 In determining the factor for the risk-free interest
rate, taxpayers must use the yield to maturity on the valuation
date of zero-coupon U.S. Treasury Bonds with a remaining term (as
of the valuation date) nearest to the expected life of the option
on the valuation date as determined in section 4.03 of this
revenue procedure.
.08 Taxpayers utilizing this revenue procedure to value a
Compensatory Stock Option for transfer tax purposes should
indicate on the applicable gift, estate, or generation-skipping
transfer tax return: "FILED PURSUANT TO REV. PROC. 98-34."
DRAFTING INFORMATION
The principal author of this revenue procedure is Robert B.
Hanson of the Office of Assistant Chief Counsel (Passthroughs and
Special Industries). For further information regarding this
revenue procedure, contact Mr. Hanson on (202) 622-3050 or

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Melissa C. Liquerman on (202) 622-3120 (not toll-free calls).