Final Guidance on the Tax Treatment of NQSOs and Deferred-Compensation Rights Transferred in Divorce

In Rev. Rul. 2004-60, the IRS adopted (with modifications) Notice 2002-31’s proposed rules on withholding and income tax reporting for the transfer of nonqualified stock options (NQSOs) and nonqualified deferred compensation incident to a divorce. Under the ruling, when interests in NQSOs and nonqualified deferred compensation are transferred from an employee spouse to his or her former spouse (nonemployee spouse) in a divorce, the transfer does not result in a payment of wages for FICA or FUTA purposes. However, FICA and FUTA withholding are required when the options are exercised or the nonqualified deferred compensation is paid or made available.

Background

Previously, in Rev. Rul. 2002-22 (which had the same facts as Rev. Rul. 2004-60), an employee spouse was not required to include amounts in gross income on the transfer of NQSOs and nonqualified deferred compensation to the former spouse in a divorce. The nonemployee spouse was required to assume the income tax responsibility associated with such payments. Consequently, he or she would include in gross income any income associated with the NQSOs on exercise or the deferred compensation when paid or made available.

Rev. Rul. 2004-60

Under the final rules, compensation associated with (1) NQSOs on exercise and (2) deferred compensation when paid or made available to the nonemployee spouse, remains subject to FICA and FUTA taxes as if it had been retained by the employee. Thus, the NQSOs are subject to FICA and FUTA when exercised by the nonemployee spouse. Similarly, any nonqualified deferred compensation is subject to FICA and FUTA taxes to the same extent as if the rights to the compensation had been retained by the employee spouse.

Although the nonemployee spouse receives the payments, they relate to the employee spouse’s employment and are his or her FICA wages. The employer reports the payments as Social Security and Medicare wages and reports the Social Security and Medicare withheld taxes on the employee spouse’s Form W-2. The Social Security and Medicare taxes are reported on the employer’s Form 941, Employer’s Quarterly Federal Tax Return; the FUTA tax is reported on the employer’s Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax.

For income tax withholding purposes, the nonemployee spouse must recognize income; the exercise of the NQSOs or payments of nonqualified deferred compensation are deemed wages. Any amounts withheld are deducted from the payments to the nonemployee spouse. Although compensation payments to an employee are generally required to be reported on Form W-2, this does not apply to the nonemployee spouse. Rather, the employer must issue Form 1099-MISC, Miscellaneous Income, to report the income realized and the income tax withheld on such amounts. The employer reports the income tax withholding on wages paid to the nonemployee spouse on Form 945, Annual Return of Withheld Income Tax.

Effective Date

Rev. Rul. 2004-60 became effective as of 2005. For prior periods, employers may rely on a reasonable, good-faith interpretation of the rules, including the interpretations in Notice 2002-31 and Rev. Rul. 2004-60. However, failure to treat compensation from NQSOs or amounts deferred under a nonqualified deferred-compensation plan as subject to FICA will not be considered a reasonable, good-faith interpretation of the rules.

From David P. Simonetti, J.D., LL.M., New York, NY