NewsNotes

Lesli S. Laffie, J.D., LL.M.

Partnership’s Formless Conversion • Transfer of NQSOs in Divorce • ElderCare/PrimePlus Services (Box)FROM THE IRS

Partnership’s Formless Conversion

Rev. Rul. 2004-59 explains the tax treatment when an unincorporated state law entity classified as a partnership for Federal tax purposes converts to a state law corporation under a state statute that does not require an actual transfer of the unincorporated entity’s assets or interests (a state formless conversion statute).

Facts: On Jan. 1, 2003, A is organized in a state as an unincorporated entity classified as a partnership for Federal tax purposes. A elects to convert under a state formless conversion statute into a state law corporation, effective Jan. 1, 2004; as a result, A is classified as a corporation for Federal tax purposes.

Background: The term “corporation” includes (1) an association under Sec. 7701(a)(3), and (2) a business entity organized under a Federal or state statute if the statute describes or refers to the entity as incorporated or as a corporation, body corporate or body politic. If an eligible entity classified as a partnership elects under Regs. Sec. 301.7701-3(c)(1)(i) to be classified as an association, the following is deemed to occur: the partnership contributes all its assets and liabilities to the association in exchange for association stock and, immediately thereafter, the partnership liquidates, distributing the stock of the association to its partners; see Regs. Sec. 301.7701-3(g)(1)(i).

Rev. Rul. 84-111 describes the tax consequences when steps are taken as part of a plan to transfer partnership operations to a corporation organized for valid business reasons. However, it does not apply for partnership conversions into a corporation under a state formless conversion statute.

Tax treatment of formless conversions: Under Rev. Rul. 2004-59, the IRS will treat a partnership that converts to a corporation under a state law formless conversion statute in the same manner as one that makes an election to be treated as an association under Regs. Sec. 301.7701-3(c)(1)(i). Thus, when unincorporated entity A converts, under state law, to A Corp., the following steps are deemed to occur: unincorporated entity A contributes all of its assets and liabilities to A Corp. in exchange for stock in A Corp. and, immediately thereafter, unincorporated entity A liquidates, distributing the stock of A Corp. to its partners.

Transfer of NQSOs in Divorce

In Rev. Rul. 2004-60, the IRS ruled that, when interests in nonqualified stock options (NQSOs) and nonqualified deferred compensation are transferred from an employee spouse to his or her former spouse (the nonemployee spouse) in a divorce, the transfer does not result in a payment of wages for FICA and FUTA purposes. However, there are FICA and FUTA tax consequences when the options are eventually exercised or the nonqualified deferred compensation is paid or made available.

Background: Previously, Rev. Rul. 2002-22 had ruled on the income tax treatment of such transfers. Under that ruling, an employee spouse is not required to include amounts in gross income on the transfer of interests in NQSOs and nonqualified deferred compensation to his or her former (nonemployee) spouse incident to a divorce. After the transfer, the income tax consequences shift to the nonemployee spouse, who essentially steps into the employee spouse’s shoes. Amounts are not included in the nonemployee spouse’s gross income until the stock options are exercised or the deferred compensation is paid or made available to the nonemployee spouse.

New ruling: Rev. Rul. 2004-60 addresses the FICA and FUTA tax consequences and adopts the rules proposed in Notice 2002-31, with some changes. Generally, compensation realized on the exercise of stock options by a nonemployee spouse and deferred compensation paid or made available to that spouse remain subject to FICA and FUTA taxes as if they had been retained by the employee. Thus, NQSOs are subject to FICA and FUTA taxes when exercised by the nonemployee spouse who received them in the divorce. The options are taxed to the same extent as if they had been retained, then exercised, by the employee spouse. 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, the amounts relate to the employee spouse’s employment and are FICA wages. The employer reports the payments as Social Security and Medicare wages and reports the Social Security and Medicare tax withheld on a Form W-2 issued to the employee spouse. The Social Security and Medicare taxes are reported on the employer’s Form 941, Employer’s Quarterly Federal Tax Return; FUTA tax is reported on the employer’s Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.

As for income tax withholding, income realized by the nonemployee spouse on the exercise of NQSOs and amounts distributed to the nonemployee spouse from the nonqualified deferred compensation plans are deemed wages subject to income tax withholding. The withheld amounts are deducted from the payments to the nonemployee spouse.

Form W-2 reporting is not required in the above situation; the nonemployee spouse is not an employee. The employer must issue Form 1099-MISC, Miscellaneous Income, to report the income realized on the exercise of NQSOs or the payments to the nonemployee spouse from nonqualified deferred compensation plans and the income tax withheld. The employer reports the income tax withholding on Form 945, Annual Return of Withheld Federal Income Tax.

Effective date: Rev. Rul. 2004-60 is effective Jan. 1, 2005. Before then, employers may rely on a reasonable, good-faith interpretation of the rules, including those 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 is not considered a reasonable, good-faith interpretation of the rules.