Individuals

Limits on Rulings on NQSOs in Divorce

The IRS held, in Rev. Rul. 2004-60, that interests in nonqualified stock options (NQSOs) or deferred compensation plans transferred as part of a divorce are subject to tax, withholding and reporting requirements when exercised, rather than when the transfer occurs.

Background

The Service first proposed the above employment and income tax withholding rule in Notice 2002-31, which accompanied Rev. Rul. 2002-22. In the latter, the IRS held that neither party to a proposed divorce settlement agreement was required to recognize income when either one transferred NQSOs and nonqualified deferred compensation rights to the other. The transfer is governed by Sec. 1041, which provides that property transfers between spouses are nontaxable events if the transfers are incident to a divorce. A transfer is “incident to a divorce” if it occurs within one year after the marriage is terminated or is related to the marriage’s cessation (i.e., as part of a divorce order, etc.).    

However, the transferee former spouse must recognize income when deferred compensation is paid or made available, and/or when the NQSOs are exercised. The Service ruled that the transferor does not recognize income, because the assignment-of-income doctrine generally does not apply to transfers incident to divorce, due to the fact that such transfers are involuntary.

Analysis: The IRS explained that nothing in Sec. 1041 excludes payments to a person other than an employee from wages for FICA and Federal income tax purposes. In the absence of a specific provision that would exclude these payments from FICA wages, the compensation realized and the deferred compensation paid or made available to the nonemployee-spouse retain their character as wages of the employee-spouse for FICA purposes. Because the payments are wages for FICA purposes, they are reportable by the employer as Social Security and Medicare wages on the employee-spouse’s Form W-2, as are the Social Security and Medicare taxes withheld. The payments are not included in box 1 or 2 of the employee’s W-2. Because these employment taxes are being withheld from the ultimate amount received by the nonemployee-spouse, this result has lead to criticism that the nonemployee-spouse is paying amounts that are being credited to FICA wages for the employee-spouse.

Because there is no provision permitting a W-2 to be provided to a nonemployee-spouse, the employer must report the amounts the transferee recognizes as taxable income and the amount of income tax withheld on Form 1099-MISC, Miscellaneous Income. Any income withholding on the nonemployee-spouse is normally reported on Form 945, Annual Return of Withheld Federal Income Tax, which would be filed by the employee-spouse’s employer. The Social Security and Medicare taxes from the employee-spouse would be reported on Form 941, Employer’s Quarterly Federal Tax Return, and filed by the employee-spouse’s employer.

Exceptions

The rulings mentioned above are limited in application, however. They do not apply to unvested options at transfer, transfers not in connection with a divorce and statutory stock options.

Another, more significant limit is the fact that most companies are unable or unwilling to transfer stock options or restricted stock to a nonemployee-spouse. Thus, it would seem that an employer cannot report the resulting income in accordance with Rev. Rul. 2004-60, because it is unable or unwilling to transfer these options to the nonemployee-spouse.

In New Jersey, when nontransferable stock options or restricted stock are at issue in a divorce settlement, a method of disposing of these assets is to place them in a “Callahan Trust,” derived from Callahan v. Callahan, 361 A2d 561 (NJ Super. Ct. Ch. Div. 1976). Normally, a Callahan Trust is a constructive trust, under which the employee-spouse holds stock options or restricted stock for the benefit of the nonemployee-spouse. Under this trust, the court would normally instruct the employee-spouse to exercise the nonemployee-spouse’s shares under the latter’s direction. Following the exercise, the proceeds are disbursed to the non-employee-spouse. Presumably, because the assets have not been transferred to the nonemployee-spouse, any income that results would be includible on the employee-spouse’s Form W-2. This amount would then be reported and taxed on the latter’s Form 1040.

Again, the primary limit, which will be the case with most publicly traded companies’ stock options and/or restricted stock, is that the company will not be able to transfer these assets to the nonemployee-spouse. Obviously, this minimizes the applicability of the three rulings mentioned above.

From Dan Gibson, CPA, Amper, Politziner & Mattia, P.C., Bridge-water, NJ