Transfers of NQSOs and Deferred Compensation

In Field Service Advice (FSA) 200005006, the IRS addressed the application of Sec. 83 to taxation of nonqualified stock options (NQSOs) exercised after a transfer pursuant to divorce.

In the FSA, an ex-husband transferred half of his compensatory options—incentive stock options (ISOs) and NQSOs—to his ex-wife as part of a divorce property settlement. The FSA concluded that the ISOs transferred to the former wife automatically became NQSOs, taxable under Sec. 83, due to the rules prohibiting transfers of ISOs. However, this particular conclusion is contrary to Sec. 424(c)(4)(A), which states that ISO transfers between spouses or incident to divorce "shall not be treated as a disposition."

Further, according to Sec. 424(c)(4)(B), when ISOs are transferred between spouses or incident to divorce, the same tax treatment that would have applied to the transferor applies to the transferee. In light of the statutory language, the FSA's conclusion for ISOs must be ignored.

When the ex-wife exercised the options, the ex-husband initially reported the spread as gain on his return, but subsequently submitted a claim for a refund, on the ground that the ex-wife's subsequent exercise of the NQSOs was not a taxable event for him.

The Office of Chief Counsel concluded that the ex-husband was correct. The FSA set forth the following guidelines for the taxation of compensatory stock options transferred pursuant to divorce:

1. The ex-husband should have been taxed under Sec. 83 at the time of the transfer of the options to his ex-wife, instead of delaying recognition until his ex-wife exercised them. The income that the husband should have recognized was the option's fair market value on the transfer date.

2. The ex-wife should receive a carryover basis in the options under Sec. 1041(b).

3. Neither the ex-husband nor the ex-wife should have been taxed when the ex-wife exercised the options.

4. The ex-wife's tax consequences on the ultimate stock disposition should be governed by Sec. 1001.

Again, these conclusions are only valid for NQSOs, not ISOs. An FSA is not binding on the IRS, but typically reflects its current thinking.

Transfers of Deferred Compensation and Stock Options to Charity

Under Sec. 691(a)(1), gross income items not properly included in a decedent's return during his life must be reported as taxable income by the item's recipient. This type of income is known as income in respect of a decedent (IRD). IRD items are subject to both estate tax and income tax. Although an income tax deduction for Federal estate tax is allowed, the resulting tax can approach 80% of the IRD's value. Qualified plans, various forms of deferred compensation and NQSOs are all IRD items and make up an increasingly large part of clients' estates.

Letter Rulings 200002011 and 200012076 expanded IRD to include deferred compensation and NQSOs, which a decedent can contribute to charity at death without triggering IRD. Because the estate receives an estate tax charitable deduction for the value of the IRD value passing to charity, both estate and income taxes are avoided by allowing IRD to pass to charity at death. Qualified plans already receive this favorable treatment.

Letter Ruling 200002011

In this ruling, a taxpayer had certain items of deferred compensation: deferred salary under his employer's deferred-compensation plan, deferred stock from his employer's deferred-stock-option plan and a death benefit that the taxpayer had negotiated to have the employer provide to his estate or designated beneficiaries. In addition, the taxpayer held NQSOs received as compensation from his employer. The taxpayer planned to name charities qualifying under Sec. 501(c)(3) as the designated beneficiaries of deferred compensation items and planned to bequeath the stock options to the same charities.

The letter ruling concluded:

1. While the deferred compensation and NQSOs will be included in the taxpayer's estate under Secs. 2033 and 2039(a), the estate will qualify for a charitable deduction under Sec. 2055(a).

2. The deferred compensation items will constitute IRD to the charities under Sec. 691(a)(1)(B) when distributed to them, not IRD to the taxpayer's estate.

3. The stock options will constitute IRD to the charities under Sec. 691(a)(1)(C) when distributed to the charities, not IRD to the taxpayer's estate.

Letter Ruling 200012076

In this ruling, the taxpayer held vested NQSOs he wanted to leave to a charity, and sought guidance on the IRD's impact on his estate when the charity exercised the options. The ruling concluded that the bequest of the NQSOs to charity would result in IRD to it under Sec. 691 at exercise. The bequest would not result in IRD to the taxpayer's estate if still open at the time of the exercise, nor to the taxpayer's heirs or devisees if closed at that time.

The letter rulings present a substantial opportunity. Although in general they cannot be relied on as precedent, this type of ruling tends to reflect the IRS's position. Taxpayers have previously been able to designate charities as beneficiaries of qualified plans, but these letter rulings suggest that the same treatment applies to other items of deferred compensation and to NQSOs.

Caution: If a will contains pecuniary bequests to charity and the estate uses IRD items to fulfill them, the IRD will be triggered and taxed to the estate on the date of distribution of the IRD items to the charity.

From David M. Pfefferkorn, J.D., LL.M., and Laura H. Peebles, CPA, PFS, Washington, DC, and Debra K. Sawyer, CPA, CFP, Dallas, TX