IRS Reversal on Stock Options and Divorce

That are the income and employment tax consequences of transferring stock options and deferred compensation in a divorce? According to the IRS, the transfer itself does not trigger income for income tax or employment tax purposes. However, exercising options or receiving deferred compensation is an income tax event for a nonemployee spouse and an employment tax event for an employee spouse. Both the income and employment tax positions represent major departures from previous Service guidance.

Income Tax

In Chief Counsel Advice (CCA) 200005006, according to the IRS, Sec. 1041 (nonrecognition of gain or loss) did not apply to stock options (both qualified (ISOs) and nonqualified (NQSOs)) transferred pursuant to a divorce, because the options’ value was compensation, not gain. However, in Rev. Rul. 2002-22, the IRS concluded that the NQSOs and nonqualified deferred compensation transferred to an ex-spouse pursuant to a divorce were Sec. 1041 property.

ISOs and NQSOs are two types of commonly recognized stock options. ISOs take advantage of the capital-gain treatment afforded Sec. 422, while NQSOs are subject to ordinary income tax rates on exercise. The tax is calculated on the difference between the exercise price and the stock’s fair market value (FMV) on the exercise date.

Facts: Husband H is employed by company Y. Prior to his divorce, Y issued NQSOs as part of H’s compensation. Y also maintains two unfunded, nonqualified deferred compensation plans, under which H had accrued rights to receive certain amounts. Under a 2002 divorce agreement, H transferred to his wife W one third of the NQSOs and a significant portion of the deferred compensation plans. In 2006, W exercises her stock options and receives stock with a value in excess of the exercise price. In 2011, H terminates employment with Y, and W receives a single lump-sum payment from each deferred compensation plan.

In CCA 200005006, the Service had concluded that a husband’s transfer of one half of his stock options to his ex-wife was a disposition taxable to him, not his ex-wife. Both ISOs and NQSOs were involved, but because Sec. 422(a) prohibits ISO transfers, the ISOs became NQSOs on transfer to the ex-wife. The husband had to recognize ordinary income in the disposition year, equal to the options’ FMV on transfer. Neither the husband nor the wife would have tax consequences on exercise.

Rev. Rul. 2002-22 changes this outcome. H would recognize no income in 2002, because Sec. 1041 now applies. In 2006, W would recognize ordinary income in the amount of the option spread. In 2011, she would recognize ordinary income in the amount of the lump sum received from the deferred compensation plans.

Presumably, the taxpayers in CCA 200005006 resided in a noncommunity-property state. The Service’s new position will equalize the treatment of divorcing taxpayers in community- and noncommunity-property states. Letter Rulings 8751029 and 9433010 had prescribed the same result reached in Rev. Rul. 2002-22 for the community-property portion retained by a spouse.

Employment Tax

The issue of whether FICA and FUTA taxes should be assessed on stock options has been simmering at the IRS for years. Notice 2001-14 promised future guidance and indicated that the IRS would not assess FICA/FUTA on ISOs issued before 2003. However, on June 25, 2002, Treasury and the IRS postponed indefinitely imposing employment taxes on ISO exercise in Notice 2002-47. Because ISOs become NQSOs on transfer, this notice should not affect stock options transferred in a divorce. However, advisers should closely monitor future IRS guidance.

In the midst of all this turmoil, on May 8, 2002, the IRS issued a proposed ruling on the employment tax consequences of transferring NQSOs and nonqualified deferred compensation in a divorce (Notice 2002-31). The facts in this proposed ruling are identical to Rev. Rul. 2002-22’s. Both rulings treat a spouse-to-spouse transfer as nontaxable. However, the income tax ruling triggers income to the nonemployee spouse, but the employment tax proposed ruling treats the option exercise/deferred compensation payment as the employee spouse’s wages. The IRS reasons that there is precedent for assessing employment taxes on a taxpayer who does not receive the income. For example, post-death wage payments to a spouse are a deceased spouse’s FICA wages, despite the fact that they are includible in the nonemployee recipient’s gross income.

According to the IRS, the following reporting/withholding consequences would result from the proposed ruling’s implications.

1. The option exercise/deferred compensation payment would be FICA/ FUTA wages for an employee. Thus, the employee portion of FICA would be deducted from the amount paid to the nonemployee spouse, unless the FICA limit has already been reached.

2. The Social Security and Medicare wages and taxes withheld are reported on Form W-2. Box 1 and Box 2 will not be affected by these payments.

3. The income recognized by a nonemployee spouse is subject to income tax withholding, entitling that spouse to the credit allowable for tax withheld at the source.

4. The income would be reported to a nonemployee spouse on Form 1099-MISC and withheld income tax would be included in Box 4, Federal Income Tax Withheld.

Tax Planning Tip

The IRS’s decision to apply Sec. 1041 but not assignment-of-income principles obviously has major implications for tax planning in divorce situations. However, the IRS will still apply these principles to treat income as the transferor’s income, not the transferee’s, if:

1. The transfer is required by a provision in an agreement or court order before Nov. 9, 2002 and

2. The agreement or court order specifically provides that the transferor must report the gross income.

This is a window of opportunity for the nonemployee spouse to avoid income taxation on exercising stock options.

From Larry Maples, CPA, DBA, and Melanie Earles, CPA, DBA, Tennessee Technological University, Cookeville, TN