Guidelines on Withholding from Compensation Payments Incident to Divorce

A recent ruling provides guidelines on FICA, FUTA and in-come tax withholding from nonstatutory stock options and deferred-compensation plans transferred between spouses incident to divorce.

Facts

Prior to As divorce from B, As employer Y issued A nonstatutory stock options as part of his compensation; no amount was included in As gross income at the grant. A also participated in Ys unfunded, deferred-compensation plans, under which he earned the right to receive post-employment payments from Y. Pursuant to the property settlement and divorce judgment, A transferred the nonstatutory stock options and the right to receive deferred-compensation payments to B. B will exercise all of the transferred stock options in 2006 and receive a single lump-sum payment from the plans when A separates from employment in 2007.

Analysis

Rev. Rul. 2002-22 previously concluded that a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to his or her former spouse incident to divorce need not include any gross income on the transfer. It also concluded that the former spouse, not the taxpayer, is required to include gross income when he or she exercises the options or when the deferred compensation is paid or made available to the him or her. A proposed ruling in Notice 2002-31 concluded that exercise of the options and the nonqualified deferred compensation remain subject to FICA and FUTA taxes to the same extent as if they had been retained by the employee; the income recognized by the nonemployee spouse on the exercise of the options and distributions of nonqualified deferred compensation is wages for income tax withholding purposes.

Social Security Wages

The transfer of interests in nonstatutory stock options and in nonqualified deferred compensation from an em-ployee spouse to a nonemployee spouse incident to a divorce does not result in a payment of wages for FICA and FUTA tax purposes. Under Sec. 3121(v)(2), amounts deferred under a nonqualified deferred-compensation plan generally are to be taken into account when the services are performed or, if later, when there is no substantial risk of forfeiture. To the extent deferred amounts were already taken into account for FICA purposes, a distribution of proceeds to B will not be wages for FICA tax purposes; however, to the extent not previously taken into account, a distribution will be wages to A for FICA tax purposes. Similarly, Bs exercise of the nonstatutory stock options will result in FICA wages to A if the fair market value of the stock received exceeds the option exercise price.

Any amount includible in Bs gross income is not reduced by FICA withholding from the payments (including property transfers). Because A was the service performer, the wages, although paid to B, are As Social Security wages. Thus, payments are reportable by Y as Social Security and Medicare wages on As Form W-2, together with the withholding.

In determining whether distributions are excepted from Social Security wages under the Sec. 3121(a)(1) maximum Social Security wage-base exception, Y may consider other wages previously paid to A in that calendar year. The Social Security tax for these wages should be deducted from the payment. Finally, the payments should not be included in Box 1, Wages, tips, other compensation, nor should any amount be reflected in Box 2, Federal income tax withheld, of As W-2.

FUTA

FUTA taxation generally applies at the same time and in the same manner as FICA, discussed above. Thus, any FICA wages are also As FUTA wages, subject to the maximum wage base contained in Sec. 3306(b)(1). As with FICA, wages previously paid to A during the calendar year may be taken into account in determining whether these amounts qualify for the FUTA maximum wage-base exception.

Income Tax

The compensatory interests transferred pursuant to a divorce under Sec. 1041 remain taxable for employment tax purposes to the same extent as if retained by the employee spouse. Any income recognized by the nonemployee spouse is remuneration for employment and wages for income tax withholding purposes under Sec. 3402. Under Sec. 1.31-1(a), B would be entitled to a credit for the withheld income tax, because the recognized income is includible in Bs gross income.

Y is not required to collect Form W-4, Employees Withholding Allowance Certificate, from B, and should not base withholding on a Form W-4 submitted by B. Y may treat compensation includible in Bs income as supplemental wages and apply the flat-rate withholding method on supplemental wages in withholding income tax on these wages (currently, 25%).

Income realized on exercise of the nonstatutory stock options would be reportable by Y to B on Form 1099-MISC, Miscellaneous Income, in Box 3, Other income, with the income tax withheld reported in Box 4, Federal income tax withheld. Payments to B from the nonqualified deferred-compensation plans and the withholding are reportable in Box 3, with the income tax withheld reported in Box 4.

Rev. Rul. 2004-60, IRB 2004-24, 1051

Reflections: Rev. Rul. 2004-60 is effective Jan. 1, 2005. For prior periods, employers may rely on a reasonable, good faith interpretation, including the proposed ruling in Notice 2002-31. However, treating compensation payments as not subject to FICA rules is not deemed a reasonable or good faith interpretation.