Tax consequences of distributing equity compensation rights in divorce.

• Author: Polsky, Gregg D.

When a corporate executive is divorced, a large proportion of the marital estate may be in the form of equity compensation, such as stock options and restricted stock. The equitable division of equity compensation implicates technical tax issues and also creates tax planning opportunities. This article discusses these issues and opportunities.

Taxation of Equity Compensation

In the context of corporate issuers (as opposed to partnership, LLC, or other noncorporate issuers), "equity compensation" refers to compensation that is valued in relation to the stock value of the employer. The most common forms of equity compensation are stock options and restricted stock.

* Stock Options--A stock option is the right to purchase a share of stock at a specified price (strike price) during a specified period. Compensatory stock options usually become exercisable (vest) pursuant to a fixed schedule. Typically, compensatory stock options have a strike price equal to the fair market value of the underlying stock at the time of grant (1) and have a vesting period of three to five years, with options vesting ratably over the period.

In general, there are no tax consequences to the employee upon the grant or vesting of compensatory options. (2) Upon exercise of an option, the employee recognizes compensation income equal to the spread between the then-existing value of the underlying stock and the strike price. (3) The income that the employee recognizes is characterized as ordinary income for federal income tax purposes and wages for federal employment tax purposes. This means that the combined federal tax rate that applies to the spread can exceed 40 percent. (4) The employee's basis in the shares received pursuant to the option exercise equals the fair market value of the shares. Therefore, if an employee exercises and then immediately sells the underlying stock, the employee will not recognize any further income on the sale of the stock.

* Restricted Stock--Restricted stock is the other most common type of equity compensation issued by corporations. Restricted stock is employer stock that is transferred to the employee for free (or at a discount) subject to a vesting schedule. The vesting schedule requires that the employee remain employed by the employer for a specified period of time in order to keep the stock. As with stock options, the issuer has great flexibility in designing the vesting arrangement, but restricted shares typically vest ratably over a three- to five-year period.

Restricted stock is generally taxable upon vesting, (5) with the amount of the employee's income based on the fair market value of the stock at that time. (6) Thus, for example, if restricted stock with a value of $10 is transferred for free to an employee in Year 1, and the stock vests in Year 2 when it is worth $15, the employee realizes no income in Year 1 because the stock did not vest in that year. In Year 2, the employee realizes $15 of compensation income because the stock vested in that year; at the time of vesting the stock was worth $15, and the employee had paid no consideration for the stock. These tax consequences are summarized in the table below.

The common tax theme of both of these equity compensation arrangements is tax deferral. While the rights to the eventual income are earned through the performance of services over a period of time, the taxable event (exercise in the case of options, vesting in the case of restricted stock) occurs after some or all of those services have been performed.

Deferral can create complications (and tax planning opportunities) when a divorce-related transfer of the property is made before the taxable event occurs. Thus, stock options may be transferred between grant (or vesting) and exercise, and restricted stock may be transferred between grant and vesting.

Section 1041 and the Assignment of Income Doctrine

I.R.C. [section] 1041, 26 U.S.C.S. [section] 1041 (2013), generally provides that divorce-related transfers of property are tax-free and that the transferee spouse takes such property with a carryover basis from the transferor spouse. Congress enacted this rule to "make the tax laws as unintrusive as possible with respect to relations between spouses." (7) Section 1041 clearly applies to nearly all kinds of property commonly transferred in a divorce, such as houses, cars, jewelry, and investment property.

However, the application of [section] 1041 to equity compensation items is not as clear because of its potential conflict with the common law assignment-of-income doctrine, which prevents the shifting of income tax liability through gratuitous transfers. For example, in the classic assignment-of-income case of Lucas v. Earl, 281 U.S. Ill (1930), the U.S. Supreme Court held that a husband was taxable on 100 percent of his compensation income even though he had previously contracted to give half of such compensation to his wife. The Court explained that "tax could not be escaped by anticipatory arrangements and contracts however skillfully devised, to prevent the salary when paid from vesting even for a second in the man who earned it." (8)

The conflict between [section] 1041 and the assignment of income doctrine was addressed in the Ninth Circuit Court of Appeals case of Kochansky v...