Divorce-related transfer of compensatory stock options is taxable.

• Author: Bakale, Anthony

In Field Service Advice (FSA) 200005006, the IRS ruled that stock option transfers from a husband to his ex-wife pursuant to a divorce resulted in compensation income for the husband when the options were transferred. The ex-wife received a carryover basis in the options equal to the compensation recognized by the husband. There were no additional tax consequences to either spouse when the wife later exercised the options.

Fact Pattern

The husband had received compensatory stock options from his employer. The options did not have a readily ascertainable fair market value (FMV) at the time of grant and therefore their receipt was not taxable. Pursuant to a domestic-relations order, the husband transferred one-half of his options to his ex-wife. When the ex-wife later exercised the options, the employer issued a Form 1099 to the husband for the difference between the stock's FMV at the time of the ex-wife's exercise and the amount paid to exercise the options. The husband included this amount in income on his tax return for the year in which the ex-wife exercised the options; however, he later filed a refund claim.

Taxation of NQSOs

Taxation of nonqualified stock options (NQSOs) is governed by Sec. 83. Most compensatory stock options do not have a readily ascertainable FMV at the grant date and thus generally are not taxable until exercised or disposed of. If the option is exercised, the optionee recognizes compensation income equal to the excess of the FMV of the stock over the amount (if any) paid to acquire it.

If the option is disposed of before it is exercised, the tax treatment of the transaction depends on whether the disposition is at arm's length. If it is, the transferor recognizes compensation income at the time of the disposition equal to the amount realized over the amount (if any) paid for the option. Following an arm's-length disposition, the transferor will not recognize additional income as a result of the transferee's later exercise (or sale of) the option stock.

If the disposition is not at arm's length, the transferor recognized compensation income at the time of the transfer to the extent the amount realized from the disposition exceeds the amount (if any) paid for the option. The transferor generally will also recognize additional compensation income when the transferee later exercises or otherwise disposes of the option.

Transfer Pursuant to Divorce Is Arm's Length

Although transactions between related individuals...