How to Unmarry a Millionaire.

• Author: McBride, Gary R.

IRC Sec. 1041 assures that gain is not recognized for income tax purposes when property is transferred between spouses or former spouses incident to a divorce. In a recently released field service advice (FSA 200005006), the IRS rejected Sec. 1041 protection and concluded that an employee who transfers stock options to a spouse as part of a divorce must recognize income immediately at the time of the transfer, even though no options are exercised.

The FSA involved an ex-husband (we'll call him Harold), who pursuant to a marital property settlement, transferred one-half of his options to purchase his employer's stock-both incentive stock options and nonqualified stock options--to his ex-wife (we'll call her Maude). The couple resided in a non-community property state.

First, the IRS noted that upon transfer from Harold to Maude, the ISOs became NQSOs. Second, the IRS determined that the transfer of the NQSOs from Harold to Maude was a taxable arm's-length disposition of the options under Reg. Sec. 1.831(b)(1), and US. v. Davis, 370 U.S. 65 (1962), resulting in compensation income to Harold equal to the options' value on the date of transfer to Maude.

The IRS denied Harold relief under IRC Sec. 1041(a) which defers "gain or loss" on "the transfer of property between spouses or former spouses incident to divorce." The IRS believes that gain under Sec. 1041 does not encompass compensation income. Implicitly, the IRS also does not regard stock options as "property" subject to nonrecognition under Sec. 1041. The FSA is consistent with Temp. Reg. Sec. 1.1041-1T, A-4, which declares that" ... transfers of services are not subject to the rules of section 1041."

However, because compensation income is triggered to Harold upon transfer, neither Harold nor Maude face another taxable event when Maude exercises the options.

TRAP #1: Market Decline After Option Transfer-Worst Case Scenario: A major stock price decline after Harold's transfer to Maude elicits the worst possible tax consequences: immediate taxable compensation income to Harold, and a delayed capital loss deduction for Maude. Assume that at the time of transfer, the stock of Harold's company is trading at a record high--$200 per share. The option exercise price is $50 per share so Harold's options are $150 per share in-the-money. Shortly after Maude receives the options, and before exercise, the stock nose-dives to $10 per share. Result: Harold pays income tax on the relatively high value of...