IRS reversal on stock options and divorce.

• Author: Beck, Allen M.

What 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 non-employee 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...