Limits on rulings on NQSOs in divorce.

• Author: Gibson, Dan
• Position: Nonqualified stock options

The IRS held, in Rev. Rul. 2004-60, that interests in nonqualified stock options (NQSOs) or deferred compensation plans transferred as part of a divorce are subject to tax, withholding and reporting requirements when exercised, rather than when the transfer occurs.

Background

The Service first proposed the above employment and income tax withholding rule in Notice 2002-31, which accompanied Rev. Rul. 200222. In the latter, the IRS held that neither party to a proposed divorce settlement agreement was required to recognize income when either one transferred NQSOs and nonqualified deferred compensation rights to the other. The transfer is governed by Sec. 1041, which provides that property transfers between spouses are nontaxable events if the transfers are incident to a divorce. A transfer is "incident to a divorce" if it occurs within one year after the marriage is terminated or is related to the marriage's cessation (i.e., as part of a divorce order, etc.).

However, the transferee former spouse must recognize income when deferred compensation is paid or made available, and/or when the NQSOs are exercised. The Service ruled that the transferor does not recognize income, because the assignment-of-income doctrine generally does not apply to transfers incident to divorce, due to the fact that such transfers are involuntary.

Analysis: The IRS explained that nothing in Sec. 1041 excludes payments to a person other than an employee from wages for FICA and Federal income tax purposes. In the absence of a specific provision that would exclude these payments from FICA wages, the compensation realized and the deferred compensation paid or made available to the non-employee-spouse retain their character as wages of the employee-spouse for FICA purposes. Because the payments are wages for FICA purposes, they are reportable by the employer as Social Security and Medicare wages on the employee-spouse's Form W-2, as are the Social Security and Medicare taxes withheld. The payments are not included in box 1 or 2 of the employee's W-2. Because these employment taxes are being withheld from the ultimate amount received by the nonemployee-spouse, this result has lead to criticism that the nonemployee-spouse is paying amounts that are being credited to FICA wages for the employee-spouse.

Because there is no provision permitting a W-2 to be provided to a nonemployee-spouse, the employer must report the amounts the transferee recognizes as taxable income and the...