Final guidance on the tax treatment of NQSOs and deferred-compensation rights transferred in divorce.

• Author: Simonetti, David P.
• Position: Nonqualified stock options

In Rev. Rul. 2004-60, the IRS adopted (with modifications) Notice 2002-31'S proposed rules on withholding and income tax reporting for the transfer of nonqualified stock options (NQSOs) and nonqualified deferred compensation incident to a divorce. Under the ruling, when interests in NQSOs and nonqualified deferred compensation are transferred from an employee spouse to his or her former spouse (nonemployee spouse) in a divorce, the transfer does not result in a payment of wages for FICA or FUTA purposes. However, FICA and FUTA withholding are required when the options are exercised or the nonqualified deferred compensation is paid or made available.

Background

Previously, in Rev. Rul. 2002-22 (which had the same facts as Rev. Rul. 2004-60), an employee spouse was not required to include amounts in gross income on the transfer of NQSOs and nonqualified deferred compensation to the former spouse in a divorce. The nonemployee spouse was required to assume the income tax responsibility associated with such payments. Consequently, he or she would include in gross income any income associated with the NQSOs on exercise or the deferred compensation when paid or made available.

Rev. Rul. 2004-60

Under the final rules, compensation associated with (1) NQSOs on exercise and (2) deferred compensation when paid or made available to the nonemployee spouse, remains subject to FICA and FUTA taxes as if it had been retained by the employee. Thus, the NQSOs are subject to FICA and FUTA when exercised by the nonemployee spouse. Similarly, any nonqualified deferred compensation is subject to FICA and FUTA taxes to the same extent as if the rights to the compensation had been retained by the employee spouse.

Although the nonemployee spouse receives the payments, they relate to the employee spouse's employment and are his or her FICA wages. The employer reports the...