Transfers of NQSOs and deferred compensation.

• Author: Sair, Edward A.
• Position: Nonqualified stock options; divorce settlement

In Field Service Advice (FSA) 200005006, the IRS addressed the application of Sec. 83 to taxation of nonqualified stock options (NQSOs) exercised after a transfer pursuant to divorce.

In the FSA, an ex-husband transferred half of his compensatory options--incentive stock options (ISOs) and NQSOs--to his ex-wife as part of a divorce property settlement. The FSA concluded that the ISOs transferred to the former wife automatically became NQSOs, taxable under Sec. 83, due to the rules prohibiting transfers of ISOs. However, this particular conclusion is contrary to Sec. 424(c)(4)(A), which states that ISO transfers between spouses or incident to divorce "shall not be treated as a disposition."

Further, according to Sec. 424(c)(4)(B), when ISOs are transferred between spouses or incident to divorce, the same tax treatment that would have applied to the transferor applies to the transferee. In light of the statutory language, the FSA's conclusion for ISOs must be ignored.

When the ex-wife exercised the options, the ex-husband initially reported the spread as gain on his return, but subsequently submitted a claim for a refund, on the ground that the ex-wife's subsequent exercise of the NQSOs was not a taxable event for him.

The Office of Chief Counsel concluded that the ex-husband was correct. The FSA set forth the following guidelines for the taxation of compensatory stock options transferred pursuant to divorce:

1. The ex-husband should have been taxed under Sec. 83 at the time of the transfer of the options to his ex-wife, instead of delaying recognition until his ex-wife exercised them. The income that the husband should have recognized was the option's fair market value on the transfer date.

2. The ex-wife should receive a carry-over basis in the options under Sec. 1041(b).

3. Neither the ex-husband nor the ex-wife should have been taxed when the ex-wife exercised the options.

4. The ex-wife's tax consequences on the ultimate stock disposition should be governed by Sec. 1001.

   Again, these conclusions are only valid for NQSOs, not ISOs. An FSA is not binding on the IRS, but typically reflects its current thinking.

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