Guidelines on withholding from compensation payments incident to divorce.

• Author: O'Driscoll, David

A recent ruling provides guidelines on FICA, FUTA and income tax withholding from nonstatutory stock options and deferred-compensation plans transferred between spouses incident to divorce.

Facts

Prior to A's divorce from B, A's employer Y issued A nonstatutory stock options as part of it is compensation; no amount was included in A's gross income at the grant. A also participated in Y's unfunded, deferred-compensation plazas, under which he earned the right to receive post-employment payments from Y Pursuant to the property settlement and divorce judgment, A transferred the nonstatutory stock options and the right to receive deferred-compensation payments to B. B will exercise all of the transferred stock options in 2006 and receive a single lump-sum payment from the plans when A separates from employment in 2007.

Analysis

Rev. Rul. 2002-22 previously concluded that a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to his or her former spouse incident to divorce need not include any gross income on the transfer. It also concluded that the former spouse, not the taxpayer, is required to include gross income when he or she exercises the options or when the deferred compensation is paid or made available to the him or her. A proposed ruling in Notice 2002-31 concluded that exercise of the options and the nonqualified deferred compensation remain subject to FICA and FUTA taxes to the same extent as if they had been retained by the employee; the income recognized by the nonemployee spouse on the exercise of the options and distributions of nonqualified deferred compensation is wages for income tax witholding purposes.

Social Security Wages

The transfer of interests in nonstatutory stock options and in nonqualified deferred compensation from an employee spouse to a nonemployee spouse incident to a divorce does not result in a payment of wages for FICA and FUTA tax purposes. Under Sec. 3121 (v)(2), amounts deferred under a nonqualified deferred-compensation plan generally are to be taken into account when the services are performed or, if later, when there is no substantial risk of forfeiture. To the extent deferred amounts were already taken into account for FICA purposes, a distribution of proceeds to B will not be wages for PICA tax purposes; however, to the extent not previously taken into account, a distribution will be wages to A for FICA tax purposes. Similarly, B's exercise of the...