More On Tax Planningfrom The Advisor's Professional Library
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
- Long Term Care Insurance: Premiums While premiums for qualified long-term-care insurance may be deductible as medical expenses there are exceptions to this general rule. Learn how to avoid unnecessary tax liabilities.
The courts and the IRS have been very active recently in the divorce arena. Developments in the areas of nonalimony designations, dependency waivers, interest, retirement plans, IRAs, stock options, and stock redemptions significantly affect the negotiation of divorces and the taking of tax return positions after a divorce.
This is part two of a two-part series on those developments. In the February 2005 issue of Investment Advisor, the authors, who teach at Tennessee Technological University, focused on nonalimony designations and pension plans. This month, the focus is on the challenges surrounding IRAs and stock options. Both parts of the series are reprinted with permission from the September 2004 issue of the The CPA Journal, the official publication of the New York State Society of CPAs.
Transfers of IRA Interests to a Former Spouse
IRC section 408(d)(1) requires a taxpayer to include amounts paid or distributed from an IRA in gross income. Under the section 408(d)(6) exception, however, the transfer of an individual's interest in an IRA to a former spouse under a divorce decree is not taxable to the individual. The interest is treated as the former spouse's IRA. Nonetheless, taxpayers must meet two requirements: There must be a transfer of the IRA participant's interest in the IRA to the spouse or former spouse, and this transfer must be made under an IRC section 71(b)(2) divorce or separation agreement. Case law contains many examples of taxpayers who withdraw funds from IRAs and then write checks to ex-spouses in order to comply with divorce judgments. These taxpayers must include the amount of the distribution in gross income and sometimes pay the 10% early-distributions penalty.
The 10% penalty on early distributions from qualified retirement plans does not apply to distributions made to an alternate payee pursuant to a QDRO within the meaning of IRC section 414(p)(1). [A QDRO is a Qualified Domestic Relations Order, pronounced "QUAD row" or "CUE dro".] A "domestic relations order" is defined as any judgment involving the provision of marital property rights to a spouse, or former spouse, of a participant that is made pursuant to a state domestic relations law. A QDRO is a specific type of domestic relations order that creates an alternate payee's right to receive all or part of the benefits payable with respect to a participant under a plan, clearly specifies certain facts, and does not alter the amount of the benefits under the plan.
To qualify for this IRC section 72(t)(2)(C) exception, the distribution must be made by the plan administrator to an alternate payee in response to a QDRO. IRC section 414(p) provides certain procedural rules for domestic relations orders to provide guidance to plan administrators. Implicit in these rules is the requirement that a domestic relations order be presented to the plan administrator and adjudged "qualified" before any distribution by the plan to the spouse or former spouse [Rodoni v. Commissioner, 105 T.C. 29, 36 (1995)]. This was the crux of the dispute in Bougas v. Commissioner (T.C. Memo 2003-194). The divorce judgment ordered Bougas to pay a lump sum of $150,000 tax free to his ex-wife, $47,000 to various credit card companies, and $10,000 to her attorney. The divorce judgment also contained a provision that Bougas's 401(k) and IRA accounts were his sole and exclusive property, free and clear of any claims by his spouse. The divorce judgment did not provide for a specific source of funds from which Bougas was to pay his divorce obligations. There was no mention of a QDRO nor any reference to making the wife an alternate payee on Bougas's IRA.
After depositing a $250,000 distribution from his IRA into his personal checking account, Bougas wrote checks to satisfy the terms of the divorce judgment. He reported the $250,000 as income on his tax return, but did not report the 10% penalty for early withdrawal. The Tax Court said the divorce judgment was a domestic relations order under section 414(p)(1)(B), but that it did not qualify as a QDRO under section 414(p). It did not qualify as a QDRO because the divorce judgment did not create or recognize the wife's right to receive any portion of her husband's IRA as an alternate payee, nor did it award her any interest in the IRA. In addition, Bougas never submitted a copy of the divorce judgment to the plan administrator prior to requesting and receiving the distribution from his IRA.
The taxpayer tried to make the argument that he was only following the directions of the New Jersey court, which required him to make the IRA distributions to pay his divorce obligations. The court rejected the same argument in Czepiel [2001-1 USTC para. 50,134 (CA-1, 2000), aff'g T.C. Memo 1999-289]: The taxpayer was not required to pay his divorce obligations from his IRA; he chose to use the IRA because he had no other source of funds.
Nonstatutory stock options (NSO) and nonqualified deferred compensation are governed by the more general principles of compensation and income recognition. The first question is whether the transfer of NSOs and nonqualified deferred compensation pursuant to a divorce will trigger the unpaid tax under IRC section 83. If not, does the assignment of income doctrine require the spouse who earned the compensation to pay the tax when the other spouse exercises the option or receives the distribution?
In Revenue Ruling 2002-22, the IRS decided that nonrecognition treatment under IRC section 1041 at the time of transfer prevails and the assignment of income doctrine does not apply to these transfers. Thus, the tax burden will pass to the receiving spouse, who must include the appropriate amount in income under IRC section 83(a) when NSOs are exercised or when distributions are received from the deferred compensation plan. This conclusion applies regardless of whether the divorcing spouses live in a community property state. The IRS will apply its holding in Revenue Ruling 2002-22 retroactively, as well as prospectively, to all situations except when the following holds:
- The transfer between spouses pursuant to a divorce was required by a provision of an agreement or court order before November 9, 2002; and
- The agreement or court order specifically provided that the transferor must report gross income attributable to the transferred interest, or it can be established to the satisfaction of the IRS that the transferor has reported gross income for federal income tax purposes.
Example. In year one, Corporation XYZ grants Mr. Smith a nonstatutory option to buy 2,000 shares of XYZ stock for a strike price of $30 per share at any time during the next eight years. In year five, Mr. Smith transfers the option to Mrs. Smith pursuant to a divorce. The transfer of the option does not result in a payment of wages for FICA and FUTA tax purposes, nor are there income tax consequences in year five. In year eight, XYZ stock is selling for $50 per share, and Mrs. Smith exercises the option. Mrs. Smith must recognize $40,000 ($100,000-$60,000) as ordinary income in year eight. Mrs. Smith's tax basis in the shares is $100,000. When Mrs. Smith sells the shares, she will have a capital gain or loss.
IRS Notice 2002-31 considers the same facts as Revenue Ruling 2002-22 and addresses the employment tax issue. When the nonemployee spouse exercises the nonqualified stock option, the nonemployee spouse gets the credit for the income tax that was withheld, but is also subject to the FICA tax due on exercise, and the employer is subject to its half of the FICA tax. IRC section 1041, which provides an exclusion from income tax, doesn't apply for FICA tax purposes. The transferred property is still treated as wages in the hands of the nonemployee spouse.
In June 2003, for the first time in nearly 20 years, the IRS issued proposed regulations addressing statutory stock options. The new regulations expand the definitions of option, corporation, and stock. Option now includes warrants. Statutory option means an incentive stock option or an option granted under an employee stock purchase plan (ESPP). An incentive stock option (ISO) is a stock option granted, typically, to key employees. The grantee has the right to purchase stock without realizing income either when the option is granted or when it is exercised. The grantee is first taxed when she sells or disposes of the stock and has a capital gain or loss. Generally, ISOs cannot be transferred by the grantee to another party while keeping their special tax treatment. If a statutory stock option is transferred incident to divorce (IRC section 1041) or pursuant to a QDRO [IRC section 414(p)], the option does not qualify as a statutory option as of the day of such transfer, and is treated like nonstatutory stock options. IRC section 424(c)(4), however, provides that a section 1041(a) transfer of stock acquired on the exercise of a statutory stock option is not a disqualifying disposition. Thus, the transfer of stock acquired by exercising an ISO incident to divorce is tax free; the tax consequences are postponed until the stock is sold.
Redemption of Stock
What if a divorce settlement obligated a husband to purchase his wife's stock in their jointly held corporation and he directed the corporation to redeem her stock? Has the husband realized a constructive dividend because the corporation's redemption satisfied his obligation to buy out his wife's holdings? If not, did the wife have to recognize capital gain on the transfer of her stock back to the corporation? The IRS has sometimes asserted deficiencies against both spouses. In the two Arnes decisions [93-1 USTC para. 50,016 (1992, CA-9) and 102 T.C. 522 (1994)], neither the husband nor the wife had to pay income tax on this redemption.
IRC section 1041 does not address third parties involved in property transfers incident to divorce. Treasury Regulations section 1.1041-2, issued January 13, 2003, addresses stock redemptions during marriage or incident to a divorce. The new regulations are limited to stock redemptions, while other third-party transfers continue to fall under Treasury Regulations section 1.1041-1T(c)(QA-9). Under the new regulations, stock redemptions not resulting in a constructive dividend to the nontransferor spouse (under applicable tax law) will be treated as redemptions by the transferor spouse, who will be liable for any tax consequences. Stock redemptions that do result in a constructive dividend to the nontransferor spouse will be treated as such, and that spouse will be liable for any tax consequences.
Who Gets to Pay?
A special rule in Treasury Regulations section 1.1041-2(c) gives taxpayers the option to choose which spouse will be responsible for the tax consequences. A divorce, separation, or other written agreement must state how both spouses intend for the IRS to treat the redemption. Both spouses must execute the agreement before the date on which the spouse responsible for the tax files his or her tax return for the year of redemption. The new regulation applies to stock redemptions on or after January 13, 2003, under agreements in effect after that date. It also applies to redemptions before that date if the spouses had executed a written agreement on or after August 3, 2001.
Larry Maples, DBA, CPA, is the COBAF Professor of Accounting, and Melanie James Earles, DBA, CPA, is an associate professor of accounting, both at Tennessee Technological University in Cookeville, Tennessee.