Divorce and Taxes: IRAs and Options

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.