Divorce can be a major disruption to a family’s financial plans. Surprisingly, the Internal Revenue Service (IRS) and Congress have actually worked to make a difficult proceeding less overwhelming and burdened with taxation.
In keeping with other aspects of the tax code that give preference to married people, Internal Revenue Code (IRC) Section 1041 was enacted to ease the transfer of assets in a divorce by not recognizing gain or loss. Instead, the code treats a transfer in the way it treats gifts. The transferor’s tax basis is conveyed along with the asset to the other spouse with limited exposure to taxation. This applies to most divorce-related transfers. A common asset that falls into this type of transfer, is the personal residence. A spouse will receive the home and the transfer of the title would almost always be considered, a tax-free transfer.
Non-Qualified Stock Options
In IRS Revenue Ruling 2002-22, it provided revised guidance on the tax treatment of NQSOs. Essentially, the ruling states that the transfer of NQSOs in a divorce by the employee to a former spouse does not result in the recognition of income. Exercise of these NQSOs by the former spouse will result in compensation to the former spouse, not the employee.
ISOs Treated Differently
Unfortunately, the transfer of incentive stock options (ISOs) remains difficult in divorce. But the tax treatment of the transfer became clearer. In general, the transfer of the ISO to a “nonqualified party” results in disqualification of the option, turning it into an NQSO. The tax advantages are lost when the ISO becomes an NQSO. But whether a transfer to a nonemployee-spouse in a divorce is a transfer to a nonqualified party remains unclear.
Community Property States
Pursuant to Revenue Ruling 74-278, in a community property state no “disposition” within the meaning of Section 425(c)(1) occurs when stock purchased by an employee-spouse with community funds through the exercise of an ISO is divided equally. As a result, the ISO “preferences” remain intact for these transfers of exercised options in a community property state. This applies only to ISOs that have been exercised into stock prior to the transfer to the nonemployee-spouse.
Revenue Ruling 2002-22 does have two major limitations. First, it applies only to the transfer of stock options in divorce. Married spouses who want to transfer stock options must look elsewhere for guidance. Second, Revenue Ruling 2002-22 does not apply to the transfer of unvested stock options. To determine the tax effect from the transfer of unvested stock options, when allowed, an “assignment of income analysis” needs to be performed. The whole area of the transfer of unvested stock options, is still not clear. Since state law dictates transfers in divorce, each case needs to be separately evaluated.
In Revenue Ruling 2004-60, the IRS provided a framework for payroll administration upon the transfer of stock options. Upon exercise of the NQSO, the employer determines and reports the related payroll taxes (Social Security and Medicare) on the employee-spouse’s earnings. The wages attributable to the exercise of the NQSO are the wages of the employee, but Social Security payment is deducted from the payment to the nonemployee-spouse.
Under this Ruling, Form W-4 is not required from the nonemployee-spouse. To deduct the federal income tax at exercise, the employer can apply the supplemental withholding rate, currently 22% for most employees (but 37% for aggregate yearly income in excess of $1 million), along with the appropriate withholding rate for any state income tax. The recipient needs to understand that this withholding will occur and take this into consideration when structuring the property settlement.
Confirm That Transfers Are Allowed
Another obstacle can complicate even the most amicable divorce: the transferability of the option. Many plans traditionally do not allow option transfers; in that case, all the IRS changes and amendments remain for naught. No divorce decree or marriage settlement can change this fact, and you must try to resolve the property settlement in a different manner.
Handling Transfer Limits
What can you do if the options are not transferable? Here are some common solutions.
- The employee-spouse could make a same-day sale before the transfer and then divide the proceeds, net of taxes, according to the provisions set forth in the divorce decree or marriage settlement agreement.
- The parties agree that the employee-spouse will maintain ownership of the options after the divorce and exercise and sell the option at a time agreeable to both parties. Upon the sale of the stock, the proceeds will be divided (again, net of taxes). Parties should consider incorporating a provision in the marriage settlement that specifies how income taxes and payroll taxes will be paid.
This alternative poses a couple of problems. First, the non-owning spouse has limited control over the exercise and distribution of the option proceeds. Second, the parties should refer to the respective state’s bankruptcy laws to determine whether bankruptcy by the owning spouse would jeopardize the non-owning spouse’s claim to the proceeds from the stock options.
- Establish a trust for the benefit of the non-owning spouse and transfer the options into the trust.
- The property settlement could be reallocated so that other assets of comparable value from the divorce estate are transferred to the nonemployee-spouse in exchange for a claim to the stock options.