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IRS issues guidance for dividing non-qualified options in a divorce

The IRS changed its position about the results of dividing non-qualifying stock options in a divorce in Revenue Ruling 2002-22. Previously, in Field Service Advice 200005006, the IRS ruled that the transfer of non-qualified stock options to a non-employee spouse resulted in the recognition of ordinary income to the employee spouse at the date of transfer. There would be no further consequence when the non-employee spouse exercised the options.

(By the way, since only an employee is allowed to hold incentive stock options (ISOs), a transfer of ISOs to a spouse relating to a property division in a divorce results in converting the options to non-qualified stock options, so they will be taxed according to the rules in this ruling.)

Now the IRS says there is no consequence when the options are transferred to the non-employee spouse. The excess of the fair market value of the stock received over the option price is taxable as ordinary income to the non-employee spouse when the options are exercised.

The IRS cites as its authority Internal Revenue Code Section 1041. Under that Code section, no income or loss is generally recognized for a division of marital assets. In the past, the IRS has said that Section 1041 does not apply to ordinary income assets, such as U.S. savings bonds. So much for consistency. Tax practitioners and divorce attorneys would prefer the IRS follow the concept that no tax results for a division of marital assets in a divorce consistently. There are enough problems to deal with in a divorce without having a tax consequence from a property division.

The new revenue ruling will not apply and the transfer may be treated as taxable based on the old Field Service Advice if

1. The income is attributable to an interest in nonstatutory stock options, unfounded deferred compensation rights, or other similar intangible property rights;
   
   
2. The options or rights were transferred from one party to a divorce to the other party to the divorce;
   
   
3. The transfer was required by a provision of an agreement or court order;
   
   
4. The provision was contained in the agreement or order before November 9, 2002; and
   
   
5. (a) The agreement or court order specifically provides that the transferor must report gross income attributable to the transferred interest or (b) It can be established to the satisfaction of the IRS that the transferor has reported the gross income for federal income tax purposes.

In a related notice, Notice 2002-19, the IRS announced its intention to release another Revenue Ruling about how an employer should implement the tax results of Revenue Ruling 2002-22. According to the notice, the employee is still subject to employment taxes, such as FICA and Medicare withholding, when the non-employee spouse exercises the options. The FICA and Medicare wages and the related withholding amounts should be reported on the employer's payroll tax returns (Form 941) and on Form W-2 for the employee spouse. The employer is also subject to FUTA (unemployment) tax for the deemed wages to the employee. Income tax withholding is required relating to the ordinary income to be reported by the non-employee spouse. The employer should report the income tax withholding and the ordinary income amount on Form 945, Annual Return of Withheld Federal Income Tax. The income and withholding for the non-employee spouse will be reported on Form 1099-MISC.

The employer will have the headache of having to deal with a non-employee. If the non-employee spouse elects to not sell the shares when the option is exercised, the employer will have to collect the cash for the "withheld" taxes from the non-employee spouse. The employer will also need to maintain information such as the non-employee spouse's social security number and address in order to prepare Form 1099-MISC.

These new rulings provide desperately-needed authoritative guidance, and will simplify the process of dividing marital assets in a divorce.

It's time for second estimated tax payments

The second estimated tax payment for 2002 is due no later than June 17. You should discuss with your tax advisor what the appropriate payment is for you or whether you can handle your estimated tax obligation through your withholding. Remember for 2002 a "protected" estimate based on last year's tax would be 112% of the tax on your 2001 income tax returns, including alternative minimum tax.

Questions and Answers

Question

Does vesting affect the $100,000 limitation relating to ISOs?

Answer

According to Internal Revenue Code Section 422(d), an employee is limited to $100,000 in stock, based on the fair market value on the grant date, exercisable for the first time during a calendar year. Any options exceeding the $100,000 limit are treated as non-qualified options.

These rules are explained in Treasury Notice 87-49.

It appears vesting does not affect whether the options qualify, although most plans don't permit exercising the options until they are vested.

Question

Can you tell me how stock options work when they are given to an employee or director by the corporation they work for?

Answer

I'm afraid your question is too general for me to give a specific answer. The option is a right for the grantee to purchase a certain number of shares at a set price during a certain time period. The options I discuss are usually granted as compensation for services to the granting corporation. The tax consequences vary by the specific type of option granted: non-qualified stock options, incentive stock options, or employee stock purchase plans.

Only employees are eligible to receive incentive stock options or participate in an employee stock purchase plan. There are books available, including our Secrets Of Tax Planning For Employee Stock Options reference manual and recordings, from which you can get more details.

Question

Will the proposed withholding requirements for employment taxes apply to ISO plans for privately-held companies?

Answer

Yes.

Question

Does filing an 83(b) election start the holding period for all (ISO) shares exercised and paid for even though total vesting of all shares will take four years?

Answer

I believe so. That's what an 83(b) election is for - to treat a transfer of property in exchange for services as completed, even though the transfer is restricted.

According to Internal Revenue Code Sections 422(a) and 421(b), if there is a disqualifying disposition, the ordinary income is determined according to Section 83 (like non-qualified options), except the income is reported in the year of disposition.

The IRS recently issued Letter Ruling 200212021 where an employee exercised an ISO and made a Section 83(b) election. The employee reported the AMT adjustment for the year of exercise based on the excess of the fair market value on the date of exercise over the option price of the shares. The IRS did not allow the employee to later revoke the Section 83(b) election as a mistake of fact, despite the fact the employer gave the employee the election as part of a "standard package" with "sign here" stickers.

Question

I am confused about the two years from grant requirement for Long Term Capital Gain. One of my employees thinks that if he was given a grant in 1998 and does not exercise it until 2002, then he qualified for long-term capital gain treatment because it is more than two years from the date of grant. Is that correct? It don't think it is because don't you have to hold it for two years?

Answer

According to Internal Revenue Code Section 422(a), there will be no ordinary income for the disposition of stock acquired by exercising an incentive stock option provided the disposition of the share is made more than 2 years after the grant date and more than 1 year after the transfer of the share to the employee. Therefore, as a general rule, the employee must hold the shares more than one year after the exercise date and may not sell the shares until more than two years after the grant date in order for the excess of the fair market value of the shares on the date of exercise over the option price to be taxable as long-term capital gains.

Question

After reading several of your articles, I am still confused about exercising NSO options. To lower my tax, I would like to exercise current shares with instructions to buy and hold with the intention of selling after one year.

Answer

I'm sorry you are confused, because my material should be clear. There is no tax benefit for exercising non-qualified options and holding the shares. You will report ordinary income for the excess of the fair market value of the shares over the option price on the date of exercise. Your employer should require you to pay in the required income tax and employment tax withholding for the income. Your tax basis in the shares will equal the fair market value of the shares on the date of exercise (option price plus ordinary income reported.) Your employer should report the ordinary income amount as wages on your Form W-2 for the year of exercise.

Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.