If an NQSO is transferred to a bankruptcy trust, what is the tax treatment for the corporation and the employee?
August 21, 1999
Subject: question re bankruptcy and stock option
Date: Wed, 18 Aug 1999
If non-qualified employee stock options are transferred to a bankruptcy trust, what would be the tax treatment for both the corporation and the employee?
Thank you for your attention.
There is no tax result when a non-statutory stock option is transferred to a bankruptcy estate.
This begs another question, what happens when the bankruptcy estate exercises a non-qualified employee stock option?
I haven’t found an IRS ruling directly on this point. Here is my suggested answer to the question.
The regular rules apply to the exercise (taxable wages to the employee, deduction for wages to the employer) unless the employee has filed for bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization) or title 11 of the U.S. Code.
When the employee files under these sections, the bankruptcy estate files a separate tax return for the assets administered by the bankruptcy trustee. The tax return is a Form 1040, attached to Form 1041 (Fiduciary Income Tax Return) as a blank transmittal. (See instructions to Form 1041.)
Internal Revenue Code Section 1398 gives the rules relating to Title 11 bankruptcy cases for individuals. According to Section 1398(e)(1), “(t)he gross income of the estate for each taxable year shall include the gross income of the debtor to which the estate is entitled under title 11 of the United States Code. The preceding sentence shall not apply to any amount received or accrued by the debtor before the commencement date.”
According to Section 1398(e)(2), the gross income of the debtor doesn’t include any amounts reportable by the bankruptcy estate.
According to Section 1398(f), transfers between the debtor and the bankruptcy estate are not treated as dispositions.
There is a Revenue Ruling relating to a decedent’s estate that I think can be extended to this case. According to Rev. Rul. 196 (1952-2 CD 178), the amount received by the estate of a decedent-employee from the exercise of a non-qualified option is compensatory income to the estate, the right to which was acquired by the estate from the decedent.
Therefore, the ordinary income from the exercise of a non-qualified stock option by a bankruptcy estate is taxable to the bankruptcy estate.
The employer is entitled to a compensation deduction for the income reported by the bankruptcy estate.
I believe that, since the income is still considered earned by the employee, but taxed to the estate, the income is subject to employment taxes. The amounts subject to employment taxes would be disclosed as such on the employee’s W-2, but not included as taxable wages on the employee’s W-2.
A W-2 should be issued to the bankruptcy estate for the taxable income. I believe the income retains its character as employee wages, so income taxes should be withheld.
That’s my “best guess.”
You, your employee, and your employee’s bankruptcy trustee should consult with your tax advisors in making your final decision about how to handle the situation.