According to the general rule for transfers of assets between spouses or ex-spouses under a divorce property settlement, the transfers are treated as gifts between spouses for federal tax purposes. As such, the transfers are federal-income-tax-free and gift-tax-free. This is good.
When this favorable general rule applies, the transferee spouse (the person who receives the asset in the divorce settlement) takes over the transferor spouse’s tax basis and holding period for the transferred asset. So when the transferee spouse subsequently sells the asset, he or she recognizes taxable gain or loss as if he or she had owned the asset from the outset. On the other side of the coin, there’s no tax impact on the transferor spouse (the person who gives up the asset in the property settlement) when the general rule applies.
Warning: Divorce-related transfers to a nonresident alien spouse don’t qualify for such benign treatment: they are considered to be taxable transactions that can trigger taxable gains or losses.
Federal income tax consequences for divorce-related transfers of vested employer stock options
What happens with a divorce-related transfer of vested employer stock options from the employee spouse to the non-employee spouse pursuant to a divorce property settlement? Good question. Read on for the answers.
For instance, assume Spouse A (the employee spouse) owns vested nonqualified employer stock options (NQSOs) that she received as compensation from her employer. Because the NQSOs are not publicly traded, Spouse A was not taxed upon receiving the options. Assume that under applicable state law, the NQSOs are considered marital property. Therefore, Spouse A is require to transfer some of her NQSOs to Spouse B (the non-employee spouse) pursuant to the couple’s divorce property settlement. Sometime later, Spouse B exercises the NQSOs. At that time, the fair market value (FMV) of the stock is above the option exercise price.
The IRS says the transfer of vested NQSOs from Spouse A to Spouse B falls under the general tax-free transfer rule (assuming the non-employee spouse is not a nonresident alien). Therefore, the transfer has no immediate federal income tax consequences for either spouse. However, upon exercising the NQSOs, Spouse B must recognize taxable income equal to the difference between the fair market value (FMV) of the option shares and the exercise price (the “spread”). This profit is ordinary income (as opposed to capital gain) because Spouse B is treated as if he received the NQSOs as compensation from his employer. (Source: IRS Revenue Ruling 2002-22.)
If the vested employer options in question are incentive stock options (ISOs), the federal income tax outcome is the same, because an ISO cannot be transferred to or exercised by a person other than the employee to whom the option was granted (except by reason of the employee’s death). Therefore, when an ISO is transferred to a non-employee spouse, it instantly ceases to be an ISO and instantly becomes an NQSO, and the federal income tax outcome is exactly the same as explained above.
These federal income tax rules are favorable to the employee spouse (the person who gives up the options in divorce), because he or she faces no further tax consequences after the divorce-related transfer. The non-employee spouse (the person who receives the options in the divorce-related transfer) bears all the federal income tax consequences.
Federal employment tax implications
The IRS has also issued rules on the federal employment tax consequences of divorce-related transfers of vested employer stock options. By federal employment taxes, I mean Social Security tax, Medicare tax, federal unemployment tax (FUTA), and federal income tax (FIT) withholding. Here’s the drill.
When the general tax-free transfer rule applies (which will usually be the case), the transfer itself does not trigger any federal employment taxes. However, when the options are subsequently exercised by the non-employee spouse, federal employment taxes are triggered to the same extent as if the employee spouse had retained the options and exercised them.
So the non-employee spouse may be hit with withholding for Social Security tax (at a 6.2% rate), will definitely be socked for Medicare tax (at a 1.45% rate), and may be hit with the new 0.9% additional Medicare tax for high earners too. To make this completely clear, the amount of withholding for these taxes is determined by the employee spouse’s year-to-date earnings from the employer. However, the taxes are actually withheld from the non-employee spouse (the person who exercises the option). This is fair and just, because the non-employee spouse is the one who reaps the economic benefit from exercising the option.
Finally, federal income tax must also be withheld from the non-employee spouse. The non-employee spouse can then claim a credit for the withholding on his or her federal income tax return. Source: IRS Revenue Ruling 2004-60.
You own vested NQSOs received as compensation from your employer. The options give you the right to buy 10,000 shares of employer stock at an exercise price of $15 per share. The options expire on 12/31/15. In 2015, you and your spouse are divorced. As part of the divorce property settlement, your ex receives half of your NQSOs.
The transfer of the vested NQSOs from you (the employee spouse) to your ex (the non-employee spouse) has no immediate tax consequences for either party.
Assume that later in 2015, your ex exercises the NQSOs by acquiring 5,000 shares for $15 each at a time when the stock is worth $25 per share. Your ex must recognize 2015 ordinary income of $50,000 (5,000 shares x $10 “spread” per share). Federal income and employment taxes will be withheld from your ex. The exercise has no tax impact on you.
The bottom line
You now understand the federal income and employment tax consequences for most divorce-related transfers of vested employer stock options. The rules actually make sense and are fair to the divorcing individuals.
I don’t say this very often, but thank you, IRS!