For some employees, stock options are regular components of
their compensation packages, whether received as non-qualified
stock options (NSOs) or incentive stock options (ISOs). Challenges
for these employees and their attorneys often arise during a
divorce when determining how to treat said stock options for
purposes of division of assets and support awards and the tax
consequences that follow. In 2001, Massachusetts courts concluded
that language in M.G.L. c. 208, s. 34 clearly indicates that both
vested and unvested stock options may be treated as marital assets
for purposes of dividing a marital estate. Massachusetts courts
have also concluded that income from the exercise of stock options
can be considered as part of gross annual income under a divorce
judgment. For those stock options divided as assets, there are a
number of factors to consider, determined primarily by what type of
stock option(s) the employee has been granted.
Types of grants
Nonqualified stock options
Nonqualified stock options (NSOs), or nonstatutory stock
options, are more commonly granted than incentive stock options
(ISOs). NSOs do not carry the same tax advantages as ISOs for
employees. Employers are able to deduct the spread between the
strike price and the price at which the option is exercised as
compensation, making NSOs more favorable for employers to grant.
NSOs generally are not taxable to employees upon the grant of the
option. The first taxable event occurs upon exercise of the option.
Upon exercise, the employee receives compensation income equal to
the spread between the strike price and the price on the date of
exercise and pays ordinary income tax on the spread. The employer
receives a tax deduction equal to the income recognized by the
employee upon exercise. The sale of stock triggers a second taxable
event with respect to the gain on the sale, which is the excess of
the sale price over the price on the date of exercise. If the stock
is sold at least one year after the option is exercised, the
employee pays long-term capital gain taxes, but if the stock is
sold within a year of exercise, the employee pays ordinary tax
rates.
NSOs can be granted to anyone, including employees, consultants,
advisors and directors. Further, NSOs may be transferrable in the
case of divorce, depending on the stock plan. Because NSOs can be
granted to anyone and they are more favorable to employers, stock
options to be considered in a divorce will most likely be NSOs.
Incentive stock options
ISOs are options that conform to all of the statutory
requirements of IRC §§ 421, 422 and 424 at the time of the grant.
ISOs are more favorable to the employee from a tax standpoint and
less advantageous for employers. Therefore, they are granted less
often than NSOs. Like NSOs, ISOs are not taxed upon the grant of
the option. If an employee makes a disposition of the stock
received from the exercise of the incentive stock option within two
years of the date he or she was granted the option and within one
year after the date exercised, the spread is treated as ordinary
income and is taxed accordingly. Any appreciation subsequent to the
exercise will be taxed as a short-term capital gain. Provided the
employee exercises the options more than one year after vesting and
sells the stocks more than two years after the options were
granted, the amount realized on sale in excess of the strike price
is taxed as long-term capital gains, an advantageous tax treatment
for the employee as this can lead to significant savings over an
NSO.
Despite the favorable income tax treatment of ISOs for
employees, ISOs are treated as NSOs for purposes of the Alternative
Minimum Tax. ISOs can only be granted to employees and if an
employee leaves his or her job, he or she has three months to
exercise the options or they revert to NSOs. Pursuant to IRC § 422,
ISOs are not transferrable. Therefore, ISOs cannot be transferred
by an employee to a nonemployee spouse in a divorce.
Issues to consider
Is an employee who transfers nonstatutory stock
options to a former spouse pursuant to a divorce required to
include an amount in gross income upon the transfer?
IRC § 1041(a) provides that no gain or loss is recognized
on a transfer of property if incident to divorce. IRC § 1041(b)
provides that the property transferred is generally treated as
acquired by the transferee by gift and that the transferee's basis
in the property is the adjusted basis of the transferor.
Although a transfer of nonstatutory stock options as part of a
property settlement may involve exchange for money, property or
other consideration, it would contravene the gift treatment
prescribed by IRC § 1041 to include the value of the consideration
in the transferor's income under IRC § 83. Accordingly, the
transfer of stock options pursuant to a divorce is entitled to
nonrecognition treatment under IRC § 1041. Rev. Rul. 2002-22, Part
1, Section 61. This tax treatment only applies to the transfer of
vested options. When the transferee exercises the stock options,
the transferee realizes ordinary income to the extent that the
value of the stock on the date of exercise exceeds the amount paid
for the stock. The employee/transferor is not required to include
any amount in gross income when the transferee exercises the stock
options.
What is the effect upon taxation under FICA, FUTA and
income tax withholding of a transfer of nonstatutory stock options
incident to divorce?
Federal Insurance Contributions Act (FICA): IRC
§§ 3101 and 3111 impose FICA taxes on "wages," as defined in §
3121(a). These taxes are imposed on both the employer and employee.
IRC § 3102(a) provides that the employee portion of FICA taxes must
be collected by the employer of the taxpayer by deducting the
amount of the tax from wages as and when paid. IRC §
31.3102(a)-1(a) provides that the employer is required to collect
the tax, notwithstanding that wages are paid in something other
than money. Section § 3102(b) provides that every employer required
to deduct the FICA employee tax is liable for the payment of that
tax, and is indemnified against the claims and demands of any
person for the amount of any such payment made by such employer.
See IRS Rev. Rul. 2004-60.
The fact that payments are includible in the gross income of an
individual other than an employee, here the employee's former
spouse, does not remove the payments from FICA wages. Nothing in
IRC § 1041, pertaining to transfers of property between spouses or
incident to divorce, excludes payments to a person other than an
employee from wages for purposes of FICA. Thus, the payment of such
remuneration is subject to FICA to the same extent as if paid to
the employee spouse. See IRS Rev. Rul. 2004-60.
To the extent the distributed payments are FICA wages, the
employee FICA tax is deducted from the payment made to the
transferee. The amount includible in the gross income of the
transferee is not reduced by any FICA withholding from the
payments, including transfers of property, to the transferee. See
Rev. Rul. 86-109 and Rev. Rul. 71-116.
Federal Unemployment Tax Act (FUTA): The FUTA taxation
provisions applicable with respect to nonstatutory stock options
are similar to the FICA provisions, except that only the employer
pays the tax imposed under FUTA. See IRC §§ 3301, 3306(b) and
3306(b)(2) and the regulations thereunder. To the extent wage
taxation applies, the wages are FUTA wages of the employee, subject
to the maximum wage base contained in § 3306(b)(1).
Income tax withholding: IRC § 3402(a), relating to
income tax withholding, generally requires every employer making a
payment of wages to deduct and withhold upon these wages a tax
determined in accordance with prescribed tables or computational
procedures. IRC § 3401(a) provides that "wages" for income tax
withholding purposes means all remuneration for services performed
by an employee for his employer, including the cash value of all
remuneration, including benefits, paid in any medium other than
cash, with certain exceptions. Under Treasury Regulation §
31.3402(a)-1(c), an employer is required to deduct and withhold the
tax notwithstanding that the wages are paid in something other than
money. Therefore, an employer is required to deduct and withhold
the tax even when the wages are paid by way of stock options.
IRC § 31 provides that the amount withheld from wages as income
tax withholding will be allowed as a credit against the income
taxes imposed by Section A to the "recipient of the income." The
"recipient of the income" for purposes of the § 31 credit, pursuant
to Treasury Regulation § 1.31-1(a), is the individual who is
subject to income taxes upon the wages from which the tax was
withheld. Because the compensatory interests transferred under §
1041 to the nonemployee spouse pursuant to the divorce remain
taxable for employment tax purposes to the same extent as if
retained by the employee spouse, the income recognized by the
nonemployee spouse with respect to the exercise of the nonstatutory
stock options are considered remuneration for employment and wages
for purposes of income tax withholding under § 3402. Therefore,
pursuant to § 1.31-1(a), because the income recognized with respect
to this compensation is includible in the gross income of the
nonemployee spouse, the nonemployee spouse is entitled to the
credit for the income tax withheld with respect to these wage
payments. See IRS Rev. Rul. 2004-60.
Reporting income: IRC § 6051 requires those who
remunerate employees to report said payments on a Form W-2. Given
the nonemployee spouse is not an employee, the reporting
requirements of IRC § 6051 do not apply. Under a scenario where a
nonemployee spouse realizes income from the exercise of the
nonstatutory stock options, the employer, under § 6041(a), must
file an information return reporting said income. The income
realized upon the exercise of the nonstatutory stock options would
be reportable to the nonemployee spouse by the employer on Form
1099-MISC and issued to the nonemployee spouse. See IRS Rev. Rul.
2004-60.
Under Treasury Regulation § 31.6051-1(a)(1), the employee's
wages that are subject to social security and Medicare taxes are
included in the appropriate boxes on the employee's Form W-2 issued
by the employer.
What is the effect of the transfer of stock received
upon exercise of an ISO?
IRC § 424(c)(4) provides that in the event of a transfer
of stock between spouses or incident to divorce, as described in §
1041(a), said transfer of stock should not be treated as a
disposition. Further, the same tax treatment with respect to the
transferred stock shall apply to the nonemployee/transferee as
would have applied to the employee/transferor.
When representing clients in a divorce who are receiving stock
issued upon the exercise of an ISO, special attention should be
given to the grant date of the original option. Provided the option
was exercised more than one year after vesting and the transferee
then sells the stocks more than two years after the grant of the
option, the amount realized on sale in excess of the exercise price
is taxed as long-term capital gains. Otherwise, the amount realized
is treated as ordinary income and is taxed accordingly.
Though significant attention is often given to the
categorization of stock options, specifically, whether they should
be deemed assets for division or as income for purposes of
calculating support, all too often insufficient attention is paid
to the tax consequences related to the options. Attorneys should be
mindful throughout the divorce process of the stock options granted
to an employee client and the potential tax consequences related to
the disposition of same. It is often prudent to engage a tax
professional to advise clients on the specific tax consequences
applicable to his or her specific scenario.