Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

The Internal Revenue Service recently released a ruling clarifying the tax treatment of non-statutory stock options and similar deferred compensation pursuant to divorce. Revenue Ruling 2002-22 addresses both the timing for recognition of gain and responsibility for tax liability upon exercise of the options or receipt of the deferred compensation.

Facts

Ruling 2002-22 outlines a fairly typical divorce transfer scenario. Spouse "A" and Spouse "B" were married individuals who used the cash receipts and disbursements method of accounting. Prior to the divorce, A's employer issued non-statutory stock options as part of A's compensation. The non-statutory stock options did not have a readily ascertainable fair market value within the meaning of the Income Tax Regulations at the time granted, and thus no amount was included in A's gross income with respect to the options at that time. A's employer also maintains two unfunded, non-qualified deferred compensation plans under which A earns the right to receive post-employment payments. One plan is based on the balance of individual accounts, and the second plan is based on years of service and compensation history. By the time of the divorce, A had accrued rights to receive payments under both deferred compensation plans following termination of employment. These contractual rights to the deferred compensation benefits were not contingent on performance of future services.

Under the state law in question, stock options and unfunded deferred compensation rights earned by a spouse during the period of marriage are marital property subject to equitable division between the spouses in the event of divorce. Pursuant to the property settlement incorporated into their judgment of divorce, A transferred the following to B: (1) one-third of the non-statutory stock options, and (2) rights to receive payments under both of the deferred compensation plans.

The ruling assumes that in later years B exercises all of the stock options and receives stock with a fair market value in excess of the exercise price of the options and A terminates employment triggering payments to B under both deferred compensation plans.

Law and Analysis

In analyzing the issues presented, the IRS reviewed the general treatment of property transfers incident to divorce under § 1041, the limitations on the assignment of income doctrine imposed by § 1041, and the application of these concepts in the context of the specific rules governing stock options and deferred compensation under § 83.

Transfers Incident to Divorce Under § 1041

Section 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to or for the benefit of a spouse or, if the transfer is incident to divorce, a former spouse. Section 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.

Section 1041 was enacted in part to reverse the effect of the Supreme Court's decision in United States v. Davis, 370 U.S. 65 (1962), which held that the transfer of appreciated property to a spouse (or former spouse) in exchange for the release of marital claims was a taxable event resulting in the recognition of gain or loss to the transferor. In addition to avoiding this negative result for divorcing spouses, Congress intended that § 1041 eliminate differing federal tax treatment of property transfers and divisions between divorcing taxpayers who reside in community property states and those who reside in non-community property states.

The term "property" is not defined in § 1041, but the IRS concluded that Congress intended § 1041 to apply broadly to transfers of many types of property, including stock options and unfunded deferred compensation.

Assignment of Income Doctrine

Having concluded that § 1041 provides non-recognition treatment to the divorce transfers, the IRS then turns to who ultimately pays tax on the items in question. The issue here is whether income derived from the transferred property and paid to the transferee is taxed to the transferor or the transferee under the assignment of income doctrine.

The assignment of income doctrine provides that income is ordinarily taxed to the person who earns it, and that the incidence of income taxation may not be shifted by anticipatory assignments. However, courts and the IRS have long recognized that the assignment of income doctrine does not apply to every transfer of future income rights. Even before the effective date of § 1041, a number of courts had concluded that transfers of income rights between divorcing spouses were not voluntary assignments within the scope of the assignment of income doctrine.

Based on these cases and the intent of § 1041, the IRS reasoned that applying the assignment of income doctrine in divorce cases to tax the transferor spouse when the transferee spouse ultimately receives income from the property transferred in the divorce would frustrate the purpose of § 1041 with respect to divorcing spouses. The IRS also recognized the substantial burdens that would be imposed on transferor spouses in marital property settlements if they were required to recognize taxable income upon receipt of funds by their former spouse. The IRS, therefore, concluded that application of the assignment of income doctrine generally is inappropriate in the context of divorce.

Specific Provisions Governing Non-Statutory Stock Options

Section 83(a) provides, in general, that if property is transferred to any person in connection with the performance of services, the excess of the fair market value of the property over the amount, if any, paid for the property is included in the gross income of the person performing the services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. In the case of non-statutory stock options that do not have a readily ascertainable fair market value at the date of grant, § 83 does not apply to the grant of the option, but applies to property received upon exercise of the option or to any money or other property received in an arm's length disposition of the option.

Although a transfer of non-statutory stock options in connection with a marital property settlement may, as a factual matter, involve an arm's length exchange for money, property, or other valuable consideration, it would contravene the gift treatment prescribed by § 1041 to include the value of the consideration in the transferor's income under § 83. Accordingly, the IRS concluded that transfers of non-statutory stock options between divorcing spouses are entitled to nonrecognition treatment under § 1041. Based on the intent of § 1041, the IRS determined that this result will be the same in both community property and non-community property states. The same treatment also results when a statutory stock option is transferred contrary to its terms, causing it to become "non-statutory."

Holdings

Based on the facts presented and the analysis outlined, the IRS made the following holdings:

(1) A taxpayer who transfers interests in non-statutory stock options and non-qualified deferred compensation to the taxpayer's former spouse incident to divorce is not required to include an amount in gross income upon the transfer.

(2) The former spouse, and not the taxpayer, is required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse.

Prospective Application

The IRS apparently intends to apply Revenue Ruling 2002-22 prospectively, beginning November 9, 2002. The ruling states the IRS's intent to apply its prior position through that date in the following circumstances:

The Service will apply §§7805(b) and assignment of income principles to treat income as gross income of the transferor and not of the transferee if–

(i) The income is attributable to an interest in nonstatutory stock options, unfunded deferred compensation rights, or other similar intangible property rights;

(ii) The options or rights were transferred from one party to a divorce to the other party to the divorce;

(iii) The transfer was required by a provision of an agreement or court order;

(iv) The provision was contained in the agreement or order before November 9, 2002; and

(v) (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 Service that the transferor has reported the gross income for federal income tax purposes.

Conclusion

The IRS appears to be making a logical ruling that takes into account the economics of divorce settlements by timing the tax appropriately and taxing the party ultimately receiving the benefit of the property in question. Although the ruling only has prospective application for agreements contemplating tax paid by the transferor spouse, it should have immediate application if divorce settlements outline tax responsibility consistent with the terms of the ruling and the intent of § 1041. Settlement agreements and divorce decrees should be drafted with these issues in mind.