Divorce-related transfer of compensatory stock options is taxable.

In Field Service Advice (FSA) 200005006, the IRS ruled that stock option transfers from a husband to his ex-wife pursuant to a divorce resulted in compensation income for the husband when the options were transferred. The ex-wife received a carryover basis in the options equal to the compensation recognized by the husband. There were no additional tax consequences to either spouse when the wife later exercised the options.

Fact Pattern

The husband had received compensatory stock options from his employer. The options did not have a readily ascertainable fair market value (FMV) at the time of grant and therefore their receipt was not taxable. Pursuant to a domestic-relations order, the husband transferred one-half of his options to his ex-wife. When the ex-wife later exercised the options, the employer issued a Form 1099 to the husband for the difference between the stock's FMV at the time of the ex-wife's exercise and the amount paid to exercise the options. The husband included this amount in income on his tax return for the year in which the ex-wife exercised the options; however, he later filed a refund claim.

Taxation of NQSOs

Taxation of nonqualified stock options (NQSOs) is governed by Sec. 83. Most compensatory stock options do not have a readily ascertainable FMV at the grant date and thus generally are not taxable until exercised or disposed of. If the option is exercised, the optionee recognizes compensation income equal to the excess of the FMV of the stock over the amount (if any) paid to acquire it.

If the option is disposed of before it is exercised, the tax treatment of the transaction depends on whether the disposition is at arm's length. If it is, the transferor recognizes compensation income at the time of the disposition equal to the amount realized over the amount (if any) paid for the option. Following an arm's-length disposition, the transferor will not recognize additional income as a result of the transferee's later exercise (or sale of) the option stock.

If the disposition is not at arm's length, the transferor recognized compensation income at the time of the transfer to the extent the amount realized from the disposition exceeds the amount (if any) paid for the option. The transferor generally will also recognize additional compensation income when the transferee later exercises or otherwise disposes of the option.

Transfer Pursuant to Divorce Is Arm's Length

Although transactions between related individuals generally are not arm's-length transactions, in Davis, 370 US 65 (1962), the Supreme Court held that stock transfers between spouses pursuant to divorce were arm's-length dispositions that caused the recognition of gain to the transferor spouse. Although the enactment of Sec. 1041 nullified the Davis holding that a stock transfer between spouses was taxable, Davis still stands for the proposition that transfers pursuant to divorce are arm's-length transactions and that the properties exchanged are of equal value.

Inapplicability of Sec. 1041

Sec. 1041(a) provides that no gain or loss is recognized on property transfers between spouses and former spouses incident to divorce. In Gibbs, TC Memo 1997-196, the Tax Court found that, although Sec. 1041 provides for nonrecognition of gain or loss, it does not provide for income exclusion. Citing Gibbs in FSA 200005006, the Service likewise found that Sec. 1041 should not apply to stock option transfers pursuant to divorce, because the options' value is considered compensation, not gain. When the IRS has taken this position, it has consistently applied the assignment-of-income doctrine, which requires the transferor (rather than the payee) to recognize assigned income.

Valuation Issues

FSA 200005006 indicates that an employee spouse's compensation income and the nonemployee's carryover basis are equal to the options' FMV at the time of the transfer. However, it does not address how to value the transferred options.

As previously discussed, when an employee exercises an NQSO, the compensation income recognized generally equals the excess of the stock's FMV on the exercise date over the option price. This excess is known as the option's intrinsic value.

The intrinsic-value method is the most commonly used method for determining the income tax consequences of an exercised option. The intrinsic-value method, however, is not a generally accepted economic pricing model for valuing unexercised stock options, because an unexercised option's value generally exceeds its intrinsic value.

For example, an option has an exercise price of $10 per share and a term of 10 years. If the value of the stock when the option is granted is $10 per share, the option has an intrinsic value of zero when it is granted. Nonetheless, because of the possibility that the stock may appreciate during the option's 10-year term, the option has a value.

The generally accepted economic-pricing model for valuing unexercised options is the Black-Scholes model, which is one of the safe harbor methods approved by the IRS for valuing nonpublicly traded compensatory stock options for gift tax purposes. Although the Black-Scholes (or other safe harbor) method may be used to value the optionee-donor's compensation income at the time of the gift, a gift is not an arm's-length disposition. Under the rules applicable to non-arm's-length dispositions, the optionee-donor generally will recognize additional compensation income when the donee later exercises the option. Thus, even for a gift, the intrinsic-value method will ultimately be used for income tax purposes.

It appears therefore that a divorce-related stock option transfer presents a unique issue. It requires options to be valued for income tax purposes prior to exercise, even though the consideration income that an employee spouse receives in exchange for the options may not be ascertainable.

If a court determines a marital estate's assets' value, the value assigned to the options should be used (and presumably recognized by the Service). If, however, the parties stipulate an option value as part of a settlement, the agreed-on value may be used, although it could be challenged by the IRS. If the parties do not specify the value, it is arguable that the Black-Scholes model (or one of the other safe harbor methods used to value options) may be used to value a transfer.

Community Property States

In Letter Rulings 8751029 and 9433010, the Service ruled that an employee spouse recognized no income on a proposed community property division of stock options under a property settlement agreement. The community property law of the taxpayers' state of residence provided that the nonemployee spouse was (and always had been) the owner of half of the stock options. The IRS allowed the allocation of the options under the divorce decree as a nontaxable event. Presumably, the taxpayers in FSA 200005006 were not residents of a community property state and thus differed from the taxpayers in the letter rulings.

Special Considerations for ISOs

An incentive stock option (ISO) satisfies the Sec. 422 statutory requirements, one of which states that the options be nontransferable (other than on the death of the optionee). As a result of this requirement, ISOs may not be transferred between spouses pursuant to a divorce.

As compared to an NQSO, an ISO is advantageous, because an optionee will generally not have any regular tax consequences on its exercise. Rather, he will be taxed at capital gains rates on the excess of the sales proceeds over the amount paid to exercise the option.

To receive favorable ISO treatment, the optionee generally must hold the stock until the later of: (1) one year from the date the option was exercised or (2) two years from the date the option was granted. If the ISO holding period is not satisfied, the optionee generally recognizes compensation income on the date of the disqualifying disposition, equal to the excess of the stock's FMV over the amount paid to exercise the option. Sec. 424 specifically provides that the transfer of stock, acquired via an ISO, to a spouse prior to the expiration of the ISO holding period is not a disqualifying disposition.

Planning Opportunities

To avoid the income tax consequences of FSA 200005006, parties to a divorce agreement may consider a division of the marital estate that does not require an option transfer. The simplest alternative would be to transfer assets of equal value to the nonemployee spouse in lieu of the options. Another alternative would be to provide for the transfer of the net after-tax proceeds from the option when exercised, in lieu of a transfer of the option. If this technique is used, the agreement should address any restrictions on the tinting of the option exercise by the employee spouse. The agreement should also contain a detailed description of the method to be used to determine the option's net after-tax proceeds, as well as a description of the tinting and manner in which the proceeds are to be paid to the nonemployee spouse. For ISOs, the agreement should also clearly address whether and how the proceeds should be adjusted, to reflect any alternative minimum tax consequences associated with exercising the options.

FROM NATALIE L. BELL, CPA, MT, COHEN & COMPANY, LLC, CLEVELAND, OH

Editor: Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH