New ruling for stock options in divorce. (Stock Options).

If you practice family law, stock options are not the hot topic they were two years ago. Yet, the issue of dividing compensatory stock options between divorcing spouses still causes major headaches.

The IRS recently issued Revenue Ruling 2002-22, purportedly to provide assistance in this area. It also issued Notice 2002-31, which details the proposed rules and guidance for employers in situations involving stock options and divorce. Unfortunately, these rulings may cause confusion rather than provide clarification.

NEW PROVISIONS

While Rev. Rul. 2002-22 and Notice 2002-3 1 apply to some deferred compensation arrangements as well, this discussion will be limited to their application to stock options.

Rev. Rul. 2002-22 and Notice 2002-31 provide that:

* The transfer of non-statutory stock options from the employee spouse to the non-employee spouse is not a taxable event.

* The non-employee spouse will recognize the ordinary income upon the subsequent exercise of their share of the options.

* The employer must issue a Form 1099 to the non-employee spouse reporting their income on the exercise. The non-employee spouse will report this income on their individual income tax return.

* The employee's W-2 must reflect, as additional FICA wages, the income from the exercise of the non-employee's non-statutory stock options. The employee spouse will not report the income on their individual tax return, but will be responsible for the Social Security and Medicare taxes resulting from the exercise.

LIMITED APPLICATION

On the surface, Rev. Rul. 2002-22 provides insight regarding the IRS position on stock options in divorce. It appears that compensation income is to be treated as community property; each party reports one-half [see Poe v. Seaborn (1930) 9 AFTR 576].

It also appears that the IRS is following previous rulings by requiring that the employee spouse be responsible for the Social Security and Medicare taxes on all earned income attributable to their efforts (Rev. Rul. 71-116, 1971-1 CB 277).

However, this ruling is quick to limit its application:

* The ruling does not apply to unvested options at transfer.

* The ruling does not apply to transfers not connected to a divorce.

* The ruling applies only to non-statutory options.

* The ruling will apply to statutory options only if they become disqualified as a result of transfer to the non-employee spouse (statutory options cannot be transferred under IRC Sec. 422 and 423).

STILL NO GUIDANCE

As a result of these limitations, there is still no guidance on how to treat statutory stock options. It is unclear if this ruling would apply to statutory stock options disqualified as a result of a same-day sale.

However, the ruling states that if statutory options are transferred, they are treated in the same manner as other non-statutory stock options and thus, fall under the treatment outlined in this ruling.

One can only speculate that since a same-day sale also would disqualify the statutory options, they would be treated in the same manner as non-statutory options and they would qualify for the treatment outlined in this ruling.

It is also unclear how to treat a division of unvested stock options, both statutory and non-statutory. Unvested options are often awarded to the non-employee spouse under the Hug, Nelson and Harrison formulas [In re Marriage of Hug (1984) 154 Cal.app.3d 780; In re Marriage of Nelson (1986) 177 Cal.App.3d 150; In re Marriage of Harrison (1986) 179 CalApp.3d 1216].

The fact that the IRS has made a distinction between vested and non-vested options seems to indicate it may be struggling with the apportionment of income from options vesting in the future between the employee spouse's personal efforts during marriage and after separation.

DEFINING "TRANSFER"

The biggest quandary is the definition of the term "transfer." Most employers restrict the transfer of the compensatory options and will not reissue options under the name of the non-employee spouse nor give them any rights to exercise the options. Thus, the non-employee spouse generally does not receive the options themselves or the rights from those options.

So, to what is this revenue ruling referring when it discusses a transfer? Will assigning the non-employee spouse the options in the marital settlement agreement constitute a transfer sufficient to invoke the above treatment?

The good news is that Rev. Rul. 2002-22 seems to have overturned the IRS rationale found in Field Service Advise 200005006 issued in November 1999.

In that FSA, the IRS ruled that the options were taxable upon transfer to the non-employee spouse and that Sec. 1041 did not apply to compensation, only property. While the case underlying this FSA appears to have been domiciled in a non-community property state, its application to community property states was unclear.

Although the FSA is not authoritative, it provided insight into the IRS position at that time. Fortunately, the IRS seems to have realized the FSA's unfairness to the employee spouse, who was taxed on the transfer, and the windfall for the non-employee spouse, who was not taxed and actually received a step-up in basis on the options.

ASSIGNMENT OF INCOME

Rev. Rul. 2002-22 specifically states that the assignment of income doctrine [see Lucas v. Earl (1930) 281 U.S. 111] is generally not applicable in the context of divorce because the transfers generally are not voluntary. The ruling also discussed that applying the assignment of income doctrine to divorce situations would frustrate the purpose of Sec. 1041 which is intended to allow a divorcing couple to sever their property interests with the least amount of tax intrusion as possible.

So, Rev. Rul. 2002-22 demonstrates that the IRS will choose Sec. 1041 treatment and be less likely to invoke the assignment of income doctrine in divorce cases. Yet, the fact that the IRS is so quick to limit the application of this ruling is somewhat disappointing.

Stay tuned for future rulings in this complex area of family and tax law.

Leslie Dawson, CPA, a partner in the Walnut Creek-based firm of Glenn Dawson, LLP practices as a forensic accountant and often serves as an expert witness. A CaICPA Litigation Sections member, she can be reached at [e-mail].