Ruling expands Sec. 1041 exemptions from assignment-of-income doctrine.

In May 2002, the IRS issued Rev. Rul. 2002-22, which provides guidance on the tax consequences when nonstatutory stock options and nonqualified deferred compensation are transferred between spouses pursuant to a divorce or separation agreement. Although such compensatory benefits may constitute a significant portion of the marital estate of divorcing taxpayers who are participants in such plans, properly anticipating the tax consequences of the division and later payment of these benefits has been difficult.

In the revenue ruling, A and B were married individuals. Prior to their divorce in 2002, A had received nonstatutory stock options from his employer. In addition, A is a participant in the employer's nonqualified deferred compensation plans. Under one of the deferred compensation plans, participants are entitled to payments based on the balance of their individual accounts. By the time of A's divorce from B, A had an account balance of $100. Under the second deferred compensation plan, participants are entitled to receive single-sum or periodic payments following separation from service, based on a formula reflecting their years of service and compensation history. By the time of the divorce, A had accrued the right to receive a single-sum payment of $50 under that plan, following A's termination of employment. A's contractual rights to the deferred compensation benefit under these plans were not contingent on A's performance of future services.

Under the law of their resident state, stock options and unfunded deferred compensation rights earned by a spouse during marriage are marital property subject to equitable division between the spouses in the event of divorce. Pursuant to the property settlement incorporated into their divorce judgment, A transferred to B (1) one third of the nonstatutory stock options; (2) the right to receive deferred compensation payments under the account balance plan based on 75% of A's account balance under the plan; and (3) the right to receive a single-sum payment of $25 under the other deferred compensation plan on A's termination of employment.

In 2006, B exercises all of the stock options and receives employer stock with a fair market value (FMV) in excess of the options' exercise price. In 2011, A terminates employment, and B receives a single-sum payment of $150 from the account-balance plan and a single-sum payment of $25 from the other deferred compensation plan.

The ruling concludes that B (the nonemployee, or transferee spouse) is required to include an amount in gross income when she exercises the stock option or when the deferred compensation is paid or made available to her. A (the employee or transferor spouse) is not required to include an amount in gross income.

Rationale of Rev. Rul. 2002-22

Under Sec. 1041(a), no gain or loss is recognized on a transfer of property from an individual to or for the benefit of a spouse or former spouse. In reaching its conclusion in the ruling, the Service relied heavily on its interpretation of the legislative intent of Sec. 1041.

Congress enacted this section in part to reverse the effect of the Supreme Court's decision in Davis, 370 US 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. Sec. 1041 was intended to "make the tax laws as unintrusive as possible with respect to relations between spouses" and to provide "uniform Federal income tax consequences" for transfers of property between spouses incident to divorce, "notwithstanding that the property may be subject to differing state property laws."

The ruling then focuses on whether nonqualified deferred compensation and stock options are "property" within the meaning of Sec. 1041. Once again examining legislative intent, the ruling states that Congress indicated that Sec. 1041 should apply broadly to transfers of many types of property, including those that involve the right to receive ordinary income that has accrued in an economic sense (such as interests in trusts and annuities). The ruling thus concludes that stock options and unfunded deferred compensation rights may constitute property within the meaning of Sec. 1041.

Finally, the ruling concludes that the assignment-of-income doctrine should not be applied to tax the transferor on the income derived from transferred property and paid to the transferee. This 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. Although the assignment-of-income doctrine is well established and is generally broadly construed, the ruling observes that the courts and the IRS have long recognized that it does not apply to every transfer of future income rights. The ruling specifically references a series of cases decided prior to the effective date of Sec. 1041 that had concluded that transfers of income rights between divorcing spouses were not voluntary assignments within the scope of the assignment-of-income doctrine.

Certain Pre-Nov. 9, 2002 Agreements

Despite the general holding of the ruling that the assignment-of-income doctrine will not be applied, the ruling specifically states that the IRS will apply the doctrine against the transferor in the case of pre-Nov. 9, 2002 agreements if (1) the agreement specifically provides that the transferor must report gross income attributable to the transferred interest or (2) it can be established to the Service's satisfaction that the transferor has reported the gross income for Federal income tax purposes.

For a pre-Nov. 9, 2002 agreement that requires the transferor to report the income, the assignment-of-income doctrine will be applied to all options or rights transferred pursuant to the agreement--regardless of when the options or rights are exercised or if the transferor has filed a return reporting the income.

For a pre-Nov. 9, 2002 agreement that does not require the transferor to report the income, however, the assignment-of-income doctrine will be applied against the transferor only to the extent that the transferor had previously reported the income for Federal income tax purposes. Because returns are generally filed in the year following the year of an exercise, the assignment-of-income doctrine will presumably be applied only against the transferor to the extent the options or rights were exercised prior to 2002 (and presumably only if the taxpayer had already filed a 2001 Form 1040).

Example 1 (Exception 1): A and B divorced in 1999 pursuant to an agreement dated Feb. 14, 1999. The agreement specified that A was to transfer to B half of A's rights under certain nonstatutory stock option and nonqualified deferred compensation plans with employer Y. The agreement required A to report the gross income attributable to the transferred interests. In 2003, B exercises stock options with a FMV in excess of the exercise price in the amount of $500,000. Neither A nor B have filed returns for 2003.

The assignment-of-income doctrine would be applied against A, as the options were transferred to B pursuant to a pre-Nov. 9, 2002 order that required A to report the gross income attributable to the transferred interests. Thus, A (not B) would be required to include the $500,000 of income from the 2003 stock-option exercise on a 2003 Form 1040.

Example 2 (Exception 2): The facts are the same as in Example 1, except the agreement did not require A to report the gross income attributable to the transferred interests.

Because A has not yet filed a 2003 return, A would be entitled to rely on Rev. Rul. 2002-22 and exclude the income attributable to the transferred interests. B would be required to include the income attributable to the transferred interests on a 2003 Form 1040.

The Potential Whipsaw 

Although transferor spouses generally will find Rev. Rul. 2002-22 to be favorable, transferee spouses presumably would prefer that the assignment-of-income doctrine continue to be applied against the transferor. Because revenue rulings do not have the force and effect of regulations, a transferee spouse could challenge the ruling's position.

In fact, in Field Service Advice (FSA) 200005006 (based on a fact pattern very similar to the one of Rev. Rul. 2002-22), the Service developed a well-constructed argument for why the assignment-of-income doctrine should be applied to the transferor spouse. The FSA relied on Gibbs, TC Memo 1997-196, in which the Tax Court found that Sec. 1041 provides for nonrecognition of gain or loss, but not for income exclusion. The IRS had concluded in the FSA that Sec. 1041 should not apply to stock option transfers pursuant to divorce, because the options' value is considered compensation, not a gain from the transfer of property. Pursuant to the FSA, the compensation income recognized by the taxpayer would have created additional stock basis for the transferee spouse.

If a transferee spouse were to successfully challenge the Service's authority to expand the Sec. 1041 nonrecognition provisions to nonstatutory stock options and nonqualified deferred compensation, the IRS could find itself whipsawed. Following its loss to the transferee spouse in court, the Service nonetheless would be held to its published rulings and would be prevented from requiring the transferor spouse to include amounts in income. Thus, the IRS would be unable to collect taxes on such payments from either spouse.

Effect of Rev. Rul. 2002-22 on Employers

Although in recent years it has become common for plans to permit the limited transfers of stock options and similar benefits, many plans still contain numerous prohibitions against transfer. By providing guidance to taxpayers and employers on the tax consequences of the division and later payment of nonqualified stock options and nonqualified deferred compensation pursuant to divorce, Rev. Rul. 2002-22 may prompt employers to reexamine the terms of their plans and amend them to permit employees to transfer their plan interests to former spouses.

Until such amendments occur, however, practitioners should remember that stock option, nonqualified deferred compensation and other similar plans are contractual agreements between an employer and an employee. A domestic relations order generally cannot modify the contractual terms of such an agreement. Thus, if a stock option agreement states that the options are nontransferable, a domestic relations order requiring the options to be transferred nonetheless will generally be unenforceable.

Divorce Planning after Rev. Rul. 2002-22

Rev. Rul. 2002-22 reemphasizes the importance not only of competent tax advice when drafting divorce and separation agreements, but also of understanding the impact of IRS pronouncements on transactions occurring pursuant to existing agreements.

Transferee spouses whose divorce or separation instruments did not require the transferor spouse to report the income from transferred options or other compensatory rights are perhaps about to discover--especially for options and rights yet to be exercised--that it is important for a divorce or separation instrument to clearly specify the income tax consequences of the division of marital property.

FROM TRACY J. MONROE, CPA, MT, COHEN & COMPANY, LTD., AKRON, OH, AND NATALIE L. BELL, CPA, MT, MEADEN & MOORE, LTD., CLEVELAND, OH (NOT AFFILIATED WITH BAKER TILLY INTERNATIONAL)