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How to Unmarry a Millionaire.

IRC Sec. 1041 assures that gain is not recognized for income tax purposes when property is transferred between spouses or former spouses incident to a divorce. In a recently released field service advice (FSA 200005006), the IRS rejected Sec. 1041 protection and concluded that an employee who transfers stock options to a spouse as part of a divorce must recognize income immediately at the time of the transfer, even though no options are exercised.

The FSA involved an ex-husband (we'll call him Harold), who pursuant to a marital property settlement, transferred one-half of his options to purchase his employer's stock-both incentive stock options and nonqualified stock options--to his ex-wife (we'll call her Maude). The couple resided in a non-community property state.

First, the IRS noted that upon transfer from Harold to Maude, the ISOs became NQSOs. Second, the IRS determined that the transfer of the NQSOs from Harold to Maude was a taxable arm's-length disposition of the options under Reg. Sec. 1.831(b)(1), and US. v. Davis, 370 U.S. 65 (1962), resulting in compensation income to Harold equal to the options' value on the date of transfer to Maude.

The IRS denied Harold relief under IRC Sec. 1041(a) which defers "gain or loss" on "the transfer of property between spouses or former spouses incident to divorce." The IRS believes that gain under Sec. 1041 does not encompass compensation income. Implicitly, the IRS also does not regard stock options as "property" subject to nonrecognition under Sec. 1041. The FSA is consistent with Temp. Reg. Sec. 1.1041-1T, A-4, which declares that" ... transfers of services are not subject to the rules of section 1041."

However, because compensation income is triggered to Harold upon transfer, neither Harold nor Maude face another taxable event when Maude exercises the options.

TRAP #1: Market Decline After Option Transfer-Worst Case Scenario: A major stock price decline after Harold's transfer to Maude elicits the worst possible tax consequences: immediate taxable compensation income to Harold, and a delayed capital loss deduction for Maude. Assume that at the time of transfer, the stock of Harold's company is trading at a record high--$200 per share. The option exercise price is $50 per share so Harold's options are $150 per share in-the-money. Shortly after Maude receives the options, and before exercise, the stock nose-dives to $10 per share. Result: Harold pays income tax on the relatively high value of the options at the time of transfer (compensation income). Maude is stuck with underwater stock options (exercise price exceeds stock FMV). At least Maude will have a basis in the stock options equal to Harold's income, and she eventually will claim a capital loss when the unexercised options expire. (Code Sec. 1234(a)).

Valuation of Harold's options on the transfer date is a related problem. Typically, with a compensatory stock option, income is triggered on the date of exercise equal to the bargain element--the spread between the stock value and the option strike price (Reg. Sec. 1.831(a)). With Harold's early transfer to Maude, the options themselves must be valued. Rev. Proc. 98-34 contains guidance on valuing nonpublicly traded options (involving publicly traded stock). Although Rev. Proc. 98-34 technically only applies for estate and gift tax purposes, the same valuation methods should be relevant to determine Harold's income. Rev. Proc. 98-34 refers to factors that are similar to those established by the FASB in FAS No. 123. Risk factors, such as stock price volatility help reduce the option value, but an underwater option may have current value.

TRAP #2: Beware of False Impression of Relief from ISO Ineligibility Rules: The IRS concluded without elaboration that a transfer of ISOs by the employee spouse to the non-employee spouse causes the options to become NQSOs. This point of law is easily misunderstood. IRC Sec. 422(b)(5), listing eligibility conditions for an ISO, declares that an ISO cannot by its terms be transferable by the employee "otherwise than by will or the laws of descent and distribution" and that the ISO must be "exercisable, during his lifetime, only by [the employee]." Therefore, absent Harold's death, Maude cannot exercise his ISOs without eliminating ISO eligibility. The trap is in the apparent relief offered by IRC Sec. 424(c) (4) (A) which states that an interspousal transfer and transfers incident to divorce under Sec. 1041(a) are "not treated as a disposition" and, per IRC Sec. 424(c)(4)(B), that the tax treatment "shall apply to the transferee as would have applied to the transferor."

Be careful: IRC Sec. 424(c) (4) (A) only applies if the employee has already exercised the option and the stock received is transferred. IRC Sec. 424(c) (4) (B) can be relevant only if the transfer is at death, not divorce. Therefore, ISOs become NQSOs when transferred in a divorce.

You can avoid this trap two ways. One, if the employee spouse exercises the ISOs and then subsequently transfers the stock to the other spouse. Sec. 1041 would preclude gain recognition on the stock transfer. In addition, IRC Sec. 424(c) (4) (A) prevents the early disposition of the stock (not the ISO) from being an IRO Sec. 422(a)(1) disqualifying disposition of stock. Alternatively, the employee spouse could avoid transferring the legal ownership of the options and simply agree to exercise the options in response to a demand by the non-employee spouse. Thereafter, the stock (not the ISO) could be transferred to the non-employee spouse.

TRAP #3: Equal Split of Community Property ISOs and NQSOs: Although community property ISOs are owned by the community under state law, IRC Sec. 422(b)(5) only permits options to be exercisable by the employee. (See Reg. Sec. 1.421-7(h).) Therefore, shifting exercise power for one-half of the community ISOs to the non-employee spouse causes the options to become NQSOs. Loss of ISO status means loss of the statutory right to avoid compensation income at the time of exercise and to convert all of the income to capital gain when the stock is sold. Instead, ordinary compensation income is triggered when the options are exercised.

An equal split of community property NQSOs does not invoke immediate taxation (absent exercise). Each spouse is treated as having equally earned the community compensation. With an equal split of community property (unlike separate property), no transfer occurs that would trigger recognition under IRC Sec. 83 or the Davis decision. The IRS reached this conclusion in PLR 9433010. Eventually, upon exercise of the community property NQSOs, each spouse pays income tax on the spread between the strike price and FMV of the stock.

TRAP #4: Non-pro-rata Divisions of Community Property Stock Options: Assume Harold and Maude reside in California and their options are all community property. In the property settlement, Harold retains 100 percent of the stock options in his employer's stock and Maude receives community property cash of equal value. The ISOs would not become NQSOs, but now Maude is threatened with immediate taxation when she relinquishes one-half of her community interest in the stock options in exchange for the cash. FSA 200005006 cites with approval PLR 8813023, which involved similar facts. The IRS concluded that she is taxed on the cash payments, citing the assignment of income doctrine.

The same taxpayer who requested PLR 8813023 appealed to the Tax Court and won--Balding v. Commissioner, 98 T.C. 368 (1992). The Tax Court agreed with the taxpayer that Sec. 1041 protected her from gain recognition and rejected IRS arguments that the assignment of income doctrine trumped Sec. 1041. Discussion of Balding was conspicuously absent from the public portion of FSA 200005006. Presumably, the IRS believes that Balding is factually distinguishable on the grounds that Balding involved cash received in exchange for her portion of a pension plan (funded deferred compensation), which the IRS may now agree is gain on the disposition of property protected from recognition under Sec. 1041. IRS views a transfer of stock Options as more akin to a transfer of service income or unfunded deferred compensation (a prohibited assignment of income) than property.

TRAP #5: Character of Stock Options is First Step in California: A critical threshold issue in California involves determining whether the stock options are all community property, all separate or partly both. California courts have traditionally determined the character by apportionment, using a variation of the "time rule" established for pensions. See 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 Cal. App. 3d. 1216.

Gary R. McBride, JD, LLM, CPA, is a professor in the graduate tax program at California Stale University, Hayward. He can be reached at garymcb@att.net.
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Author:McBride, Gary R.
Publication:California CPA
Geographic Code:1USA
Date:May 1, 2001
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