Deferred Compensation: Dramatic Changes

The recent issuance of Revenue Ruling 2002-22, 2002-19 I.R.B. 849 dramatically changes how income tax principles will be applied to the marital division of deferred or incentive compensation arrangements, and, potentially, to other types of assets, the gain from which is taxable as ordinary income. Stock options and contractual deferred compensation arrangements have become a standard form of compensation for corporate employees. In the marital dissolution law of practically every state where marital rights to these compensation arrangements have been examined, the value represented by these rights has been determined to be marital property, subject to division at divorce to the extent earned before divorce. Indeed, deferred compensation rights may be the most valuable marital asset, so negotiation and litigation over division of this value has become a fertile area for marital settlements.

The income tax consequences of dividing compensation assets pose significant problems and require careful attention to ensure that each spouse will receive the economic value of his or her share. Now, with Revenue Ruling 2002-22, issued by the IRS last May, matrimonial practitioners must familiarize themselves with another wrinkle in the equation.

A Little Background

Compensation is taxed as ordinary income, almost invariably to the employee spouse. In order to defer the tax on compensation that has already been earned, the employee must agree to contingent property rights or unsecured promises. These arrangements inevitably create uncertainty and attendant valuation difficulties. The value is not taxed until actually received, whether as a cash payment or in the form of vested property rights. When the value of deferred compensation rights is allocated to the non-employee spouse in a divorce settlement, basic income tax principles make it difficult to assign liability for the tax on that value. But if the tax liability is not accurately accounted for, the employee spouse may end up paying the full income tax liability out of his or her share, while the non-employee spouse walks away with the cash.

In marital dissolution cases where deferred compensation has been allocated to the non-employee spouse, the IRS has asserted that the employee spouse is nonetheless taxable on the non-employee's share under the fundamental assignment-of-income doctrine. This principle is one of the foundations of the income tax system and stems from Lucas v. Earl, 281 U.S. 111 (1930). There, the husband and wife agreed that income he earned in his law practice would be divided between them as it was earned, but the US Supreme Court, conceding that the parties' agreement was enforceable, held the assignment ineffective to prevent taxing all the income to the husband. In the same year, however, the Court also held that income earned in a community property state should be divided between the husband and wife for tax purposes. Poe v. Seaborn, 282 U.S. 101 (1930). Are divisions of ordinary income assets in divorce settlements more like Earl or more like Seaborn?

Over the years, the government has consistently asserted that the assignment-of-income doctrine prevented allocation of the tax liability along with the value of the asset. In Kochansky v. Commissioner, 92 F.3d 957 (9th Cir. 1996), for example, the husband assigned to the wife a portion of a contingent fee to which he would be entitled at the conclusion of a malpractice case. The portion paid to the wife under their settlement agreement was nonetheless held taxable to him under the assignment-of-income doctrine because he was the earner and, according to the courts, earnings could not be assigned. Contractual deferred compensation and nonvested stock options have been taxed in the same way.
IRS Applies the Doctrine

In February 2000, the IRS issued a Field Service Advisory, which held that the 'award' of unexercised stock options in a divorce decree to the non-employee spouse was a transfer for value under ' 83 of the Internal Revenue Code (IRC), resulting in an immediately taxable event to the employee, presumably at the time the divorce decree was entered. In reaching this conclusion, the Service relied on the assignment-of-income doctrine and applied it to transfers of assets earned as compensation for personal services even though, absent the marital transfer, there would have been no taxable event. In its view, IRC ' 1041, which provides that transfers of 'property' between spouses or ex-spouses in divorce are not taxable, did not apply.

The ruling was troublesome. It required imposition of tax even though the options themselves had not been exercised, and might never be exercised. As events played out, the general decline in stock values meant that the employee spouse would have to pay a tax measured by a value that, by that time, had vanished. But the internal logic of the ruling was compelling, and the tax result could be avoided only by surrendering the premises on which the conclusions stated in the ruling had been based. This is what happened in May.

A Change in the Law

As stated above, Revenue Ruling 2002-22, 2002-19 I.R.B. 849 significantly affects the application of income tax principles to the marital division of deferred or incentive compensation arrangements. In the ruling, the husband had been granted non-statutory options to purchase his employer's stock as part of his compensation. In addition, he had unfunded contractual rights to receive deferred compensation in the future. Pursuant to a property settlement incorporated in their divorce decree, the husband 'transferred' to the wife a stated portion of each of these deferred compensation assets. Years later, the wife 'exercised' her share of the options and received payments under the deferred compensation contracts when her ex-husband terminated his employment. However, reversing the service's earlier position on this issue, Revenue Ruling 2002-22 held that the wife was deemed to be taxable on her share of the options at the time she exercised them.
Thus, the ruling explicitly repudiates application of the assignment of income doctrine to transfers of 'property' in divorce settlements when IRC
' 1041 applies to the transfer of the option. Recognizing that ' 1041 was intended by Congress to facilitate transfers between divorcing couples by allowing the initial transfer to be tax free, the ruling concludes that the term 'property' should have a broad meaning to include assets, the gain from which would be taxed as ordinary income, and which under other circumstances could not be effectively assigned to a person other than the person who earned the income or owned the asset when the income involved accrued.

The ruling relies on authority approving the transfer of business receivables from a sole proprietor to a corporation to conclude that application of the assignment of income doctrine is 'inappropriate in the context of divorce.' This is particularly true when ' 1041 applies to the transfer because, under the community property model on which that section is based, the ordinary income asset allocated in divorce is more like Seaborn; that is, income earned during marriage is properly viewed as owned by both spouses together, and under that model should be taxed to the spouse to whom it is assigned.

This reasoning represents an important change in the Service's approach to the tax treatment of divorce settlements. Because a significant proportion of the value of marital assets may be tied to the value of deferred compensation, there is much greater flexibility in arranging for these transfers and assigning the risk that the value may not be recognized between the spouses. For stock options, in particular, the value of the option depends entirely on the value of the stock subject to the option at some future time, so division of these assets in kind is the only practical way to ensure that the risk has been fairly allocated. Now, after Revenue Ruling 2002-22, this can be done across a variety of compensation-related assets without immediate tax effects.

The problem with transferring nonvested options was illustrated by a recent Connecticut case, Kiniry v. Kiniry, 71 Conn. App. 614, 803 A.2d 352 (Conn. Ct. App. 2002). In that case, after separating from his wife, the husband began new employment with an employer that, among other benefits, provided him with approximately $325,000 in vested and nonvested stock options. The options vested (probably meaning that they became exercisable) over a 4-year period. The divorce court divided the nonvested stock options 60% to the wife 'if, as, and when received by [the husband].' Whether an option is transferable depends on the terms of the option itself, and many options now may be transferred to family members. Whatever the terms of the option, however, it seems clear that once the stock options became exercisable, 60% of them belonged to the wife. This is sufficient to be a transfer for tax purposes, and, until the issuance of Revenue Ruling 2002-22, would have resulted in adverse tax consequences for the husband. 
But not now. Under the Service's interpretation in the ruling, deferred compensation will be treated as property for marital transfer purposes. Even though property may remain titled in the name of only one of the spouses, the property right to a share of the proceeds belongs, for tax purposes, to the spouse to whom it was allocated or awarded in the division of marital property. See Yonadi v. Commissioner, 21 F.3d 1292 (3d Cir. 1994), in which the sale of business assets by the husband was nonetheless held taxable partly to the wife under the parties' property settlement (applying New Jersey law).

Therefore, after Revenue Ruling 2002-22, options allocated to the nonemployee spouse will belong to that spouse for tax purposes. When that spouse exercises these options, income resulting from the spread between the striking price and the value of the stock will be taxed to him or her as compensation under IRC ' 83. The nonemployee spouse will be treated for tax purposes in the same manner as will the employee spouse when he or she exercises his or her share of the options. It will not be necessary to disguise transfers in order to prevent unexpected tax costs, or to determine the net value of the options after payment of tax in order to assure both parties that the correct amount has actually been paid to the nonemployee spouse. These problems often vexed state divorce courts, which at times felt compelled to retain jurisdiction in order to sort out future tax or payment problems.

Employment Taxes

This does leave a loose end. Even though deferred compensation has been awarded to the non-employee spouse in the divorce proceedings, it remains compensation subject to employment tax and withholding. Having concluded that the income tax consequences can be allocated along with the value of the compensations rights, however, the service also made common sense proposals to apply employment taxes and withholding issues consistently with the income tax treatment. Notice 2002-31, 2002-19 I.R.B. 908 (May 8, 2002).

The notice sets out a proposed revenue ruling that would provide that the deferred compensation represented by the value of exercised non-statutory stock options and payments under unfunded deferred compensation contracts are nonetheless wages of the employee spouse. Accordingly, the employer will be required to withhold the employee spouse's share of FICA and Medicare taxes from these payments. Although the payments to the wife will be reduced by the FICA and Medicare taxes, she will not receive any reduction in her income tax because of these payments. The payment to her will, therefore, be less than the amount to which she is entitled under the divorce settlement. Obviously, some kind of adjustment will be necessary to reimburse her for this cost. One should note that in cases involving these kinds of payments, the compensation already paid to the employee spouse should exceed the Social Security wage base by a comfortable margin, so the exposure is limited to the hospital insurance tax, which is only 1.45%.

If the deferred compensation is wages, the employer is also required to withhold income tax on the payments and to complete a W-2 withholding statement for the employee. The rulings hold that for tax purposes, the non-employee spouse will be treated in the same manner as the employee spouse, ie, the employer will be required to withhold income tax from any payments to the non-employee spouse. Thus, he or she will be entitled to the income tax credit for the tax withheld, and the employer will be required to file an information return on his or her behalf, noting the amount of the withholding, but on a form 1099-MISC.
The employment tax ruling remains for the moment in proposed form, presumably because the interests of employers, who are involved in the collection and payment of employment taxes on wages assigned in the divorce settlement, must also be considered. The proposed solutions make sense, however, and seem likely to be adopted in a form similar to that proposed.

Limits of the Ruling

The IRS did assert limits to the scope of Revenue Ruling 2002-22, stating that it would not apply to transfers between spouses not made in a divorce settlement nor to transfers of future income rights to the extent such rights are 'unvested' at the time of transfer or are 'subject to substantial contingencies' at 'the time of transfer,' citing Kochansky, supra. But these limitations are inconsistent both with the reasoning and the express holding of this ruling. If the assignment-of-income doctrine does not apply to disqualify transfers of value from the application of ' 1041, it should not be used to justify different treatment for the transfer of some types of assets.

Attempts to transfer the right to receive income that will be earned in the future might be ineffective because the asset has not yet been created and thus cannot be transferred. But when the asset in question has been earned, even if realization of the asset's value is still contingent, it should be transferable under ' 1041. A similar problem exists in determining marital shares of unvested compensation because a non-employee spouse would, in general, not have any property right to compensation that will not be earned by the employee until after the divorce. Unvested stock options are often awarded to employees for past services, a problem explicitly discussed in Kiniry and other similar state court decisions, but these options are subject to division, as the ruling quite properly recognizes. If the service's explanation of the holding in the ruling accurately reflects its position on the tax treatment of marital property transfers ' ie, by adopting the community property model for interpreting ' 1041 ' then the limitations stated in the conclusion are too restrictive. Thus, until the IRS is more explicit about its view on the application of these concepts in marital property settlements, the tax implications should carefully be considered when a proposed transfer is even slightly different from the transfers discussed in the ruling.

The recent issuance of Revenue Ruling 2002-22, 2002-19 I.R.B. 849 dramatically changes how income tax principles will be applied to the marital division of deferred or incentive compensation arrangements, and, potentially, to other types of assets, the gain from which is taxable as ordinary income. Stock options and contractual deferred compensation arrangements have become a standard form of compensation for corporate employees. In the marital dissolution law of practically every state where marital rights to these compensation arrangements have been examined, the value represented by these rights has been determined to be marital property, subject to division at divorce to the extent earned before divorce. Indeed, deferred compensation rights may be the most valuable marital asset, so negotiation and litigation over division of this value has become a fertile area for marital settlements.

The income tax consequences of dividing compensation assets pose significant problems and require careful attention to ensure that each spouse will receive the economic value of his or her share. Now, with Revenue Ruling 2002-22, issued by the IRS last May, matrimonial practitioners must familiarize themselves with another wrinkle in the equation.

A Little Background

Compensation is taxed as ordinary income, almost invariably to the employee spouse. In order to defer the tax on compensation that has already been earned, the employee must agree to contingent property rights or unsecured promises. These arrangements inevitably create uncertainty and attendant valuation difficulties. The value is not taxed until actually received, whether as a cash payment or in the form of vested property rights. When the value of deferred compensation rights is allocated to the non-employee spouse in a divorce settlement, basic income tax principles make it difficult to assign liability for the tax on that value. But if the tax liability is not accurately accounted for, the employee spouse may end up paying the full income tax liability out of his or her share, while the non-employee spouse walks away with the cash.

In marital dissolution cases where deferred compensation has been allocated to the non-employee spouse, the IRS has asserted that the employee spouse is nonetheless taxable on the non-employee's share under the fundamental assignment-of-income doctrine. This principle is one of the foundations of the income tax system and stems from Lucas v. Earl, 281 U.S. 111 (1930). There, the husband and wife agreed that income he earned in his law practice would be divided between them as it was earned, but the US Supreme Court, conceding that the parties' agreement was enforceable, held the assignment ineffective to prevent taxing all the income to the husband. In the same year, however, the Court also held that income earned in a community property state should be divided between the husband and wife for tax purposes. Poe v. Seaborn, 282 U.S. 101 (1930). Are divisions of ordinary income assets in divorce settlements more like Earl or more like Seaborn?

Over the years, the government has consistently asserted that the assignment-of-income doctrine prevented allocation of the tax liability along with the value of the asset. In Kochansky v. Commissioner, 92 F.3d 957 (9th Cir. 1996), for example, the husband assigned to the wife a portion of a contingent fee to which he would be entitled at the conclusion of a malpractice case. The portion paid to the wife under their settlement agreement was nonetheless held taxable to him under the assignment-of-income doctrine because he was the earner and, according to the courts, earnings could not be assigned. Contractual deferred compensation and nonvested stock options have been taxed in the same way.
IRS Applies the Doctrine

In February 2000, the IRS issued a Field Service Advisory, which held that the 'award' of unexercised stock options in a divorce decree to the non-employee spouse was a transfer for value under ' 83 of the Internal Revenue Code (IRC), resulting in an immediately taxable event to the employee, presumably at the time the divorce decree was entered. In reaching this conclusion, the Service relied on the assignment-of-income doctrine and applied it to transfers of assets earned as compensation for personal services even though, absent the marital transfer, there would have been no taxable event. In its view, IRC ' 1041, which provides that transfers of 'property' between spouses or ex-spouses in divorce are not taxable, did not apply.

The ruling was troublesome. It required imposition of tax even though the options themselves had not been exercised, and might never be exercised. As events played out, the general decline in stock values meant that the employee spouse would have to pay a tax measured by a value that, by that time, had vanished. But the internal logic of the ruling was compelling, and the tax result could be avoided only by surrendering the premises on which the conclusions stated in the ruling had been based. This is what happened in May.

A Change in the Law

As stated above, Revenue Ruling 2002-22, 2002-19 I.R.B. 849 significantly affects the application of income tax principles to the marital division of deferred or incentive compensation arrangements. In the ruling, the husband had been granted non-statutory options to purchase his employer's stock as part of his compensation. In addition, he had unfunded contractual rights to receive deferred compensation in the future. Pursuant to a property settlement incorporated in their divorce decree, the husband 'transferred' to the wife a stated portion of each of these deferred compensation assets. Years later, the wife 'exercised' her share of the options and received payments under the deferred compensation contracts when her ex-husband terminated his employment. However, reversing the service's earlier position on this issue, Revenue Ruling 2002-22 held that the wife was deemed to be taxable on her share of the options at the time she exercised them.
Thus, the ruling explicitly repudiates application of the assignment of income doctrine to transfers of 'property' in divorce settlements when IRC
' 1041 applies to the transfer of the option. Recognizing that ' 1041 was intended by Congress to facilitate transfers between divorcing couples by allowing the initial transfer to be tax free, the ruling concludes that the term 'property' should have a broad meaning to include assets, the gain from which would be taxed as ordinary income, and which under other circumstances could not be effectively assigned to a person other than the person who earned the income or owned the asset when the income involved accrued.

The ruling relies on authority approving the transfer of business receivables from a sole proprietor to a corporation to conclude that application of the assignment of income doctrine is 'inappropriate in the context of divorce.' This is particularly true when ' 1041 applies to the transfer because, under the community property model on which that section is based, the ordinary income asset allocated in divorce is more like Seaborn; that is, income earned during marriage is properly viewed as owned by both spouses together, and under that model should be taxed to the spouse to whom it is assigned.

This reasoning represents an important change in the Service's approach to the tax treatment of divorce settlements. Because a significant proportion of the value of marital assets may be tied to the value of deferred compensation, there is much greater flexibility in arranging for these transfers and assigning the risk that the value may not be recognized between the spouses. For stock options, in particular, the value of the option depends entirely on the value of the stock subject to the option at some future time, so division of these assets in kind is the only practical way to ensure that the risk has been fairly allocated. Now, after Revenue Ruling 2002-22, this can be done across a variety of compensation-related assets without immediate tax effects.

The problem with transferring nonvested options was illustrated by a recent Connecticut case, Kiniry v. Kiniry, 71 Conn. App. 614, 803 A.2d 352 (Conn. Ct. App. 2002). In that case, after separating from his wife, the husband began new employment with an employer that, among other benefits, provided him with approximately $325,000 in vested and nonvested stock options. The options vested (probably meaning that they became exercisable) over a 4-year period. The divorce court divided the nonvested stock options 60% to the wife 'if, as, and when received by [the husband].' Whether an option is transferable depends on the terms of the option itself, and many options now may be transferred to family members. Whatever the terms of the option, however, it seems clear that once the stock options became exercisable, 60% of them belonged to the wife. This is sufficient to be a transfer for tax purposes, and, until the issuance of Revenue Ruling 2002-22, would have resulted in adverse tax consequences for the husband. 
But not now. Under the Service's interpretation in the ruling, deferred compensation will be treated as property for marital transfer purposes. Even though property may remain titled in the name of only one of the spouses, the property right to a share of the proceeds belongs, for tax purposes, to the spouse to whom it was allocated or awarded in the division of marital property. See Yonadi v. Commissioner, 21 F.3d 1292 (3d Cir. 1994), in which the sale of business assets by the husband was nonetheless held taxable partly to the wife under the parties' property settlement (applying New Jersey law).

Therefore, after Revenue Ruling 2002-22, options allocated to the nonemployee spouse will belong to that spouse for tax purposes. When that spouse exercises these options, income resulting from the spread between the striking price and the value of the stock will be taxed to him or her as compensation under IRC ' 83. The nonemployee spouse will be treated for tax purposes in the same manner as will the employee spouse when he or she exercises his or her share of the options. It will not be necessary to disguise transfers in order to prevent unexpected tax costs, or to determine the net value of the options after payment of tax in order to assure both parties that the correct amount has actually been paid to the nonemployee spouse. These problems often vexed state divorce courts, which at times felt compelled to retain jurisdiction in order to sort out future tax or payment problems.

Employment Taxes

This does leave a loose end. Even though deferred compensation has been awarded to the non-employee spouse in the divorce proceedings, it remains compensation subject to employment tax and withholding. Having concluded that the income tax consequences can be allocated along with the value of the compensations rights, however, the service also made common sense proposals to apply employment taxes and withholding issues consistently with the income tax treatment. Notice 2002-31, 2002-19 I.R.B. 908 (May 8, 2002).

The notice sets out a proposed revenue ruling that would provide that the deferred compensation represented by the value of exercised non-statutory stock options and payments under unfunded deferred compensation contracts are nonetheless wages of the employee spouse. Accordingly, the employer will be required to withhold the employee spouse's share of FICA and Medicare taxes from these payments. Although the payments to the wife will be reduced by the FICA and Medicare taxes, she will not receive any reduction in her income tax because of these payments. The payment to her will, therefore, be less than the amount to which she is entitled under the divorce settlement. Obviously, some kind of adjustment will be necessary to reimburse her for this cost. One should note that in cases involving these kinds of payments, the compensation already paid to the employee spouse should exceed the Social Security wage base by a comfortable margin, so the exposure is limited to the hospital insurance tax, which is only 1.45%.

If the deferred compensation is wages, the employer is also required to withhold income tax on the payments and to complete a W-2 withholding statement for the employee. The rulings hold that for tax purposes, the non-employee spouse will be treated in the same manner as the employee spouse, ie, the employer will be required to withhold income tax from any payments to the non-employee spouse. Thus, he or she will be entitled to the income tax credit for the tax withheld, and the employer will be required to file an information return on his or her behalf, noting the amount of the withholding, but on a form 1099-MISC.
The employment tax ruling remains for the moment in proposed form, presumably because the interests of employers, who are involved in the collection and payment of employment taxes on wages assigned in the divorce settlement, must also be considered. The proposed solutions make sense, however, and seem likely to be adopted in a form similar to that proposed.

Limits of the Ruling

The IRS did assert limits to the scope of Revenue Ruling 2002-22, stating that it would not apply to transfers between spouses not made in a divorce settlement nor to transfers of future income rights to the extent such rights are 'unvested' at the time of transfer or are 'subject to substantial contingencies' at 'the time of transfer,' citing Kochansky, supra. But these limitations are inconsistent both with the reasoning and the express holding of this ruling. If the assignment-of-income doctrine does not apply to disqualify transfers of value from the application of ' 1041, it should not be used to justify different treatment for the transfer of some types of assets.

Attempts to transfer the right to receive income that will be earned in the future might be ineffective because the asset has not yet been created and thus cannot be transferred. But when the asset in question has been earned, even if realization of the asset's value is still contingent, it should be transferable under ' 1041. A similar problem exists in determining marital shares of unvested compensation because a non-employee spouse would, in general, not have any property right to compensation that will not be earned by the employee until after the divorce. Unvested stock options are often awarded to employees for past services, a problem explicitly discussed in Kiniry and other similar state court decisions, but these options are subject to division, as the ruling quite properly recognizes. If the service's explanation of the holding in the ruling accurately reflects its position on the tax treatment of marital property transfers ' ie, by adopting the community property model for interpreting ' 1041 ' then the limitations stated in the conclusion are too restrictive. Thus, until the IRS is more explicit about its view on the application of these concepts in marital property settlements, the tax implications should carefully be considered when a proposed transfer is even slightly different from the transfers discussed in the ruling.