Employment Taxes and Stock Options

The employment tax issue was addressed in a Notice, issued by the IRS concurrently with Rev. Rul. 2002-22, that set out a proposed ruling under which the employer would be required to withhold FICA taxes and income tax. Notice 2002-31, 2002-1 C.B. 908. The IRS has now confirmed the position it took in the Notice by issuing Rev. Rul. 2004-60, 2004-24 I.R.B. 1051, in which it issued basically the same ruling as that set out in the Notice, with clarification how income tax withholding would be calculated by the employer.

The employment tax problem does cause concern when the tax liability is shifted to the non-employee spouse because withholding is required with respect to the employee. Thus, any FICA tax withheld would be credited to the employee, and not the transferee spouse, and there would be no adjustment to the income taxable to the transferee. In effect, the amount paid to her would be reduced by his social security tax, and she would pay income tax on the amount credited to him. As for income tax withholding, however, the withheld tax would be treated as tax withheld from her income and she would be entitled to claim credit against her tax liability under IRC ' 31.

The only question left unanswered in the earlier Notice was how to compute income withholding on the compensation transferred to her. In the Ruling, the Service specified that the taxable compensation would be treated as supplemental compensation subject to flat rate withholding, currently the third lowest marginal rate (25%) on unmarried individuals. Consequently, obtaining a W-4 from the transferee is unnecessary, and the income would be reported to her as miscellaneous income on Form 1099.

The Withholding Problem

These provisions do make sense as a reasonable way to deal with the withholding problem when compensation results from the exercise of nonqualified stock options and other deferred compensation arrangements. Many, if not most, employees who have stock options and/or unfunded deferred compensation arrangements subject to division in divorce proceedings will have received aggregate compensation in excess of the contribution and benefit base for Social Security purposes ($87,900 in 2004). In these cases, the Old-Age, Survivors, and Disability Insurance (OASDI) tax will not be withheld. As noted above, flat rate income tax withholding will be creditable against the transferee 's income tax liability. That leaves the hospitalization tax (1.45%), which is imposed on all wages without limit, but, unlike the OASDI “contribution,” there is no insurance component to this tax, which specifically benefits either party, and characterization of the income as wages in the hands of the transferee subjects it to the hospitalization tax whether or not it has been assigned to the transferee. Accordingly, the transfer of a stock option or an interest in an unfunded deferred compensation arrangement should not cause withholding that confers a benefit on the transferor at the same time as it is taxed to the transferee.

Tax withholding and payment to the IRS is the legal responsibility of the employer, so the employer's interest in retaining funds necessary to pay the tax will have to be respected. This problem may complicate the employer's willingness to cooperate with an assignment in a marital settlement to a non-employee spouse because failure to comply with withholding and payment requirements can result in significant penalties, even when the income tax has been shifted, to the nonemployee spouse. In that case, withheld taxes may have to be deposited in the same manner and at the same time as employment taxes with respect to compensation taxable to employees.

Executive Compensation

The tax treatment of interests in executive compensation arrangements that have been assigned in a marital settlement may seem straightforward, but the tax rules are applied in a more complex environment, particularly for stock options. In the first place, the term “transfer” is not defined, and there may be instances in which the assignment of a beneficial interest in the option is not clearly a transfer. Often, the method of exercise is as important, if not more so, as the value of the option itself. An option is a contract to purchase stock of the employer at a specific price (usually, the value of the employer 's stock on the date the option was granted) and within a predetermined time period. Employees may not have the cash necessary to pay the option price at the time of exercise, a situation even more likely to be present for options assigned to an estranged spouse in a divorce settlement. To permit em-ployees to realize the value of their options, a technique described as a “cashless exercise,” in which the stock subject to the option being exercised is sold at its current market price, is often used. The employer agrees with the broker to transfer the shares at the time of exercise, and before the settlement date, in return for payment by the broker of the option price plus an amount equal to the amounts required to be withheld. At settlement, proceeds of the sale less the transaction cost to the broker, which may include some interest charges, are paid to the employee.

Employer Cooperation

So far, so good. However, this technique requires the cooperation of the employer. While there are no legal impediments to the transfer of as-yet-unexercised options from the employee to a member of the employee's family, stock option plans usually require the employer 's consent to such a transfer, and agreement to permit use of an exercise technique which allows the spouse to determine an appropriate exercise date and then to cash out the assigned options. Most companies seem to be unwilling to cooperate in facilitating a divorce settlement under which options to purchase its stock have been assigned to the nonemployee spouse. To cope with this situation, and to protect the nonemployee spouse 's interest in her share of the options, the options can be placed in trust, with specific authorization executed by the employee for the employer to act at the direction of a broker selected by the nonemployee spouse. The employee, theoretically at least, must still exercise the option, although his action in doing so is subject to the compulsion of the settlement agreement.

What Constitutes a 'Transfer'?

Is this arrangement a “transfer”? Because, as a technical matter, ownership of the options remains with the employee, the arrangement may not be viewed as a transfer. The tax to be withheld, then, would be the employee 's income tax, and presumably a carefully negotiated divorce settlement would require the transfer to be made net of these taxes, which the transferee will have agreed must be paid. Because of employer resistance, and IRS concern over the scope of the ruling, as discussed below, treating the income realized from exercise of these options as the income of the employee is not likely to be challenged by the IRS. The income tax liability of the employee would usually be greater than the tax liability of the employee 's spouse after divorce, and to be on the safe side, one might expect that most settlements would be negotiated for the employee 's tax to be the tax that is paid. That arrangement might be viewed as leaving control over the exercise date in the hands of the employee, but there are risks if the employee does not act as the parties have agreed. See Elliott v. Elliott, 2004 WL 769254 (TN Ct. App. 2004) (employee liable to pay after-tax proceeds which would have been realized had he exercised options when asked to do so by divorced spouse).

Apart from the question whether (and when) a “transfer” has occurred for tax purposes, the scope of Revenue Ruling 2002-22 was left uncertain by an IRS reservation in the last paragraph of the ruling. Although the reasoning relied upon in the ruling is very broad indeed and could be interpreted as abandoning reliance on the assignment of income doctrine for all transfers under marital settlements, the IRS limited the application of the ruling in cases where the “options or rights are unvested at the time of transfer or to the extent that the transferor 's rights to such income are subject to substantial contingencies,” citing Kochansky v. Commissioner, 92 F.3d 957 (9th Cir. 1996). “Unvested” must mean that the option or deferred compensation would be forfeited unless the employee spouse were to have completed some additional period of employment before the option could be exercised or the deferred compensation paid. Under state law, however, divorce courts have not been inhibited by forfeiture clauses in determining that “unvested” options relate to a period of employment during marriage and are, therefore, marital property that is distributable to the non-employee spouse in divorce. See, e.g., Kiniry v.Kiniry, 71 Conn. App. 614, 803 A.2d 352 (2002); DeJesus v. DeJesus, 90 N.Y. 2d 643, 687 N.E. 2d 1319 (1997).

If, as the ruling states, a division of marital property in a common law state is to be taxed in the same way as the division of community property, then whether the option or deferred compensation involved is “unvested” at the time of divorce should not be relevant to the tax question. It is clear, however, that the IRS may have second thoughts about the rationale stated in the ruling, an observation suggested by informal discussions with IRS personnel, and therefore, reliance on the ruling to shift the tax consequences of incentive compensation to the nonemployee spouse is problematic.

The use of stock options to compensate employees has recently been subjected to unfavorable publicity. The Financial Acccounting Standards Board (FASB) is considering whether to require employers to account for the value of stock options as expenses for financial purposes, a development which would significantly diminish the attractiveness of options as compensation. Moreover, after the burst of the technology bubble, the stock market has not performed nearly as well as it did in the late 1990s. According to news reports, employers have begun to rely less on stock options and more on other techniques, such as restricted stock plans or phantom stock plans in which the value conferred on the employee is tied to performance of the employer 's stock. Under these plans, taxation of compensation is deferred until restrictions lapse or payment is triggered, usually after an additional period of service. Assignment of an interest in stock, which is subject to restrictions on transfer or contractual deferral compensation, may not involve the same complexity as transfers of the right to exercise stock options. Consequently, tax might be more readily shifted to the transferee, particularly if payments were to be made by the corporation directly to the transferee, subject to the employer 's withholding obligations. When the payoff must be routed through the employee spouse, however, one might wonder whether there has been a “transfer” when similar arrangements for options are not.

Thomas R. White, 3rd, is a John C. Stennis Professor of Law at the University of Virginia Law School, where he teaches Tax, Benefits and Real Estate courses. A former chair of the Domestic Relations Committee of the ABA Tax Section, he has written and lectured extensively on domestic relations tax problems.

More than 2 years ago, the Internal Revenue Service published Revenue Ruling 2002-22, 2002-19 I.R.B. 849, in which it held that section 1041 of the Internal Revenue Code governed the transfer of stock options and interests in certain unfunded deferred compensation arrangements to the employee's spouse under a marital property settlement. As a result, the employee spouse was not taxable on the transfer. Instead, the spread on the options (the difference between the value of the employer 's stock at the time of exercise and the striking price) and the amount received as deferred compensation under unfunded arrangements were taxable to the nonemployee spouse in the same way and to the same extent as it would have been taxed to the employee.

The ruling interpreted section 1041 to have established the rule that property transfers in divorce should be taxed as if the property conveyed were community property that had been transferred in settlement of the transferee 's community property rights. As community property, stock options and interests in unfunded deferred compensation arrangements constituted “property” for section 1041 purposes, and the amounts received by the nonemployee spouse would be ordinary income to her (or him), taxable as compensation under IRC ' 83 and would be “wages” subject to employment taxes and withholding by the employer.

A Brief Explanation

The employment tax issue was addressed in a Notice, issued by the IRS concurrently with Rev. Rul. 2002-22, that set out a proposed ruling under which the employer would be required to withhold FICA taxes and income tax. Notice 2002-31, 2002-1 C.B. 908. The IRS has now confirmed the position it took in the Notice by issuing Rev. Rul. 2004-60, 2004-24 I.R.B. 1051, in which it issued basically the same ruling as that set out in the Notice, with clarification how income tax withholding would be calculated by the employer.

The employment tax problem does cause concern when the tax liability is shifted to the non-employee spouse because withholding is required with respect to the employee. Thus, any FICA tax withheld would be credited to the employee, and not the transferee spouse, and there would be no adjustment to the income taxable to the transferee. In effect, the amount paid to her would be reduced by his social security tax, and she would pay income tax on the amount credited to him. As for income tax withholding, however, the withheld tax would be treated as tax withheld from her income and she would be entitled to claim credit against her tax liability under IRC ' 31.

The only question left unanswered in the earlier Notice was how to compute income withholding on the compensation transferred to her. In the Ruling, the Service specified that the taxable compensation would be treated as supplemental compensation subject to flat rate withholding, currently the third lowest marginal rate (25%) on unmarried individuals. Consequently, obtaining a W-4 from the transferee is unnecessary, and the income would be reported to her as miscellaneous income on Form 1099.

The Withholding Problem

These provisions do make sense as a reasonable way to deal with the withholding problem when compensation results from the exercise of nonqualified stock options and other deferred compensation arrangements. Many, if not most, employees who have stock options and/or unfunded deferred compensation arrangements subject to division in divorce proceedings will have received aggregate compensation in excess of the contribution and benefit base for Social Security purposes ($87,900 in 2004). In these cases, the Old-Age, Survivors, and Disability Insurance (OASDI) tax will not be withheld. As noted above, flat rate income tax withholding will be creditable against the transferee 's income tax liability. That leaves the hospitalization tax (1.45%), which is imposed on all wages without limit, but, unlike the OASDI “contribution,” there is no insurance component to this tax, which specifically benefits either party, and characterization of the income as wages in the hands of the transferee subjects it to the hospitalization tax whether or not it has been assigned to the transferee. Accordingly, the transfer of a stock option or an interest in an unfunded deferred compensation arrangement should not cause withholding that confers a benefit on the transferor at the same time as it is taxed to the transferee.

Tax withholding and payment to the IRS is the legal responsibility of the employer, so the employer's interest in retaining funds necessary to pay the tax will have to be respected. This problem may complicate the employer's willingness to cooperate with an assignment in a marital settlement to a non-employee spouse because failure to comply with withholding and payment requirements can result in significant penalties, even when the income tax has been shifted, to the nonemployee spouse. In that case, withheld taxes may have to be deposited in the same manner and at the same time as employment taxes with respect to compensation taxable to employees.

Executive Compensation

The tax treatment of interests in executive compensation arrangements that have been assigned in a marital settlement may seem straightforward, but the tax rules are applied in a more complex environment, particularly for stock options. In the first place, the term “transfer” is not defined, and there may be instances in which the assignment of a beneficial interest in the option is not clearly a transfer. Often, the method of exercise is as important, if not more so, as the value of the option itself. An option is a contract to purchase stock of the employer at a specific price (usually, the value of the employer 's stock on the date the option was granted) and within a predetermined time period. Employees may not have the cash necessary to pay the option price at the time of exercise, a situation even more likely to be present for options assigned to an estranged spouse in a divorce settlement. To permit em-ployees to realize the value of their options, a technique described as a “cashless exercise,” in which the stock subject to the option being exercised is sold at its current market price, is often used. The employer agrees with the broker to transfer the shares at the time of exercise, and before the settlement date, in return for payment by the broker of the option price plus an amount equal to the amounts required to be withheld. At settlement, proceeds of the sale less the transaction cost to the broker, which may include some interest charges, are paid to the employee.

Employer Cooperation

So far, so good. However, this technique requires the cooperation of the employer. While there are no legal impediments to the transfer of as-yet-unexercised options from the employee to a member of the employee's family, stock option plans usually require the employer 's consent to such a transfer, and agreement to permit use of an exercise technique which allows the spouse to determine an appropriate exercise date and then to cash out the assigned options. Most companies seem to be unwilling to cooperate in facilitating a divorce settlement under which options to purchase its stock have been assigned to the nonemployee spouse. To cope with this situation, and to protect the nonemployee spouse 's interest in her share of the options, the options can be placed in trust, with specific authorization executed by the employee for the employer to act at the direction of a broker selected by the nonemployee spouse. The employee, theoretically at least, must still exercise the option, although his action in doing so is subject to the compulsion of the settlement agreement.

What Constitutes a 'Transfer'?

Is this arrangement a “transfer”? Because, as a technical matter, ownership of the options remains with the employee, the arrangement may not be viewed as a transfer. The tax to be withheld, then, would be the employee 's income tax, and presumably a carefully negotiated divorce settlement would require the transfer to be made net of these taxes, which the transferee will have agreed must be paid. Because of employer resistance, and IRS concern over the scope of the ruling, as discussed below, treating the income realized from exercise of these options as the income of the employee is not likely to be challenged by the IRS. The income tax liability of the employee would usually be greater than the tax liability of the employee 's spouse after divorce, and to be on the safe side, one might expect that most settlements would be negotiated for the employee 's tax to be the tax that is paid. That arrangement might be viewed as leaving control over the exercise date in the hands of the employee, but there are risks if the employee does not act as the parties have agreed. See Elliott v. Elliott, 2004 WL 769254 (TN Ct. App. 2004) (employee liable to pay after-tax proceeds which would have been realized had he exercised options when asked to do so by divorced spouse).

Apart from the question whether (and when) a “transfer” has occurred for tax purposes, the scope of Revenue Ruling 2002-22 was left uncertain by an IRS reservation in the last paragraph of the ruling. Although the reasoning relied upon in the ruling is very broad indeed and could be interpreted as abandoning reliance on the assignment of income doctrine for all transfers under marital settlements, the IRS limited the application of the ruling in cases where the “options or rights are unvested at the time of transfer or to the extent that the transferor 's rights to such income are subject to substantial contingencies,” citing Kochansky v. Commissioner , 92 F.3d 957 (9th Cir. 1996). “Unvested” must mean that the option or deferred compensation would be forfeited unless the employee spouse were to have completed some additional period of employment before the option could be exercised or the deferred compensation paid. Under state law, however, divorce courts have not been inhibited by forfeiture clauses in determining that “unvested” options relate to a period of employment during marriage and are, therefore, marital property that is distributable to the non-employee spouse in divorce. See, e.g., Kiniry v.Kiniry, 71 Conn. App. 614, 803 A.2d 352 (2002); DeJesus v. DeJesus , 90 N.Y. 2d 643, 687 N.E. 2d 1319 (1997).

If, as the ruling states, a division of marital property in a common law state is to be taxed in the same way as the division of community property, then whether the option or deferred compensation involved is “unvested” at the time of divorce should not be relevant to the tax question. It is clear, however, that the IRS may have second thoughts about the rationale stated in the ruling, an observation suggested by informal discussions with IRS personnel, and therefore, reliance on the ruling to shift the tax consequences of incentive compensation to the nonemployee spouse is problematic.

The use of stock options to compensate employees has recently been subjected to unfavorable publicity. The Financial Acccounting Standards Board (FASB) is considering whether to require employers to account for the value of stock options as expenses for financial purposes, a development which would significantly diminish the attractiveness of options as compensation. Moreover, after the burst of the technology bubble, the stock market has not performed nearly as well as it did in the late 1990s. According to news reports, employers have begun to rely less on stock options and more on other techniques, such as restricted stock plans or phantom stock plans in which the value conferred on the employee is tied to performance of the employer 's stock. Under these plans, taxation of compensation is deferred until restrictions lapse or payment is triggered, usually after an additional period of service. Assignment of an interest in stock, which is subject to restrictions on transfer or contractual deferral compensation, may not involve the same complexity as transfers of the right to exercise stock options. Consequently, tax might be more readily shifted to the transferee, particularly if payments were to be made by the corporation directly to the transferee, subject to the employer 's withholding obligations. When the payoff must be routed through the employee spouse, however, one might wonder whether there has been a “transfer” when similar arrangements for options are not.

Thomas R. White, 3rd, is a John C. Stennis Professor of Law at the University of Virginia Law School, where he teaches Tax, Benefits and Real Estate courses. A former chair of the Domestic Relations Committee of the ABA Tax Section, he has written and lectured extensively on domestic relations tax problems.