Guest Article

(From the May 20, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

IRS Issues Guidance on Income and Employment Tax Reporting/Withholding Rules for Divorce Settlements Involving Nonstatutory Stock Options and Nonqualified Deferred Compensation

Divorce is a messy business, particularly if there is a substantial marital estate to divvy up. And if the marital estate includes nonstatutory stock options and interests in nonqualified deferred compensation plans, employers may find themselves in the middle of their employees' private lives trying to decipher the tax reporting and withholding obligations associated with transfers of these property interests in the context of a divorce settlement. In an effort to make life a little bit less complicated (but not necessarily less cumbersome) for everyone involved in such situations, the IRS on May 8 issued a revenue ruling (2002-22) and a proposed revenue ruling (Notice 2002-31) that provide answers to several key questions.

Impact on Employers

Basically, IRS is taking the position that there are no immediate tax, withholding, or reporting consequences when employees transfer their interests in nonstatutory stock options and nonqualified deferred compensation to their former spouses incident to a divorce. However, the employee's former spouse (the "transferee") must recognize income when he/she exercises the options and/or when the deferred compensation is paid or made available to him/her (Rev. Rul. 2002-22). The employer's FICA and income tax withholding obligations are the same as if the transfer had not occurred, but the employer must report income on a Form 1099-MISC for the transferee and FICA and FUTA wages on the employee's Form W-2. This bifurcated reporting requirement will represent another headache for payroll administrators faced with this uncommon, but not necessarily unusual, circumstance.

Facts

Both Rev. Rul. 2002-22 and Notice 2002-31 are based on the following hypothetical fact pattern.

A is married to B, and A is an employee of Company Y. Company Y issues nonstatutory stock options to A as part of A's compensation. (The nonstatutory stock options do not have a readily ascertainable market value when they are granted to A, so A does not recognize income at the time of grant.) In addition, A participates in each of Company Y's two nonqualified deferred compensation plans: Plan L pays benefits based on a participant's account balance; and Plan M pays benefits based on a formula reflecting service and compensation history.

A and B divorce in 2002. At that time, A's Plan L account balance was $100x and A's Plan M accrued benefit (stated as a single-sum payment upon termination of employment) was $50x. As part of their property settlement, A transferred to B --

1. One-third of the nonstatutory stock options Company Y issued to A;

2. The right to receive deferred compensation payments from Company Y based on $75x of A's account balance under Plan L at the time of divorce; and

3. The right to receive a single sum payment of $25x from Company Y based on A's Plan M accrued benefit.

In 2006, B exercises all of the transferred stock options and receives Company Y stock with a fair market value in excess of the exercise price. In 2011, A terminates employment with Company Y, and B receives a $150x single sum payment from Plan L and a $25x single sum payment from Plan M.

Rev. Proc. 2002-22

Revenue Procedure 2002-22 focuses on the income tax consequences of the following transactions--

1. A transfers property rights to B;

2. Company Y pays nonqualified deferred compensation to B; and

3. B exercises nonstatutory stock options.

According to IRS, neither A nor B is required to recognize income when A transfers nonstatutory stock options and rights to nonqualified deferred compensation to B. This transfer is governed by IRC section 1041, which provides that property transfers from an individual to his/her former spouse are not taxable events if the transfers are incident to the divorce. A transfer is incident to a divorce if it occurs within 1 year after the marriage ends or is related to marriage cessation (i.e., as part of a divorce order, etc.).

However, B must recognize income when deferred compensation is paid or made available to B, and/or when B exercises the stock options. A does not recognize income because the assignment of income doctrine-- which 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-- generally does not apply in the divorce context, IRS ruled.

Interestingly, Rev. Proc. 2002-22 notes the same conclusions would apply if an employee transferred statutory stock options to a spouse or former spouse in connection with a divorce. This is so because such a transfer of the option is a disqualifying disposition, meaning the transferred option essentially becomes a nonstatutory stock option.

Notice 2002-31

The proposed revenue ruling outlined in Notice 2002-31 deals with the more complicated issues of the income and employment tax reporting and withholding requirements associated with this fact pattern. In general, IRS clarifies that there are no reporting or withholding requirements associated with the transfer of rights from A to B, but that these rules do apply when Company Y pays (or makes available) deferred compensation to B and/or when B exercises the stock options.

According to Notice 2002-31, the fact that B-- who is not a current or former Company Y employee-- is exercising the stock options or receiving the deferred compensation does not change the character of those payments as "wages" for purposes of the Federal income tax, Federal Insurance Contributions Act (FICA), or the Federal Unemployment Tax Act (FUTA) rules. As a result, Company Y must withhold income and FICA taxes from deferred compensation payments to B and from any transfers to B resulting from B's exercise of the stock options. Of course, Company Y must pay the employer's share of any FICA and FUTA taxes due on the transfer.

How does Company Y report these wages? For income tax purposes there is no reporting requirement with respect to A because A does not have to recognize any income (see above). But Company Y does have an income tax reporting obligation with respect to B. According to Notice 2002-31, Company Y must report the amounts B recognizes as taxable income on a Form 1099-MISC. However, Notice 2002-31 concludes that the FICA and FUTA wages, as well as the FICA taxes withheld, must be reported on A's Form W-2. (Note that A, not B, gets credit for these wages for purposes of the FICA and FUTA maximum wage base exceptions.)

Some Closing Thoughts

As noted above, Notice 2002-31 requires Company Y to withhold the employee's share of FICA taxes from payments to B even though the FICA wages and withholding are reported on A's Form W-2. Additionally, according to Notice 2002-31, B is not allowed to recognize less income to offset the FICA withholding. As a practical matter, this means B is being forced to pay A's FICA obligations with respect to these payments. Presumably B's divorce lawyer will address this problem in the context of the settlement agreement.

IRS is looking for comments on Notice 2002-31, and it is possible that there will be changes to the final revenue ruling-- if a final revenue ruling is in fact issued. However, unless and until a final revenue ruling is issued, Notice 2002-31 makes clear that IRS expects employers to at least withhold FICA taxes in these circumstances.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about this article, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Copyright 2002, Deloitte.