The Revenue Ruling does not address incentive stock options ("ISOs"). Under IRC Sec. 422(b)(5), an ISO cannot be transferred to or exercised by a person other than the employee to whom the option was granted, except by reason of the employee's death. Therefore, if an ISO is transferred to the employee's spouse in connection with their divorce, it ceases to be an ISO and becomes a non-qualified stock option. Thus, the tax treatment would be the same as described in Revenue Ruling 2004-60.
The following is a bit technical, but outlines the Service's guidelines on these issues. Revenue Ruling 2004-60 concludes that income must be recognized as wages by the non-employee spouse upon exercise of the option. The company issues a 1099 MISC to the non-employee spouse. Further, the exercise of options remains subject to FICA and FUTA taxes, just as if the employee had retained them. Upon exercise of the options, FICA and FUTA taxes are to be deducted from payments to the non-employee spouse. The employer shall report the income in Box 3 and tax withholdings in Box 4 of the 1099 MISC issued to the non-employee spouse. Employers may treat the compensation to the non-employee spouse as supplemental wages subject to the flat withholding rate, which is currectly 25 percent. Employers also shall report FUTA tax withheld on wages paid to the non-employee spouse to the State of California on form 940, social security and Medicare taxes withholdings on form 941 and income tax withholdings on form 945.
Revenue Ruling 2004-60 also holds that the tax treatment of transferring non-qualified deferred compensation from the employee spouse to the non-employee spouse, incident to divorce, is essentially the same as described herein for vested non-qualified stock options.
The ruling is effective January 1, 2005. However, there is an important exception for non-qualified stock options transferred between divorcing spouses pursuant to a court order or divorce agreement. If the order or agreement specifically provides that the employee spouse must report the gross income attributable to the transferred non-qualified stock option, that treatment will be respected by the Internal Revenue Service. For periods before the effective date, employers may rely on a reasonable, good faith interpretation including the interpretations in the prior notice and Revenue Ruling 2004-60.
With the release of these Rulings, practitioners and employers now have authoritative guidance on the handling of taxation of vested non-qualified stock options in a divorce setting. Revenue Ruling 2004-60 does not provide authority regarding the taxation of unvested options. When guidance comes, we will let you know.
