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Options Transferred Subsequent to a Divorce
When all or a portion of a nonstatutory stock options is transferred to the former spouse of one of your employees subsequent to a divorce, there are no income reporting or tax withholding obligations on the transfer. However, the exercise of those option shares requires special handling by the company.
When an incentive stock option is transferred in a divorce settlement, it no longer qualifies for preferential tax treatment. Once the ISO has been transferred, the income reporting and tax withholding obligations are the same as for NSOs. However, if the transfer of the shares happens only at exercise, then the ISO shares maintain their preferential tax treatment. The transfer of the shares at exercise does not constitute a disqualifying disposition. The transferred shares are then subject to the same holding requirements from the date of grant and exercise to determine if the sale is a qualified or disqualified disposition.
There are two important revenue rulings that govern the income reporting and tax withholding on options transferred pursuant to a divorce.
Revenue Ruling 2002-22 establishes that a transfer of nonstatutory stock options as part of a divorce settlement does not constitute an income event. For stock plan managers, this means that there is no need to establish the fair value of the option, report any income, or withhold any taxes on the date of transfer. It also establishes that the former spouse realizes income on the exercise of those option shares.
Revenue Ruling 2004-60 clarifies the withholding and reporting obligations for an exercise made by the non-employee former spouse of options that were transferred in a divorce settlement.
Withholding and Reporting at Exercise
So, we know from Revenue Ruling 2004-60 that the former spouse realizes income at the exercise of options transferred pursuant to a divorce. What's more, FICA and FUTA are both applied to the income at exercise. But, don't worry; you won't need to collect a Form W-4 from the former spouse. The income and FICA tax rates are applied based on the employee's supplemental income and the Social Security tax she or he paid in that tax year as of the exercise date.
When the former spouse exercises the option, the company withholds income, Social Security, and Medicare from the exercise proceeds based on the employee's withholding rates. The income tax withholding is attributed to the former spouse, but the FICA taxes are attributed to the employee even though they are paid by the former spouse. The income (i.e.; spread at exercise) and the income taxes withheld are reported on a Form 1099-MISC to the former spouse. That same income amount is reported to the employee as Social Security and Medicare wages on Form W-2. Additionally, the Social Security (if applicable) and Medicare withheld are reported on the employee's Form W-2. For a great example of this, see our Tax Withholding on Option Exercises Subsequent to Divorce alert. You can also find more information in these recorded webcasts: Death and Divorce: The Lighter Side of Equity Compensation and The 2nd Annual NASPP Webcast on Tax Reporting.
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