Tax Treatment of Stock Options
By: JUDY S. ENGEL
March 2005
A stock option is defined as a right issued by a corporation to an individual or entity to buy a given amount of shares of company stock at a stated price within a specified period of time. During the last several years, stock options have become a popular way for corporations to compensate employees. Thus, more people have an interest in stock options than ever before. This has led to new concerns about how to deal with these unique assets when a couple divorces.
The transfer of stock options in a divorce context can be complex, and IRS treatment quite varied, depending upon the facts.
Basically, there are two types of stock options:
- statutory (or qualified); and
- non-statutory (or non-qualified).
Statutory stock options qualify for tax treatment under IRC §422 or §423, which address stock options acquired through employee incentive or stock purchase plans. Non-statutory stock options are acquired in any other way.
Generally speaking, when statutory stock options are exercised, the profits are taxed as capital gains, which is currently at a rate of only 15%. When a non-statutory stock option is exercised, the profits are taxed as ordinary income, which is often at much higher rates.
If a statutory stock option is transferred from one spouse to another in a divorce, it loses its statutory classification. When the receiving spouse exercises the option, profits are taxed as ordinary income. Savvy litigants will work around this problem by agreeing that literal ownership will not transfer in the divorce. Rather, the owner of the option will “hold” it on the transferee’s behalf. When the transferee wants to exercise the option, the former spouse does so on his or her behalf and transfers the proceeds to the transferee spouse. Since the former spouse still technically “owned” the option, he or she will owe the capital gains tax; the agreement typically provides that proceeds are transferred net of taxes.
A former problem with respect to stock option divorce transfers has recently been fixed. Under IRC §1041, assets transferred in the context of a divorce are not taxed at that time. However, in 1999, the IRS suggested that if non-statutory stock options were transferred in a divorce, the transferor spouse should be taxed on their fair market value despite IRC §1041. The IRS fixed this problem in 2002 with revenue ruling 2002-22, which brought the transfer of non-statutory stock options in line with IRC §1041. It is now clear that when a non-qualified stock option is transferred in a divorce, there is no immediate taxable event. Rather, the transferee spouse will pay ordinary income tax on the profits on exercise. Unfortunately, this rule applies to vested stock options only; if a non-vested non-statutory stock option is transferred in a divorce, it will still likely be taxed at the time of transfer.
The laws and rules governing stock options transferred in a divorce are likely to continue to change. Thus, any party to a divorce contemplating the transfer of stock options would be well advised to seek the advice of a knowledgeable attorney and/or accountant.