Page 82 - Family Law Services

If the stock received as the result of the exercise of an ISO is held for more than the minimum holding
period before the stock is sold, it will be deemed to be a qualifying disposition. Specifically, if the stock
is held for longer than two years after the grant date of the ISO or longer than one year after the exercise
of the option, the entire gain will be treated as a long-term capital gain. The long-term capital gain will
be the excess of the sale proceeds at disposition over the exercise price of the ISO.

Other Tax Issues for Stock Options and Deferred Compensation in Divorce

Often, a conflict exists when analyzing IRC Sections 83 and 1041. IRC Section 83 addresses the recog-
nition of income from restricted property. Included within the governance of IRC Section 83 is income
from nonqualified stock options and nonqualified deferred compensation. IRC Section 1041, on the oth-
er hand, addresses the transfer of assets between spouses and former spouses. Generally, under IRC Sec-
tion 1041, no gain or loss is recognized on the transfer of property between spouses or former spouses if
the transfer is incident to a divorce. Incident to a divorce is defined as occurring within one year after
the date the marriage ceases or if it is related to the cessation of a marriage, pursuant to a divorce in-
strument and occurring within six years after the divorce is final. The conflict between IRC Sections 83
and 1041 arises in the context of the assignment of income rules. Readers are advised to review Revenue
Ruling 87-112 for a clear, concise explanation of the inherent conflict.

The transfer or distribution of nonqualified stock options and deferred compensation has been deemed to
be a transfer that triggers a taxable event. Under IRC Section 83, nonqualified stock options and de-
ferred compensation have, in some circumstances, been deemed to have been exercised upon transfer
between spouses. The deferred compensation or nonqualified stock options, or both, were deemed to be
taxable compensation to the employee spouse and reportable upon transfer. The nonemployee spouse
was deemed to have carryover basis equal to the amount of compensation reported by the transferor
spouse. Under the scenario discussed previously, the employee-transferor spouse recognized taxable in-
come, yet received no cash. This phantom income resulted in substantial tax due and owing by the trans-
feror spouse. The transferee spouse generally received the proceeds tax-free. In transactions in which the
situation is known, the transfer was often tax-effected so that funds were retained by the transferor
spouse sufficient to pay taxes due resulting from the transfer. Because the transferor spouse was often in
a higher tax bracket than the transferee spouse, the transferee spouse received the proceeds after being
taxed in a higher bracket than he or she would have otherwise incurred.

In a number of cases in which the options or deferred compensation were not immediately vested, or for
strategic reasons would not be exercised, constructive trusts have been instituted wherein the nonem-
ployee spouse would inform the employee spouse of his or her intent to exercise that portion of the de-
ferred compensation or stock options that were allocated to them.

The IRS Field Service Memorandum dated July 29, 1999, addressed the issue of the transfer of ISOs be-
tween spouses or former spouses. The Field Service Memorandum indicated that in the event of transfer
of ISOs from the employee spouse to the nonemployee spouse, the ISOs would cease to be ISOs and
would be converted to nonqualified stock options. The converted ISOs would then be treated and taxed
in the same manner as nonqualified stock options upon transfer from the employee spouse to nonem-
ployee spouse. Consequently, the ISOs would result in immediate income to the employee transferor
spouse upon transfer to the nonemployee spouse.

Recognizing the inherent conflict between IRC Sections 83 and 1041, the IRS issued Revenue Ruling
2002-22 in May 2002. This revenue ruling addresses the transfer of nonqualified stock options and de-
ferred compensation only in the context of divorce; it does not otherwise apply. Additionally, nonquali-
fied stock options, deferred compensation, and other future income rights, to the extent that they are un-

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