Page 83 - Family Law Services

vested at the time of transfer and subject to forfeiture, are not transferable in accordance with IRS Reve-
nue Ruling 2002-22 and, therefore, subject to all the cautions that follow.

Upon transfer of nonqualified stock and deferred compensation options, no gain or loss is triggered to
either the transferor or the transferee spouse. The transferor spouse is deemed to have transferred the de-
ferred compensation and stock options under IRC Section 1041 to a spouse or former spouse, and no
gain is recognized. The transferee spouse receives the deferred compensation or stock options with an
effective carryover basis and reports a gain upon the exercise of the stock options or receipt of the de-
ferred compensation. Consequently, the transferee spouse or nonemployee spouse, rather than the trans-
feror or employee spouse, recognizes income under IRC Section 83(a).

Although IRS Revenue Ruling 2002-22 addresses nonqualified stock options and deferred compensa-
tion, it is assumed that substantially the same treatment would be afforded the transfer of ISOs issued
under IRC Section 422. In keeping with the general theory of the IRS Field Service Memorandum is-
sued on July 29, 1999, upon transfer of the ISOs by the employee transferor spouse to the nonemployee
transferee spouse, the ISOs issued under IRC Section 422 would cease to be ISOs and would, upon
transfer, become nonqualified stock options subject to taxation under IRC Section 83(a). As a result of
this deemed conversion from ISO to nonqualified stock option, former ISOs would not be taxable to the
employee transferor spouse upon transfer and would be received with carryover basis by the transferee
spouse. Upon the exercise of the former ISOs by the transferee spouse, the transferee spouse would rec-
ognize income taxable in the year of exercise.

Revenue Ruling 2004-60 addresses the employment tax aspect of transfers under Revenue Ruling 2002-
22. Revenue Ruling 2004-60 states that federal income tax is due from the transferee spouse at the time
of exercise, not transfer. Income taxes are based on the transferee's facts and tax situation. Social Securi-
ty and Medicare taxes are due based upon the employee spouse's earnings levels and reported on the
employee's W-2. The proceeds received by the nonemployee spouse are reduced by these incremental
employment taxes.

Knowledge of the opportunities and requirements contained in Revenue Ruling 2002-22 allows practi-
tioners the opportunity to assist the divorcing spouses through tax planning. The conclusion that IRC
Section 1041 governs the transfer of stock options and deferred compensation in divorce affords the di-
vorcing spouses the opportunity to select who will be taxed on the transaction through asset division.

Taxation of Retirement Proceeds

Most employer retirement plans encountered in family law cases are qualified under IRC Section 401.
Qualified plan assets and future benefits are transferable between the parties without tax consequence to
the employee pursuant to a qualified domestic relations order (QDRO). A QDRO is a court order that is
made pursuant to federal and state laws that deals with a divorcing spouse’s right to receive all or a por-
tion of the benefits payable with respect to the ex-spouse’s retirement plan.

If assets are divided pursuant to a QDRO, the nonemployee spouse has several options regarding what to
do with the proceeds. The proceeds can be rolled over into an IRA. If this occurs, the proceeds are sub-
ject to all the rules applicable to IRAs. Alternatively, the nonemployee spouse can also choose to take
the proceeds and put them into a nonretirement vehicle. In this case, the spouse will pay income tax on
the balance received but can avoid the 10% early withdrawal penalty that would be normally be applied,
if applicable, pursuant to IRC Section 72(t). The nonemployee spouse also has the option of mixing
these results. The administrator of the plan will forward documents that detail these options and provide
information regarding the timing of the disbursement to the nonemployee spouse.

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