IRS changes stock option tax liability rule in divorce

Fort Worth Business Press
August 9, 2002
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Amid all the recent press attention focused on stock options - should they be counted as expenses or not - a different but arguably more "taxing" problem has been plaguing divorce proceedings for more than 20 years. The issue is who should pay taxes on stock options transferred from one spouse to the other during a divorce settlement.

Stock options are as much a part of the marital property to be divided upon divorce as the parties' joint bank accounts. Some of the stock options might remain with the spouse who earned them (the employee-spouse), while some of them might be transferred to the non-employee-spouse. The nonemployee-spouse has the same discretion to exercise the options - cash them in - at any point in the future as does the employee-spouse. But when the nonemployee-spouse does this, who pays the taxes?

According to Internal Revenue Code § 1041, as a general policy, neither spouse should recognize a tax gain or loss at the time of divorce when property is transferred from one spouse to another. Section 1041 does not, however, address how to deal with income earned in the future when stock options obtained by the non-employee spouse in a divorce are exercised.

The IRS previously applied the "assignment of income doctrine" to such situations. The doctrine says that income is to be taxed to the person who earns it, and that the tax burden cannot be shifted to another person by assigning the interest in the income.

For example, assume that A receives stock options from her employer as part of her compensation package. After these stock options are earned, A and B get divorced. In the divorce settlement, A transfers stock options to B. According to Section 1041, neither party will recognize income from this transaction at the time of the transfer. One year later, B exercises the options he acquired in the divorce settlement. B would receive the income from the options, yet A would still pay the taxes!

Recently, with the release of Revenue Ruling 2002-22, the IRS has attempted to eliminate this unjust arrangement. The IRS ruled that applying the "assignment of income doctrine" in divorce cases would frustrate the purpose of § 1041 "by impos(ing) substantial burdens on marital property settlements involving such property and thwart(ing) the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible."

Under this new ruling, which takes effect Nov. 9, the tax liability for stock options transferred as part of a divorce settlement are the responsibility of the non-employee spouse who exercises those options. Now the party who receives the benefit of the income also carries the burden of paying the taxes. In our example above, B's exercise of the options would have no affect on A; instead, B would receive both the benefit and the burden of the resulting income.

The new policy is a much more appropriate method of assigning tax liability for stock options. Specifically, it matches the interests of Texas law and policy. First, it ensures that an employee who earned the stock options will no longer experience the frustration of being saddled with the burden of paying taxes on income received by his or her ex-spouse. The new ruling also furthers Texas' public policy of striving to achieve finality in all litigation matters. Third, the new ruling simplifies the division of assets for the purposes of achieving a just and right division of community property, as required by Texas law.

The IRS intends to apply the old rule to any stock options transferred pursuant to a divorce settlement agreement or court order before Nov. 9. However, this does not prevent parties from structuring their settlement that assigns tax responsibilities in accordance with Revenue Ruling 2002- 22 before its effective date. Parties to pending divorces and their attorneys should keep this in mind when preparing settlement agreements and divorce decrees.

Given the amount of criticism the IRS receives (and some of it deservedly so), it should be applauded for eliminating such an unfair practice and replacing it with a more equitable approach. At least this is one stock option issue that won't keep making headlines.

Mary Johanna McCurley is a partner in the Dallas family law boutique of McCurley, Kinser, McCurley & Nelson, L.L.P. Brian W. Clark is an associate in the firm. For more information on this and other family law topics, please visit the firm's Web site at www.mkmn.com.