Probate & Trust Law Section Conference Manual ... - Minnesota CLE

E. Transfers in Divorce
The IRS first addressed the tax
consequences of the transfer of options incident to a
divorce in a field service advice. 26 Its holding,
which was particularly harsh on the transferor,
engendered howls of protest. While the rationale of
the holding was a bit fuzzy, the bottom line was that
the Section 83 overrode the protections of Section
1041, with result that the employee-spouse was
treated as making a transfer to the ex-spouse. This
of course triggered recognition of compensation
income to the employee, which Section 1041 was
expressly enacted to prevent.
Ultimately, the IRS reversed course in Rev.
Rul. 2002-22, 2002-1 C.B. 849, which holds that
Section 1041 takes precedence over Section 83. As
a result, its seems settled now that the division of
options pursuant to a divorce proceeding does not
trigger compensation income to either party,
provided the requirements of Section 1041 are met.
The critical point highlighted by the IRS in its u-turn
was the congressional intent to put divorcing
couples on equal footing regardless of the property
law that governed their marital relations. In effect,
Section 1041’s purpose is to harmonize the tax
consequences of marital property settlements in
separate property states with those in community
property states. The net effect of the ruling is to
treat the transferee spouse as the original owner of
the options.
This distinction is very important. Under
Rev. Rul. 2002-22, when the non-employee-spouse
later exercises or disposes of the options, any
income triggered under Section 83 is the nonemployee-spouse’s
income. Had the ruling merely
held that the transfer is a gift, as Section 1041
literally provides, then the transfer would have been
a non-arm’s-length transfer. This would have
protected the employee-spouse from immediate
income recognition under Section 83. However,
Section 83 would have continued to apply to the
options after the transfer, leaving the employeespouse
exposed to tax on compensation income
triggered by any subsequent exercise or sale of the
options by the non-employee-spouse.
The ruling also addressed the special issues
pertaining ISOs. The prior FSA had held that the
transfer of ISOs incident to a divorce was a
prohibited transfer, causing the ISOs to become
NQSOs from that point forward. The later public
ruling reconfirmed that holding. In doing so, the
IRS pointed to Section 424(c)(4), which specifically
exempts divorce-related transfers of ISO stock from
the disqualifying disposition rules. That there is no
similar provision applicable to the ISOs themselves
seems to be the basis for this holding.
Oddly, the IRS paints this latter holding as
the “same conclusion” it reached for NQSOs earlier
in the ruling. This is a real head-scratcher. The IRS
contends that a primary objective of Section 1041 is
to put similarly-situated couples on an equal federal
tax footing, regardless of state property law. As
noted above, under this rationale, it treats the
transferee spouse as if she were the employee with
respect to the NQSOs she receives in a divorce. If
this logic truly applies to ISOs (and there is nothing
that says otherwise), the transferred ISOs should
also retain their status as such in the hands of the
non-employee-spouse.
The end result of the contrary holding for
ISOs is that divorcing spouses will have a serious
conflict with respect to the division of ISOs. Those
retained by the employee-spouse will continue to be
ISOs (because they aren’t transferred), while the
ones transferred to the non-employee spouse will
lose their status as such. This hardly seems fair, and
it certainly departs from the congressional policy the
IRS so carefully articulated in its holdings
concerning NQSOs. But, until the IRS comes to its
senses, this anomalous result appears to govern the
division of ISOs.
F. Transfers at Death
There can be no doubt that vested
compensatory options owned by a decedent are
includable in the decedent’s gross estate. The value
of the inclusion is has been confusing, however.
Long ago, the IRS issued a ruling that held that the
estate tax value of a compensatory option at death
was its equity value (i.e., the excess of the FMV of
the underlying stock over the strike price). 27 Taken
to its logical extreme, this policy would mean that
out-of-the-money options are worthless, something
that is patently incorrect.
Today, it is clear that the methodology for
valuing options for other purposes also apply in the
26 See FSA 200005006.
– 11 –
27 See Rev. Rul. 196, 1955-2 C.B. 178.