Revenue Ruling 83-52: Tax on Stock Options in Divorce
Explore the tax framework for stock options in divorce under Rev. Rul. 83-52, clarifying how income is allocated and basis is determined for each party.
The transfer of assets during a divorce often involves employee stock options. IRS guidance clarifies the tax responsibilities for both the employee who originally received the options and the former spouse who receives them in a settlement. Understanding the rules for vested non-statutory stock options (NSOs) is important for financial planning, as they dictate when income is recognized and by whom.
The Core Ruling Explained
Under Internal Revenue Code Section 1041, the transfer of property between former spouses incident to a divorce is not a taxable event. When vested, non-statutory stock options are transferred from an employee to their former spouse in a divorce, neither party recognizes a gain or loss at the time of transfer. A non-statutory stock option is a right to purchase company stock at a predetermined price, known as the exercise or strike price.
The tax implications are postponed until the options are exercised, which is when their economic value is realized. This deferral of tax liability prevents the division of marital assets from creating an immediate financial burden and shifts the focus from the division of the options to their eventual use.
Tax Implications for the Employee Spouse (Transferor)
The employee spouse does not recognize ordinary income when their former spouse exercises the transferred options. However, the income recognized by the non-employee spouse is considered wages of the employee for employment tax purposes.
This means the employee spouse is responsible for paying their share of Social Security and Medicare (FICA) taxes on the income generated by the exercise. The employer will report these amounts on the employee’s annual Form W-2, as the options were originally granted as compensation for the employee’s labor.
Tax Implications for the Non-Employee Spouse (Transferee)
When the non-employee spouse exercises the stock options, they recognize ordinary compensation income. The amount of this income is the “spread,” which is the difference between the fair market value of the stock on the exercise date and the exercise price paid. This income is subject to federal income tax withholding, and the employer reports it to the non-employee spouse on Form 1099-MISC.
For example, if a non-employee spouse exercises options to buy 100 shares at an exercise price of $10 per share when the stock is trading at $50 per share, they must recognize $4,000 in compensation income (($50 – $10) x 100 shares).
The non-employee spouse’s tax basis in the acquired stock is its fair market value on the date of exercise. This is calculated by adding the exercise price paid for the stock to the amount of compensation income recognized. In the example, the basis would be $5,000 ($1,000 paid + $4,000 income). If the shares were immediately sold for $5,000, there would be no capital gain.
Practical Application and Reporting
A well-drafted divorce agreement should detail the responsibilities of each party. It should require the non-employee spouse to provide advance notification to the employee spouse and the employer before exercising any options. This allows the employer to properly calculate FICA taxes for the employee and arrange income tax withholding for the non-employee.
The employer is responsible for issuing a Form W-2 to the employee reflecting the FICA wages and a Form 1099-MISC to the non-employee spouse showing the ordinary income and any tax withheld. The divorce agreement should specify notification timelines and may include provisions for the non-employee spouse to reimburse the employee for the FICA taxes paid on their behalf.