Tax treatment of Stock Options

Tax Treatment of Stock Options
Warren R. Shiell, Attorney At Law © 2006

The tax treatment of stock options in divorce depends to a large extent on whether the options are qualified or non-qualified stock options. Qualified stock options include incentive stock options (ISO's) that meet the requirements of IRC 422 and employee stock options (ESPP's) that meet the requirements of IRC 423. Qualified stock options generally receive more favorable tax treatment.

The benefit to the taxpayer of receiving qualified stock options is that they do not have to report the "price break" or "compensation element" as regular taxable income, although they may still have to make an adjustment for the Alternative Minimum Tax. The "compensation element" is the difference between the exercise price or "strike price" and the market price on the day when the options are exercised multiplied by the amount of options exercised. If the taxpayer then holds onto them for the statutory "qualifying period" - at least one year and one day after the date of purchase and two years after the original grant date - the taxpayer is only taxed on the gain at the capital gains rate of 15% of less - a lot lower than the regular income tax rate.

Contrast this with the treatment of non-qualified stock options. The taxpayer has to report the "compensation element" as taxable compensation in the year when the options are exercised which is then taxed at the regular income tax rate. The taxpayer is taxed again on any taxable gain when the shares are subsequently sold.

The following an example will illustrate the difference. The exercise price for the shares which are covered by the option is $25 per share. The taxpayer exercises 100 options to purchase shares at $45 per share. The "compensation element" is $2,000 (($45-$20) x 100). If these are qualified stock option's, the taxpayer wouldn’t have to report anything on his Schedule D (capital gains and losses) and his employer wouldn't include any compensation on his W2. He may still have to include the $2,000 on Form 6251 Alternative Minimum Tax. However, if these shares were non-qualified stock options, the employer would have to include the $2,000 in Box 1(wages) of the taxpayers W2 and he'd be taxed on it as ordinary income. In both cases, the taxpayer would again be liable for capital gains tax when he sold the shares. The amount of capital gains would depend on the amount of the gain and when the shares were sold.

In a divorce, it's important to consider the tax consequences of any transfers of stock options because the favorable tax treatment of qualifying stock options may be jeopardized. IRC 422 (b)(5) provides that an ISO cannot be transferred to or exercised by any person other that the employee to whom the option is granted, except upon death. This means that if, for example, ISO's are transferred to a spouse as part of a divorce settlement, the ISO's lose their qualified status and are treated as non-qualified stock options. It should be noted that the situation is different if, instead of transferring qualifying stock options, the employee transfers the stock that is acquired upon the exercise of the qualifying stock options. IRC 424 (c) (4) provides that a section 1041(a) transfer of such stock incident to a divorce is not a disqualifying disposition. The non-employee in only then liable for capital gains tax when the stock is sold.

The treatment of vested non-qualified stock options in a divorce is discussed in IRS Revenue rulings 2002-22 and 2004-60. These rulings first clarify that rule that an employee spouse is not required to include an amount in gross income when making a transfer of either qualified or non-qualified stock options to the non-employee spouse as part of the divorce settlement. It's only when the non-employee spouse exercises those options, that he or she will be required to pay income tax on any "compensation element". The rulings also make it clear that the same principles apply to transfers of any deferred compensation. A non-employee spouse must include distributions from a deferred compensation plan as income when received.

Going back to the above example, the non-employee spouse would be only taxable on $2,000 when they exercised the options. The non-employee spouse would have an additional taxable gain or loss when they subsequently sold the shares. There is, however, one important exception. Where non-qualified stock options are transferred pursuant to a divorce and the divorce order or agreement specifically provides that the employee spouse must report the gross income attributable, the IRS will treat the gross income as that of the transferor upon the exercise of the option.