According to the general rule for transfers of assets between spouses or ex-spouses under a divorce property settlement, the transfers are treated as gifts between spouses for federal tax purposes. As such, the transfers are federal-income-tax-free and gift-tax-free. So when the transferee spouse subsequently sells the asset, he or she recognizes taxable gain or loss as if he or she had owned the asset from the outset.

Federal income tax consequences for divorce-related transfers of vested employer stock options. What happens with a divorce-related transfer of vested employer stock options from the employee spouse to the non-employee spouse pursuant to a divorce property settlement?

Read on for the answers. For instance, assume Spouse A the employee spouse owns vested nonqualified employer stock options NQSOs that she received as compensation from her employer. Because the NQSOs are not publicly traded, Spouse A was not taxed upon receiving the options. Assume that under applicable state law, the NQSOs are considered marital property.

Sometime later, Spouse B exercises the NQSOs. At that time, the fair market value FMV of the stock is above the option exercise price. The IRS says the transfer of vested NQSOs from Spouse A to Spouse B falls under the general tax-free transfer rule assuming the non-employee spouse is not a nonresident alien.

Therefore, the transfer has no immediate federal income tax consequences for either spouse. This profit is ordinary income as opposed to capital gain because Spouse B is treated as if he received the NQSOs as compensation from his employer. IRS Revenue Ruling Therefore, when an ISO is transferred to a non-employee spouse, it instantly ceases to be an ISO and instantly becomes an NQSO, and the federal income tax outcome is exactly the same as explained above.

These federal income tax rules are favorable to the employee spouse the person who gives up the options in divorce , because he or she faces no further tax consequences after the divorce-related transfer.

The non-employee spouse the person who receives the options in the divorce-related transfer bears all the federal income tax consequences. The IRS has also issued rules on the federal employment tax consequences of divorce-related transfers of vested employer stock options. By federal employment taxes, I mean Social Security tax, Medicare tax, federal unemployment tax FUTA , and federal income tax FIT withholding.

When the general tax-free transfer rule applies which will usually be the case , the transfer itself does not trigger any federal employment taxes. However, when the options are subsequently exercised by the non-employee spouse, federal employment taxes are triggered to the same extent as if the employee spouse had retained the options and exercised them.

QDRO Clause Uses in Non Qualified Stock Option Agreement

So the non-employee spouse may be hit with withholding for Social Security tax at a 6. However, the taxes are actually withheld from the non-employee spouse the person who exercises the option. This is fair and just, because the non-employee spouse is the one who reaps the economic benefit from exercising the option. Finally, federal income tax must also be withheld from the non-employee spouse. The non-employee spouse can then claim a credit for the withholding on his or her federal income tax return.

You own vested NQSOs received as compensation from your employer. In , you and your spouse are divorced. As part of the divorce property settlement, your ex receives half of your NQSOs.

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The transfer of the vested NQSOs from you the employee spouse to your ex the non-employee spouse has no immediate tax consequences for either party.

Federal income and employment taxes will be withheld from your ex. The exercise has no tax impact on you. You now understand the federal income and employment tax consequences for most divorce-related transfers of vested employer stock options. The rules actually make sense and are fair to the divorcing individuals.

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