Post Divorce: What are the Taxation Non-qualified Stock Options?
In many industries non-qualified stock options have been issued to key employees. If these options have been earned by a spouse during the period of marriage they are considered marital property for divorce purposes. If according to the divorce decree the non-qualified stock options are divided between the spouses there are tax ramifications to both spouses when the options are exercised.
Take for example the situation in which the ex-wife works for a technology company and during the marriage was awarded non-qualified stock options with an exercise price of $100,000. The divorce has been finalized and as a part of the property settlement, in 2012 the husband (non-employee spouse) received a right to 50% of the stock options.
The IRS has ruled that when a taxpayer transfers non-qualified stock options incident to a divorce there is no taxable income upon the transfer to the former spouse. The ruling also states that the former spouse upon exercise of the options has to report in gross income the difference between the exercise price and the fair market value of the stock. The question now is how the exercise of the options should be reported by the non-employee spouse.
If in 2016 the non-employee spouse exercises his 50% of the options with an exercise price of $50,000 and a fair market of $1,250,000.
Revenue Ruling 2002-22 holds that the property transferred to the non-employee spouse has the same character and is includible in the income of the non-employee spouse under section 83(a) to the same extent as the property would have been includible in the income of the employee spouse. For FICA tax purposes the income is reportable by the employee spouse as FICA and Medicare wages on Form W-2 and requires the employer to withhold and remit the FICA and Medicare taxes due.
The income recognized by the non-employee spouse upon exercise is subject to withholding taxes even though the non-employee spouse is not considered an employee. The employer is required to withhold income tax at a rate of 25% on the first million dollars of income and anything over one million dollars of income at the federal highest income tax rate. In this example the withholding would be $250,000 on the first million of income and $79,200 on the remaining income of $200,000. The withholding taxes are withheld from the non-employee spouse’s income at the time of the exercise of the stock options.
The employer of the ex-wife is required to report the income of $1,200,000 of the non-employee spouse on Form 1099-MISC in box 3 and the income tax withheld of $329,200 in box 4 and issue the Form 1099 at year end. The employer is also required to make timely deposits of the withheld taxes. Penalties could be substantial if not timely.
Tax guidance in this area is available from Withum. There are too many pitfalls for all parties involved not to have proper advice.
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