IRS Holds That Options Are Immediately Taxable in Divorce

The IRS has taken the position that a spouse who transfers incentive or nonqualified stock options as part of a divorce is subject to immediate taxation on the fair market value of the options.

Because the market value of the options was a factor in allocating other assets between the two spouses, the IRS concluded that the husband received compensation equal to the fair market value of the options on the date of transfer.

When the ex-wife later exercised the options, it was not a taxable event, according to the IRS. Instead, as part of the transfer of options during the divorce, the wife received a new carryover basis, which would be used to calculate capital gains when the stock is actually sold.

Domestic relations orders are increasingly including provisions regarding stock options and other forms of executive compensation (such as top-hat plans and excess benefit plans), and the likely publicity surrounding this new opinion may accelerate this trend.

The ruling, which was released in Field Service Advice 2000050006 on February 4, 2000, apparently will not apply in community property states, where spouses are considered automatically to have shared ownership interest in assets such as options.