Deferred Payment Arrangements in Divorce Settlements: What Spouses and Employers Need to Know

In the age of COVID-19-related lockdowns, divorce might seem like an appropriate remedy to many problems. If divorce is your chosen solution and you or your soon-to-be ex-spouse hold non-statutory stock options (NSOs) or nonqualified deferred compensation (NQDC), then read on — this article contains an explanation of the federal income tax consequences associated with the transfer of NSOs and NQDC incident to a divorce.

Non-Statutory Stock Options

The grant of a NSO is normally not a taxable event to the recipient-employee. Rather, the taxable event is normally deferred until the NSO is exercised. At that time, the difference between the value of the stock acquired and the exercise price paid is taxable income to the employee, and this amount is reported on a Form W-2 as wages paid to the employee.

If a NSO is transferred by the recipient-employee to his or her spouse or former spouse as part of a divorce agreement, there is no immediate tax consequence to either party. The employee is not required to recognize a taxable gain or loss as a result of the transfer, nor is he or she required to report the transfer as a gift on a gift tax return.  (While the transfer is treated as a gift for income tax purposes, and thus is not a taxable event for income tax purposes, it is not treated as a gift for gift tax purposes, and thus is not a taxable event for gift tax purposes either.)

But what happens when the NSO is exercised? Specifically, who pays taxes on the income that is generated? Well, according to Revenue Ruling 2002-22, if the former spouse exercises the NSO, he or she will be subject to tax on the income. 

However, according to Revenue Ruling 2004-60, even though the income is taxable to the former spouse, it is still treated as wages subject to Social Security tax and Medicare tax (collectively referred to as “FICA” taxes) and income tax withholding to the same extent as if it were paid to the employee. Thus, the employee’s share of these taxes will be withheld by the employer, reducing the amount actually paid to the former spouse.  And while the former spouse will get credit for any federal and state income taxes withheld from the payment, the employee will get credit for the FICA taxes withheld from the payment.

The employer should file and provide the former spouse with a Form 1099-MISC that reports the amount of income associated with the NSO exercise and the amount of income tax withheld from that income. The employer should also report the amount of FICA taxes withheld from the income on the employee’s Form W-2. In order to make sure the employer properly reports the income and withholding, the employee should inform the employer of the transfer of the NSO pursuant to the divorce agreement.

Nonqualified Deferred Compensation

The income tax consequences associated with the transfer of NQDC incident to a divorce are essentially identical to the income tax consequences associated with the transfer of a NSO incident to divorce. The transfer of the NQDC incident to a divorce is not a taxable event, and the former spouse will include in income distributions received from a NQDC plan in the year those distributions are received.

To the extent the amount deferred under the NQDC plan has been previously subject to FICA taxes (which is often the case), distributions from the plan to the former spouse will not again be treated as wages subject to FICA taxes (and, thus, FICA taxes will not be withheld from the distributions to the former spouse). However, to the extent the amount deferred under the NQDC plan has not been previously subject to FICA taxes, distributions from the plan to the former spouse will be treated as wages subject to FICA taxes and the employer will withhold FICA taxes from those distributions. 

Federal and, if applicable, state income taxes will also be withheld by the employer from the distributions to the former spouse, and the former spouse will receive credit for the amount of income tax withheld. Any FICA taxes withheld from the distributions will, however, be credited to the employee.

The employer should file and provide the former spouse with a Form 1099-MISC that reports the amount of income associated with the distributions made from the NQDC plan to the former spouse during the year and the amount of federal and state income tax withheld from those distributions. The employer should also report the amount of FICA taxes withheld from the distributions, if any, on the employee’s Form W-2 for the subject year. In order to make sure the employer properly reports the income and withholding, the employee should inform the employer of the transfer of the NQDC pursuant to the divorce agreement.

Conclusion

Deferred compensation in the form of NSOs and NQDC is commonly used by employers to reward employees and, thus, these assets will often need to be divided when spouses get a divorce. In order to determine the economic consequences associated with such a division, both spouses need to understand the federal income tax consequences and the reporting requirements associated with the transfer of NSOs and NQDC incident to a divorce.

For information about these and other tax aspects of divorce, contact us. We are here to help.

Authored by Deanna Warren, CPA.

© 2021