Tax Consequences of Distributing Equity Compensation Rights in Divorce

When a corporate executive gets divorced, a lot of their money might be in the form of stock options or restricted stock from their job. These are called equity compensation. Stock options are the right to buy a share of stock at a certain price, and they usually become available to use over a few years. When an executive uses their stock options, they have to pay income tax on the difference between the stock’s value and the price they bought it for. This tax can be really high, but if they sell the stock right away, they don’t have to pay any more tax on it. Restricted stock is when a company gives its employees free or discounted company stock, but the employee has to wait for a certain period of time before they actually own it. When the stock finally becomes theirs, they have to pay taxes on its value at that time. This can get tricky in a divorce if the stock is transferred before the employee officially owns it, but there are special rules to handle that situation. When people get divorced and divide their assets, there’s a rule called §1041 that says the person who receives property or money in the divorce doesn’t have to pay taxes on it right away. But there’s another rule called the assignment-of-income doctrine that says you can’t avoid paying taxes on money you earned by giving it to someone else. This caused a problem when it came to dividing stock options and other equity compensation in a divorce. In 2002, the IRS made a rule that cleared up some of the confusion, but there are still some unanswered questions about how this works. If someone gets divorced and transfers their vested options to their ex-spouse, it’s not considered a taxable event. The ex-spouse doesn’t have to pay taxes on the options until they actually use them. When they do use the options, they’ll have to pay taxes on the money they make. The ex-spouse will also have to pay employment taxes on the income they make from the options. The amount of tax they have to pay depends on how much they’ve earned from their job so far that year. People who receive compensatory stock options often choose to sell the stock right away. They may also use a “cashless exercise” where they borrow money from their employer to buy the stock and then pay back the loan with the money they make from selling the stock. When a nonemployee spouse does this, they are responsible for paying any taxes that come from it. However, it’s not entirely clear who is responsible for employment taxes. In cases where restricted stock or unvested stock options are involved, the rules are a bit different and may not be covered by the same tax rulings. The IRS rules on how to tax stock and other assets transferred during a divorce are not very clear. A recent ruling said that the person who receives the stock in a divorce has to pay taxes when it becomes fully theirs, but this goes against a previous court case. This ruling is not legally binding and doesn’t give any good reasons for its decision. If a divorce lawyer is unsure about how to handle transferring unvested assets like stock options or restricted stock, they can take a few different approaches. One option is to only transfer items that have already fully vested. They could also wait until unvested items vest before transferring them. If that’s not possible, they could ask the IRS for a ruling on how to handle the transfer. This might take some time and money, but it could provide clarity. If none of those options work, the divorcing spouses could agree that the spouse transferring the assets will pay the taxes on the transfer, but the other spouse will bear the economic burden. They could set up a trust to hold the assets until they vest, and then transfer them after paying the taxes. A constructive trust may not change the fact that unvested items have been transferred for tax purposes. But it has some good points, like being consistent with tax rules and protecting both spouses. The trust should include rules to make sure both spouses get what they expect. For example, the spouse who transferred the items should pay back the other spouse if the IRS taxes them twice. This will also stop the first spouse from trying to get extra money from the IRS. When a married couple gets divorced, the tax on stock options that the working spouse has will be paid by the non-working spouse. If the non-working spouse has a lower tax rate, it’s better for them to get the stock options. To figure out how much tax will be paid, both spouses can agree on a set tax rate or wait until the end of the year to see the actual tax rate. This can make things easier and avoid sharing tax documents. Overall, dealing with stock options in a divorce can be tricky, but it can also help lower the total tax bill for both spouses. When dealing with stock options and restricted stock in a divorce, it can be complicated to figure out who will have to pay taxes when the options are exercised or the stock vests. It’s best to avoid transferring these items if possible. If they have to be transferred, a special legal approach should be considered. In some cases, the tax rate can be as high as 39.6 percent, plus a Medicare tax. Restricted stock recipients may have the option to make an election for when the stock becomes taxable, but this is not often done. If the stock was granted for free, the employee has to include its full value in their income. If the stock was purchased, the employee includes the difference between the value and the purchase price in their income. If the stock never vests, there are no tax consequences. Private letter rulings are written statements from the IRS that give advice to taxpayers about how their specific tax situation will be treated. They are not for everyone, and you can’t rely on someone else’s private letter ruling. If you want to get one, you can find instructions on the IRS website. It’s important to understand your effective marginal tax rate, which can be tricky to figure out. There are hidden tax rate increases in the tax code that can affect your taxes. If you want more information, you can look at a study by Gerald T. Prante & Austin John about top marginal effective tax rates. Jeffrey D. Fisher is an attorney who specializes in marital and family law, and he has a lot of experience in complex cases involving high net worth individuals and corporate officers. Zachary R. Potter is a lawyer who went to Princeton University and Yale Law School. He represents big companies in courts all over the country and focuses on high net worth family law cases in Florida.

Source: https://www.floridabar.org/the-florida-bar-journal/tax-consequences-of-distributing-equity-compensation-rights-in-divorce/