Divorce Assignment of Stock Options is Taxable Income, not Capital Gains

stock options

Divorce Assignment of Stock Options is Taxable Income, not Capital Gains

When stock options are assigned to a former spouse as part of a divorce settlement, the transferee who receives the options is responsible for paying the tax when they are exercised.  See Frumkes & Vertz, Divorce Taxation 2.1.3; Rev.Rul.2002-22.  The taxable income resulting from the exercise of stock options is taxed as ordinary income, not capital gains.

In Davis v. Commissioner, 716 F.3d 560 (11th Cir. 2013), an executive and his wife negotiated a marital settlement in which she received half of his corporate stock (188.86 shares) while granting husband an option to repurchase them from her for $16 million.  When the shares were transferred to wife, she sold them back to the company and assigned her option to the company, so that husband could purchase her 188.86 shares from the company for $16 million.  Subsequently, husband and the company renegotiated the terms of the option, so that husband could exercise the option by using paying in shares instead of $16 million cash.  In a cashless exercise of the stock options, husband surrendered 57.0545 of the 188.86 shares (worth $16 million) to receive the remaining 131.8055 shares (worth more than $36 million).  The company deducted the expense as executive compensation for the performance of services under IRC § 83, but Husband did not report the income on his return, claiming that it was a divorce transfer under IRC § 1041.  The IRS flagged both husband and the corporation, and the Tax Court held that the stock option exercise created taxable income for the performance of services, which husband must report on his return.  When Husband appealed, the 11th Circuit Court of Appeals held that IRC § 1041 applied to wife’s grant to husband of an option to purchase her shares, but not to husband’s subsequent exercise of the option.  Furthermore, the modified option that husband exercised to purchase stock from the company was separate and distinct from the option that wife had previously granted to him.