IRS Revenue Ruling
2002-22

Code Secs. 61, 83, 1041

<<FULL TEXT>>

26 CFR 1.61-1: Gross income.
(Also: Section 83, 1041; 1.83-7, 1.1041-1T.)

Gross income; transfers of property incident to divorce. A taxpayer who
transfers interests in nonstatutory stock options and nonqualified
deferred compensation to the taxpayer's former spouse incident to divorce
is not required to include an amount in gross income upon the transfer.
Rather, the former spouse is required to include an amount in gross income
when the former spouse exercises the stock options or when the deferred
compensation is paid or made available to the former spouse.


REV. RUL. 2002-22

ISSUES

(1) Is a taxpayer who transfers interests in nonstatutory stock options
and nonqualified deferred compensation to the taxpayer's former spouse
incident to divorce required to include an amount in gross income upon the
transfer?

(2) Is the taxpayer or the former spouse required to include an amount
in gross income when the former spouse exercises the stock options or when
the deferred compensation is paid or made available to the former spouse?


FACTS

Prior to their divorce in 2002, A and B were married individuals
residing in State X who used the cash receipts and disbursements method of
accounting.

A is employed by Corporation Y. Prior to the divorce, Y issued
nonstatutory stock options to A as part of A's compensation. The
nonstatutory stock options did not have a readily ascertainable fair
market value within the meaning of section 1.83-7(b) of the Income Tax
Regulations at the time granted to A, and thus no amount was included in
A's gross income with respect to those options at the time of grant.

Y maintains two unfunded, nonqualified deferred compensation plans
under which A earns the right to receive post-employment payments from Y.
Under one of the deferred compensation plans, participants are entitled to
payments based on the balance of individual accounts of the kind described
in section 31.3121(v)(2)-1(c)(1)(ii) of the Employment Tax Regulations. By
the time of A's divorce from B, A had an account balance of $100x under
that plan. Under the second deferred compensation plan maintained by Y,
participants are entitled to receive single sum or periodic payments
following separation from service based on a formula reflecting their
years of service and compensation history with Y. By the time of A's
divorce from B, A had accrued the right to receive a single sum payment of
$50x under that plan following A's termination of employment with Y. A's
contractual rights to the deferred compensation benefits under these plans
were not contingent on A's performance of future services for Y.

Under the law of State X, stock options and unfunded deferred
compensation rights earned by a spouse during the period of marriage are
marital property subject to equitable division between the spouses in the
event of divorce. Pursuant to the property settlement incorporated into
their judgment of divorce, A transferred to B (1) one-third of the
nonstatutory stock options issued to A by Y, (2) the right to receive
deferred compensation payments from Y under the account balance plan based
on $75x of A's account balance under that plan at the time of the divorce,
and (3) the right to receive a single sum payment of $25x from Y under the
other deferred compensation plan upon A's termination of employment with
Y.

In 2006, B exercises all of the stock options and receives Y stock with
a fair market value in excess of the exercise price of the options. In
2011, A terminates employment with Y, and B receives a single sum payment
of $150x from the account balance plan and a single sum payment of $25x
from the other deferred compensation plan.


LAW AND ANALYSIS

SECTION 1041 AND THE ASSIGNMENT OF INCOME DOCTRINE

Section 1041(a) provides that no gain or loss is recognized on a
transfer of property from an individual to or for the benefit of a spouse
or, if the transfer is incident to divorce, a former spouse. Section
1041(b) provides that the property transferred is generally treated as
acquired by the transferee by gift and that the transferee's basis in the
property is the adjusted basis of the transferor.

Section 1041 was enacted in part to reverse the effect of the Supreme
Court's decision in United States v. Davis, 370 U.S. 65 (1962), which held
that the transfer of appreciated property to a spouse (or former spouse)
in exchange for the release of marital claims was a taxable event
resulting in the recognition of gain or loss to the transferor. See H.R.
Rep. No. 432, 98th Cong., 2d Sess. 1491 (1984). Section 1041 was intended
to "make the tax laws as unintrusive as possible with respect to relations
between spouses" and to provide "uniform Federal income tax consequences"
for transfers of property between spouses incident to divorce,
"notwithstanding that the property may be subject to differing state
property laws." Id. at 1492. Congress thus intended that section 1041
would eliminate differing federal tax treatment of property transfers and
divisions between divorcing taxpayers who reside in community property
states and those who reside in non-community property states.

The term "property" is not defined in section 1041. However, there is
no indication that Congress intended "property" to have a restricted
meaning under section 1041. To the contrary, Congress indicated that
section 1041 should apply broadly to transfers of many types of property,
including those that involve a right to receive ordinary income that has
accrued in an economic sense (such as interests in trusts and annuities).
Id. at 1491. Accordingly, stock options and unfunded deferred compensation
rights may constitute property within the meaning of section 1041. See
also Balding v. Commissioner, 98 T.C. 368 (1992) (marital rights to
military pension treated as property under section 1041).

Although section 1041 provides nonrecognition treatment to transfers
between spouses and former spouses, whether income derived from the
transferred property and paid to the transferee is taxed to the transferor
or the transferee depends upon the applicability of the assignment of
income doctrine. As first enunciated in Lucas v. Earl, 281 U.S. 111
(1930), the assignment of income doctrine provides that income is
ordinarily taxed to the person who earns it, and that the incidence of
income taxation may not be shifted by anticipatory assignments. However,
the courts and the Service have long recognized that the assignment of
income doctrine does not apply to every transfer of future income rights.
See, e.g., Rubin v. Commissioner, 429 F.2d 650 (2d Cir. 1970); Hempt
Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), cert. denied,
419 U.S. 826 (1974); Rev. Rul. 80-198 (1980-2 C.B. 113). Moreover, in
cases arising before the effective date of section 1041, a number of
courts had concluded that transfers of income rights between divorcing
spouses were not voluntary assignments within the scope of the assignment
of income doctrine. See Meisner v. United States, 133 F.3d 654 (8th Cir.
1998); Kenfield v. United States, 783 F.2d 966 (10th Cir. 1986); Schulze
v. Commissioner, T.C.M. 1983-263; Cofield v. Koehler, 207 F. Supp. 73 (D.
Kan. 1962).

In Hempt Bros., Inc. v. United States, the court concluded that the
assignment of income doctrine should not apply to the transfer of accounts
receivable by a cash basis partnership to a controlled corporation in a
transaction described in section 351(a), where there was a valid business
purpose for the transfer of the accounts receivable together with the
other assets and liabilities of the partnership to effect the
incorporation of an ongoing business. The court reasoned that application
of the assignment of income doctrine to tax the transferor in such
circumstances would frustrate the Congressional intent reflected in the
nonrecognition rule of section 351(a). Accordingly, the transferee, not
the transferor, was taxed as it received payment of the receivables. In
Rev. Rul. 80-198, the Service adopted the court's position in Hempt Bros.,
but ruled that the assignment of income doctrine would nonetheless apply
to transfers to controlled corporations where there was a tax avoidance
purpose.

Similarly, applying the assignment of income doctrine in divorce cases
to tax the transferor spouse when the transferee spouse ultimately
receives income from the property transferred in the divorce would
frustrate the purpose of section 1041 with respect to divorcing spouses.
That tax treatment would impose substantial burdens on marital property
settlements involving such property and thwart the purpose of allowing
divorcing spouses to sever their ownership interests in property with as
little tax intrusion as possible. Further, there is no indication that
Congress intended section 1041 to alter the principle established in the
pre-1041 cases such as Meisner that the application of the assignment of
income doctrine generally is inappropriate in the context of divorce.


SPECIFIC PROVISIONS GOVERNING NONSTATUTORY STOCK OPTIONS

Section 83(a) provides, in general, that if property is transferred to
any person in connection with the performance of services, the excess of
the fair market value of the property over the amount, if any, paid for
the property is included in the gross income of the person performing the
services in the first taxable year in which the rights of the person
having the beneficial interest in such property are transferable or are
not subject to a substantial risk of forfeiture, whichever is applicable.
In the case of nonstatutory stock options that do not have a readily
ascertainable fair market value at the date of grant, section 83 does not
apply to the grant of the option, but applies to property received upon
exercise of the option or to any money or other property received in an
arm's length disposition of the option. See section 83(e) and section
1.83-7(a).

Although a transfer of nonstatutory stock options in connection with a
marital property settlement may, as a factual matter, involve an arm's
length exchange for money, property, or other valuable consideration, it
would contravene the gift treatment prescribed by section 1041 to include
the value of the consideration in the transferor's income under section
83. Accordingly, the transfer of nonstatutory stock options between
divorcing spouses is entitled to nonrecognition treatment under section
1041.

When the transferee exercises the stock options, the transferee rather
than the transferor realizes gross income to the extent determined by
section 83(a). Since section 1041 was intended to eliminate differing
federal tax treatment for property transferred or divided between spouses
in connection with divorce in community property states and in
non-community property states, section 83(a) is properly applied in the
same manner in both contexts. Where compensation rights are earned through
the performance of services by one spouse in a community property state,
the portion of the compensation treated as owned by the nonearning spouse
under state law is treated as the gross income of the non-earning spouse
for federal income tax purposes. Poe v. Seaborn, 282 U.S. 101 (1930).
Thus, even though the non-employee spouse in a non-community property
state may not have state law ownership rights in nonstatutory stock
options at the time of grant, section 1041 requires that the ownership
rights acquired by such a spouse in a marital property settlement be given
the same federal income tax effect as the ownership rights of a
non-employee spouse in a community property state. Accordingly, upon the
subsequent exercise of the nonstatutory stock options, the property
transferred to the non-employee spouse has the same character and is
includible in the gross income of the non-employee spouse under section
83(a) to the same extent as if the non-employee spouse were the person who
actually performed the services.

The same conclusion would apply in a case in which an employee
transfers a statutory stock option (such as those governed by section 422
or 423(b)) contrary to its terms to a spouse or former spouse in
connection with divorce. The option would be disqualified as a statutory
stock option, see sections 422(b)(5) and 423(b)(9), and treated in the
same manner as other nonstatutory stock options. Section 424(c)(4), which
provides that a section 1041(a) transfer of stock acquired on the exercise
of a statutory stock option is not a disqualifying disposition, does not
apply to a transfer of the stock option. See H.R. Rep. No. 795, 100th
Cong., 2d Sess. 378 (1988) (noting that the purpose of the amendment made
to section 424(c) is to "clarif[y] that the transfer of stock acquired
pursuant to the exercise of an incentive stock option between spouses or
incident to divorce is tax free").


CONCLUSION

Under the present facts, the interests in nonstatutory stock options
and nonqualified deferred compensation that A transfers to B are property
within the meaning of section 1041. Section 1041 confers nonrecognition
treatment on any gain that A might otherwise realize when A transfers
these interests to B in 2002. Further, the assignment of income doctrine
does not apply to these transfers. Therefore, A is not required to include
in gross income any income resulting from B's exercise of the stock
options in 2006 or the payment of deferred compensation to B in 2011. When
B exercises the stock options in 2006, B must include in income an amount
determined under section 83(a) as if B were the person who performed the
services. In addition, B must include the amount realized from payments of
deferred compensation in income in the year such payments are paid or made
available to B. The same conclusions would apply if A and B resided in a
community property state and all or some of these income rights
constituted community property that was divided between A and B as part of
their divorce.

This ruling does not apply to transfers of property between spouses
other than in connection with divorce. This ruling also does not apply to
transfers of nonstatutory stock options, unfunded deferred compensation
rights, or other future income rights to the extent such options or rights
are unvested at the time of transfer or to the extent that the
transferor's rights to such income are subject to substantial
contingencies at the time of the transfer. See Kochansky v. Commissioner,
92 F.3d 957 (9th Cir. 1996). Transfers of certain types of property
incident to divorce, the tax consequences of which are governed by a
specific provision of the Code or regulations (for example, section 402,
408, 414, 424, or 453B) are not affected by this ruling.


HOLDINGS

(1) A taxpayer who transfers interests in nonstatutory stock options
and non-qualified deferred compensation to the taxpayer's former spouse
incident to divorce is not required to include an amount in gross income
upon the transfer.

(2) The former spouse, and not the taxpayer, is required to include an
amount in gross income when the former spouse exercises the stock options
or when the deferred compensation is paid or made available to the former
spouse.


PROSPECTIVE APPLICATION

The Service will apply section 7805(b) and assignment of income
principles to treat income as gross income of the transferor and not of
the transferee if--

(i) The income is attributable to an interest in nonstatutory stock
options, unfunded deferred compensation rights, or other similar
intangible property rights;

(ii) The options or rights were transferred from one party to a divorce
to the other party to the divorce;

(iii) The transfer was required by a provision of an agreement or court
order;

(iv) The provision was contained in the agreement or order before
November 9, 2002; and

(v)(a) The agreement or court order specifically provides that the
transferor must report gross income attributable to the transferred
interest, or

(b) It can be established to the satisfaction of the Service that the
transferor has reported the gross income for federal income tax purposes.


EFFECT ON OTHER DOCUMENTS

Rev. Rul. 87-112 (1987-2 C.B. 207) which deals with the treatment of
transfers of United States savings bonds between spouses or former
spouses, is clarified by eliminating references to assignment of income
principles. As so clarified, the ruling is reaffirmed respecting the
application of section 454 and the regulations thereunder to the transfer
and the determination of the transferee's basis.


FURTHER INFORMATION

For further information or questions regarding section 61 or 1041,
contact Edward Schwartz of the Office of Associate Chief Counsel (Income
Tax and Accounting) at (202) 622-4960. For further information or
questions regarding section 83, 402, 408, 414, 422, 423, 424, or 453B,
contact Erinn Madden of the Office of the Associate Chief Counsel (Tax
Exempt and Government Entities) at (202) 622-6030. These are not toll-free
calls.

<<END RULING>>

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