rr-04-60.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 3121.BDefinitions
(Also: 3306, 3401)

26 CFR 31.3121(a)-1: Wages
(Also: 31.3306(b)-1, 31.3401(a)-1)

Rev. Rul. 2004-60

ISSUES:

(1) What is the effect upon taxation under the Federal Insurance Contributions Act
(FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax
at Source on Wages (income tax withholding) of a transfer of interests in a nonstatutory
stock option and in nonqualified deferred compensation to a former spouse incident to a
divorce?

(2) What is the appropriate reporting of income and/or wages recognized with respect to
nonstatutory stock options and nonqualified deferred compensation transferred to a
former spouse incident to a divorce?

FACTS

The facts are the same as in Rev. Rul. 2002B22, 2002-1 C.B. 849, and are
restated here for convenience.

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 ' 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, 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 ' 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

2
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 the 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 the 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 transferred 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

Rev. Rul. 2002-22 concludes that 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. The ruling also concludes that the former spouse, rather than 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.

FICA Wages

Sections 3101 and 3111 impose FICA taxes on Awages@ as that term is defined in
' 3121(a). FICA taxes consist of the Old-Age, Survivors and Disability Insurance tax
(social security tax) and the Hospital Insurance tax (Medicare tax). These taxes are
imposed on both the employer and employee. Sections 3101(a) and 3101(b) impose
the employee portions of the social security tax and the Medicare tax, respectively.
Sections 3111(a) and (b) impose the employer portions of the social security tax and the
Medicare tax, respectively.

Section 3102(a) provides that the employee portion of FICA taxes must be
collected by the employer of the taxpayer by deducting the amount of the tax from

3
wages as and when paid. Section 31.3102(a)-1(a) provides that the employer is
required to collect the tax, notwithstanding that wages are paid in something other than
money. Section 3102(b) provides that every employer required to deduct the FICA
employee tax is liable for the payment of that tax, and is indemnified against the claims
and demands of any person for the amount of any such payment made by such
employer.

The term Awages@ is defined in ' 3121(a) for FICA purposes as all remuneration
for employment, including the cash value of all remuneration (including benefits) paid in
any medium other than cash, with certain specific exceptions. Section 3121(b) defines
Aemployment@ as any service, of whatever nature, performed by an employee for the
person employing him, with certain specific exceptions.

Section 31.3121(a)-1(e) provides that in general the medium in which the
remuneration is paid is immaterial. It may be paid in cash or other than in cash.
Remuneration paid in any medium other than cash is computed on the basis of the fair
market value of such items at the time of payment.

Under ' 3121(v)(2), amounts deferred under a nonqualified deferred
compensation plan generally are to be taken into account when the services are
performed or, if later, when there is no substantial risk of forfeiture. To the extent
benefit payments under a nonqualified deferred compensation plan are attributable to
amounts deferred under the plan that have been taken into account for FICA tax
purposes, the benefit payments are not treated as FICA wages. To the extent benefit
payments are attributable to an amount deferred that has not been taken into account
for FICA tax purposes, then the benefit payments are treated as FICA wages. See

' 31.3121(v)(2)-1(d)(1)(ii).

In the Social Security Amendments of 1983, Public Law No. 98-21, 1983-2 C.B.
309, Congress added language to ' 3121(a) providing that nothing in the income tax
withholding regulations that provides an exclusion from wages for income tax
withholding purposes is to be construed to require a similar exclusion from wages for
FICA purposes. The legislative history in connection with this provision states that
A[s]ince the [social] security system has objectives which are significantly different from
the objective underlying the income tax withholding rules, the committee believes that
amounts exempt from income tax withholding should not be exempt from FICA tax
unless Congress provides an explicit tax exclusion.@ S. Rep. No. 23, 98th Cong., 1st
Sess. at 42 (1983).

The fact that payments are includible in the gross income of an individual other
than an employee does not remove the payments from FICA wages. See
Rev. Rul. 71-
116, 1971-1 C.B. 277, holding that payments of wages to an employee in a community
property state are FICA wages although one-half of the wages is includible in the gross
income of the nonemployee spouse. See
also Rev. Rul. 86-109, 1986-2 C.B. 196,
which holds that payments of remuneration for employment made after the death of an

4
employee and in the calendar year of the death are wages for FICA tax purposes,
although the amounts are includible in the gross income of the recipient and not the
employee.

Rev. Rul. 2002-22 holds that, upon the exercise of a nonstatutory stock option
obtained by a nonemployee spouse pursuant to divorce, the property transferred to the
nonemployee spouse by the employer has the same character and is includible in the
income of the nonemployee spouse under ' 83(a) to the same extent as the property
would have been includible in the income of the employee spouse had the option been
retained and exercised by the employee spouse. Rev. Rul. 2002-22 further holds that
nonqualified deferred compensation, the right to which is obtained by a nonemployee
spouse pursuant to divorce, paid or made available to the nonemployee spouse has the
same character and is includible in the income of the nonemployee spouse to the same
extent as the compensation would have been includible in the income of the employee
spouse had the compensation been paid or made available to the employee spouse.
Nothing in ' 1041, pertaining to transfers of property between spouses or incident to
divorce, excludes payments to a person other than an employee from wages for
purposes of FICA. In the absence of a specific provision that would exclude these
payments from FICA wages, the compensation realized on the exercise of the stock
options by the nonemployee spouse and the deferred compensation paid or made
available to the nonemployee spouse retain their character as wages of the employee
spouse for purposes of FICA. Thus, the payment of such remuneration is subject to
FICA to the same extent as if paid to the employee spouse.

At the same time that the Service published Rev. Rul. 2002-22, it also published
Notice 2002-31, 2002-1 C.B. 908, which included a proposed revenue ruling addressing
the application of FICA, FUTA, and income tax withholding, and reporting of income and
wages, with respect to nonstatutory stock options and nonqualified deferred
compensation transferred to a former spouse incident to a divorce (as described in the
Facts above), and requested comments on the proposal. In general, the proposed
ruling included the conclusion that the exercise of the options and the nonqualified
deferred compensation remain subject to FICA and FUTA taxes to the same extent as if
they had been retained by the employee, and that the income recognized by the
nonemployee spouse with respect to the exercise of the options and distributions of
nonqualified deferred compensation are wages for purposes of income tax withholding.
The proposed ruling also concluded that any employee FICA taxes and income tax
withholding applicable to the exercise of the options or distribution of the nonqualified
deferred compensation would be deducted from the payments to the nonemployee
spouse.

Accordingly, the nonqualified deferred compensation paid or made available to
the former spouse remains subject to the rules of ' 3121, including ' 3121(v)(2) and the
regulations thereunder, to determine when and whether FICA tax is applicable. Thus, to
the extent the amount deferred has been previously taken into account for FICA
purposes, the distribution to the former spouse of the proceeds of the account balance

5
plan would not be treated as wages for FICA tax purposes. However, to the extent the
amount deferred has not been previously taken into account for FICA tax purposes, the
distribution to the former spouse of the proceeds of the account balance plan would be
wages of the employee for FICA tax purposes. Similarly, under ' 3121 and the
regulations thereunder, a former spouse=s exercise of a nonstatutory stock option
results in FICA wages of the employee to the extent that the fair market value of the
stock received pursuant to the exercise of the option exceeds the option exercise price.

To the extent the distributed payments are FICA wages, the employee FICA tax
is deducted from the payment made to the transferee. The amount includible in the
gross income of the transferee is not reduced by any FICA withholding from the
payments (including transfers of property) to the transferee. See
Rev. Rul. 86-109 and
Rev. Rul. 71-116.

Because A
was the service performer and the remuneration relates to A=s service
in employment with Y, the wages, although paid to B, are FICA wages of A. See Rev.
Rul. 71-116. Thus, because the payments are wages for FICA tax purposes, the
payments are reportable by Y as social security wages and Medicare wages on a Form
W-2, Wage and Tax Statement, issued to A, and the social security tax withheld and
Medicare tax withheld are also reportable on the Form W-2 to A
. Y may take into
account other wages previously paid to A in that calendar year in determining whether
these distributions are excepted from social security wages under ' 3121(a)(1), the
maximum social security wage base exception. The employee FICA tax for these
wages should be deducted from the payment of these wages. Finally, these payments
should not be included in Box 1, Wages, tips, other compensation, nor should any
amount be reflected in Box 2, Federal income tax withheld, of the Form W-2 issued to A

with respect to these payments.

FUTA

The FUTA taxation provisions applicable with respect to nonstatutory stock
options and nonqualified deferred compensation plans are similar to the FICA
provisions, except that only the employer pays the tax imposed under FUTA. See
''
3301, 3306(b), and 3306(r)(2) and the regulations thereunder. Because of the similar
statutory provisions, FUTA taxation applies at the same time and in the same manner
as FICA. To the extent wage taxation applies, the wages are FUTA wages of the
employee A
, subject to the maximum wage base contained in ' 3306(b)(1). As with
FICA, wages previously paid to the employee during the calendar year may be taken
into account in determining whether these amounts qualify for the FUTA maximum
wage base exception.

Income Tax Withholding

Section 3402(a), relating to income tax withholding, generally requires every
employer making a payment of wages to deduct and withhold upon those wages a tax

6
determined in accordance with prescribed tables or computational procedures.

Section 3401(a) provides that Awages@ for income tax withholding purposes
means all remuneration for services performed by an employee for his employer,
including the cash value of all remuneration (including benefits) paid in any medium
other than cash, with certain exceptions not pertinent to this ruling.

Under ' 31.3402(a)-1(c), an employer is required to deduct and withhold the tax
notwithstanding that the wages are paid in something other than money (for example,
wages paid in stock or bonds) and to pay over the tax in money. If the wages are paid
in property other than money, the employer should make necessary arrangements to
insure that the amount of the tax required to be withheld is available for payment in
money.

Section 31 provides that the amount withheld from wages as income tax
withholding will be allowed to the Arecipient of the income@ as a credit against the
income taxes imposed by Subtitle A. Section 1.31-1(a) of the Income Tax Regulations
provides that the Arecipient of the income@ for purposes of the ' 31 credit is the
individual who is subject to income taxes upon the wages from which the tax was
withheld. For example, if an employee spouse and nonemployee spouse are domiciled
in a community property state and file separate income tax returns, each reporting for
income tax purposes one-half of the wages received by the employee spouse, each
spouse is entitled to one-half of the credit allowable for the tax withheld at the source
with respect to the wages.

Because the compensatory interests transferred under '1041 to the
nonemployee spouse pursuant to the divorce remain taxable for employment tax
purposes to the same extent as if retained by the employee spouse, the income
recognized by the nonemployee spouse with respect to the exercise of the nonstatutory
stock options and the distributions from the nonqualified deferred compensation plans
are remuneration for employment and wages for purposes of income tax withholding
under ' 3402. Pursuant to '1.31-1(a), because the income recognized with respect to
this compensation is includible in the gross income of the nonemployee spouse, the
nonemployee spouse is entitled to the credit for the income tax withheld with respect to
these wage payments.

Employers are not required to collect Form W-4, Employee=s Withholding
Allowance Certificate, from the nonemployee spouse, and should not base withholding
on a Form W-4 submitted by the nonemployee spouse. Employers may treat the
compensation includible in the income of the nonemployee spouse as supplemental
wages and apply the flat rate withholding method on supplemental wages in withholding
income tax on these wages. The flat rate for withholding on supplemental wages is
currently 25 percent. See
§ 101(c)(11) of the Economic Growth and Tax Relief
Reconciliation Act of 2001 (Pub. L. No. 107-16), which provides that the flat rate for
withholding on supplemental wages is the third lowest rate of tax applicable under § 1(c)

7
of the Code, and §§ 1(c), 1(i)(1)(A)(i), and 1(i)(2) of the Code, which provide that the
third lowest rate of tax applicable under § 1(c) is 25 percent.

Reporting of payments

Section 6051 requires payors of remuneration to an employee to report those
payments on Form W-2, Wage and Tax Statement. Because the former spouse is not
an employee, the reporting requirements of ' 6051 do not apply.

Section 6041(a) and the accompanying regulations generally require that all
persons engaged in a trade or business who make a payment to a third party during the
course of such business must file an information return with the IRS, reporting all
payments totaling $600 or more in a taxable year, of rent, salaries, wages, premiums,
annuities, compensations, remunerations, emoluments, or other fixed or determinable
gains, profits and income. In this case, pursuant to ' 6041(a), Y
must file an information
return reporting both the income B
realized from B=s exercise of the nonstatutory stock
options and the payments made to B from the deferred compensation plans.

Under ' 31.6051-1(a)(1), the wages of an employee that are subject to social
security and Medicare taxes are included in the appropriate boxes on the Form W-2
issued to the employee. See
also Rev. Rul. 71-116.

Because there is no provision for the issuance of Form W-2 in the name of a
nonemployee spouse, the income realized upon the exercise of the nonstatutory stock
options would be reportable to the nonemployee spouse by Y
on Form 1099-MISC,
Miscellaneous Income, issued to the nonemployee spouse, in Box 3, Other income, with
the income tax withheld reported in Box 4, Federal income tax withheld. The payments
to the nonemployee spouse B from the nonqualified deferred compensation plans and
the withholding thereon would also be reportable by Y
on a Form 1099-MISC in Box 3,
with the income tax withheld reported in Box 4.

Social security wages, social security tax withheld, Medicare wages, and
Medicare taxes withheld, if applicable, are reported on the employee spouse=s Form
W-2 as described above.

Employers would report the income tax withholding on wages paid to the
nonemployee spouse on Form 945, Annual Return of Withheld Federal Income Tax.
The social security and Medicare tax paid with respect to these wages of the employee
spouse would be reported on Form 941, Employer=s Quarterly Federal Tax Return.
FUTA tax with respect to wages of the employee spouse would be reported on Form
940, Employer=s Annual Federal Unemployment (FUTA) Tax Return.

HOLDINGS

(1) The transfer of interests in nonstatutory stock options and in nonqualified

8
deferred compensation from the employee spouse to the nonemployee spouse incident
to a divorce does not result in a payment of wages for FICA and FUTA tax purposes.

The nonstatutory stock options are subject to FICA and FUTA taxes at the time
of exercise by the nonemployee spouse to the same extent as if the options had been
retained by the employee spouse and exercised by the employee spouse. The
nonqualified deferred compensation also remains subject to FICA and FUTA taxes to
the same extent as if the rights to the compensation had been retained by the employee
spouse. To the extent FICA and FUTA taxation apply, the wages are the wages of the
employee spouse. The employee portion of the FICA taxes is deducted from the wages
as and when the wages are taken into account for FICA tax purposes. The employee
portion of the FICA taxes is deducted from the payment to the nonemployee spouse.

The income recognized by the nonemployee spouse with respect to the exercise
of the nonstatutory stock options is subject to withholding under ' 3402. The amounts
distributed to the nonemployee spouse from the nonqualified deferred compensation
plans are also subject to withholding under ' 3402. The amounts to be withheld for
income tax withholding are deducted from the payments to the nonemployee spouse.
The supplemental wage flat rate may be used to determine the amount of income tax
withholding. Pursuant to ' 31, the nonemployee spouse is entitled to the credit
allowable for the income tax withheld at the source on these wages.

(2) The social security wages, Medicare wages, social security taxes withheld,
and Medicare taxes withheld, if applicable, are reportable on a Form W-2 with the
name, address, and social security number of the employee spouse. However, no
amount is includible in Box 1 and Box 2 of the employee=s Form W-2 with respect to
these payments. The income with respect to the exercise of the nonstatutory stock
options by the nonemployee spouse and the distributions from the nonqualified deferred
compensation plans to the nonemployee spouse are reportable in Box 3 as other
income on a Form 1099-MISC with the name, address, and social security number of
the nonemployee spouse. Income tax withholding with respect to these payments of
wages is included in Box 4, Federal income tax withheld.

Income tax withholding on payments to the nonemployee spouse is included on a
Form 945 filed by Y
. The social security tax and Medicare tax are reported on Y=s Form
941, and the FUTA tax is reported on Y
=s Form 940.

EFFECT ON OTHER PUBLISHED ITEMS

Notice 2002-31, 2002-1 C.B. 908, included a proposed revenue ruling addressing
the application of FICA, FUTA, and income tax withholding, and reporting of income
and/or wages with respect to nonstatutory stock options and nonqualified deferred
compensation transferred to a former spouse incident to a divorce, and requested
comments on the proposal. After consideration of the comments that were received,
the proposed ruling is adopted as revised by this revenue ruling.

9

PROSPECTIVE APPLICATION

This revenue ruling is effective January 1, 2005. For periods before the effective
date, employers may rely on a reasonable, good faith interpretation including the
interpretations in the proposed revenue ruling in Notice 2002-31 and this revenue ruling.
However, with respect to compensation transferred to a spouse incident to divorce,
failure to treat nonstatutory stock option compensation, or amounts deferred under a
nonqualified deferred compensation plan, as subject to FICA will not be considered a
reasonable, good faith interpretation.

DRAFTING INFORMATION

The principal author of this revenue ruling is A. G. Kelley of the Office of the
Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For
further information regarding this revenue ruling, contact Mr. Kelley at (202) 622-6040
(not a toll-free call).