rr-02-22.pdf

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Part I

Section 61.--Gross Income Defined

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

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 § 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 § 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

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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, 98
th
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 §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.

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The term “property” is not defined in § 1041. However, there is no indication that
Congress intended “property” to have a restricted meaning under § 1041. To the
contrary, Congress indicated that § 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 § 1041. See also Balding v. Commissioner,
98 T.C. 368 (1992) (marital rights to military pension treated as property under § 1041).

Although § 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 § 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 (8
th
Cir. 1998); Kenfield v. United States, 783 F.2d 966 (10
th
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 § 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 § 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 § 1041 with respect to

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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 § 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, § 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 § 83(e) and § 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 § 1041 to include the value of the consideration in the transferor’s income
under § 83. Accordingly, the transfer of nonstatutory stock options between divorcing
spouses is entitled to nonrecognition treatment under § 1041.

When the transferee exercises the stock options, the transferee rather than the
transferor realizes gross income to the extent determined by § 83(a). Since § 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, § 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 non-earning 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, § 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 § 83(a) to the same

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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 § 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 §§ 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 § 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, 100
th
Cong., 2d Sess. 378 (1988) (noting that the purpose of
the amendment made to § 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 §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 § 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 (9
th
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,
§ 402, 408, 414, 424, or 453B) are not affected by this ruling.

HOLDINGS

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(1) 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.

(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 § 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 § 454 and the regulations thereunder to the
transfer and the determination of the transferee’s basis.

FURTHER INFORMATION

For further information or questions regarding § 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 § 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.