Tax Aspects Of Dividing Stock Options In Divorce

Tax Aspects Of Dividing Stock Options In Divorce

Mr. Kochansky Meets Revenue Ruling 2002-22

Richard W. Kochansky was a medical malpractice attorney who divorced his wife, Carol, in 1985. As part of their property settlement Richard agreed that he would share the contingent fee in a medical malpractice suit he was pursuing.

Little did he know that his agreement to share his prospective earnings with his soon to be former spouse would, more than a decade later, become part of a landmark revenue ruling that would determine how Silicon Valley royalty would be taxed on millions (perhaps billions) of dollars in stock options.

The general rule of dividing property between spouses in a divorce is governed by IRC Section 1041, which states that such transfers are as tax free gifts between the spouses with mandatory non-recognition of gain or loss. There is a carryover of basis and holding period to the transferee spouse. If and when the transferee spouse disposes of the property, he or she will recognize gain or loss as if he or she had owned the property from inception, and there is no tax effect on the transferor spouse.

However, these matters are not always so easy to determine, particularly at the intersection for tax purposes of income and property, especially in light of the fact that the term “property” is not defined in Section 1041.

The enactment of Section 1041 provided legislative relief from 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 return for a release of marital claims, (for example Alimony), was a taxable event resulting in the recognition of gain or loss to the transferor. It was also the intent of Congress that Section 1041 would equalize the federal tax treatment of property transfers between divorcing taxpayers who reside in Community Property states, and those who reside in Common Law states.

It happened that Richard and Carol Kochansky lived in the Community Property state of Idaho at the time of their divorce. The fact that the forthcoming tax drama took place in a Community Property state turned out to be much less significant than one might suppose, but this is largely due to a technical oversight in Tax Court made by Mr. Kochansky acting as his own attorney. Evidently, he was a much better personal injury attorney than tax attorney.

While Richard and Carol were still married, Richard entered into an agreement with Mr. & Mrs. McNary which provided that Richard would represent them in a medical malpractice suit on a contingent fee basis.

After the suit commenced, but prior to its settlement, Richard and Carol divorced. As part of there divorce agreement, it was decided that if and when the contingent fee from the McNary’s lawsuit was paid, it would be split evenly between them.

The lawsuit settled, and the success fee was split as agreed. Richard paid the tax on his portion, and Carol paid the tax on hers.

Upon audit the IRS determined that Richard was responsible for all of the tax on all of the contingent fee. The IRS took the position that the portion of the fee that was allocated to Carol constituted an anticipatory assignment of income that should be included in Richard’s gross income from his law practice in the year received. Furthermore, IRS determined that Richard was liable for a negligence penalty. The case went to Tax Court (Kochansky v. Commissioner, 92F.3d 957(1996)) where the IRS prevailed on both the tax assessment to Richard (who represented himself) as well as the negligence penalty.

As would any self-respecting attorney he filed an appeal.

The Appeals Court (Ninth Circuit) ruled that the Tax Court did not error in holding that the entire contingent fee resulting from the malpractice suit was taxable to Richard Kochansky, despite the fact that half of it was paid to his former spouse.

The Court opined that Kochansky’s case was controlled by the definitive Supreme Court decision of Lucas v. Earl 1930, in which it was held that income is taxable to the person who earns it. Thus, laying the cornerstone for the Assignment of Income Doctrine. This ancient case is eerily similar to Kochansky, in that Earl was an attorney who had executed a contract whereby half of the salary and attorney’s fees earned by him were to become the property of his wife. The Court came down solidly on the side of the Government.

The essence of the Court’s reasoning boils down to one often quoted sentence from the decision: “The fruits of a person’s labor cannot be attributed to a different tree from that on which they grew”. In a gallant but futile attempt to differentiate his case from Lucas v. Earl, Kochansky argued that because his prospective fee in the malpractice case was “uncertain, doubtful, and contingent”, it was not subject to the Assignment of Income Doctrine. To put it another way, he could not assign income that he had not yet earned. He also cited two cases which appeared to support his argument (Jones v. C.I.R. 306 F.2nd 1962; and Cold Metal Process Co. v. C.I.R. 247 F.2nd 1957). However, the Court pointed out that both these cases were distinguishable from Lucas v. Earl, as well as Kochansky’s case, because they involved the transfer of underlying income producing assets, as opposed to merely a contractual right to receive future earned income. Jones was a case of a construction contractor who had earlier transferred all of his assets to a successor corporation, and then assigned it a disputed claim for past overages on a government contract.

The Circuit Court held that the claims award, when paid, was taxable not to Jones, but rather the transferee. One reason offered by the Court in Jones, was the “uncertain, doubtful, and contingent” nature of the assigned claim. However, the Court also pointed out that the assignment contract was conducted at arm’s length for a business purpose. This is a key distinction. Mr. Jones transferred his entire business to a corporation which then undertook to maintain and finance the litigation of a claim for past construction services disputed by a customer. Kochansky is distinct, because he transferred only his right to the income, which was by no means disputed.

The Appeals Court further opined that the Cold Metal case is even more easily distinguished from Kochansky. Here the Sixth Circuit held that Cold Metal did not have to pay tax on royalties from patents it had assigned, in part because the collection of the royalties was contingent on the outcome of a lawsuit. As in the Jones case, Cold Metal involved a transfer of income producing property where the donor relinquished to the recipient not merely the future income, but also complete ownership and control of the income producing property.

Kochansky did not own, and therefore could not transfer, his client’s malpractice claim that produced the contingent income which he assigned to his former spouse. He only transferred to Carol the right to receive future income that might never have materialized. This is not the same thing as a transfer of property. Further, the Court noted even though the fee was contingent upon the successful outcome of the malpractice litigation, this did not change the fact that when it was paid, it was without question compensation for Kochansky’s personal legal services. In short, the Kochansky case fell well within the parameters of Lucas v. Earl, and the contingent legal fee was 100 percent taxable to Richard Kochansky.

Richard and Carol Kochansky resided in the Community Property state of Idaho at the time Richard filed the medical malpractice claim on behalf of his clients. One might ask why Richard simply did not argue that under Community Property law, Carol had a 50% Community Property interest in the contingent fee at the time of the divorce, and that upon divorce, that interest became her sole and separate property, and she therefore was solely responsible for the tax on her portion of it.

In the author’s opinion, Mr. Kochansky’s argument that Community Property rules trumped Lucas v. Earl was not bad. However, the Appeals Court dismissed it out of hand because he did not raise it in Tax Court, and because the necessary facts to support the existence of a Community Property interest had not been developed. Thus, Mr. Kochansky learned the hard way that putting forth arguments in tax cases, like voting in Chicago, should be done “early and often”.

Time marched on for Richard Kochansky. From what can be gleaned from the record, he had identical Assignment of Income issues during subsequent years with the outcomes similar to his original case. After his divorce he remarried, and for at least one year his new spouse was granted Innocent Spouse Relief. One presumes that by the time that happened, the new spouse had become former spouse number two, or greater.

While Kochansky was doing battle with his former spouses and IRS, the granting of stock options and other forms of deferred compensation was becoming increasingly popular in large part due to the proliferation of start up companies that were the fruit of the and technology boom.

Broadly speaking stock options come in two varieties, Incentive Stock Options (ISOs) and Non-Statutory Stock Options.

If a Non-Statutory Stock Option has a readily ascertainable Fair Market Value (FMV) at the time it is granted, the taxpayer will recognize ordinary income equal to the stock’s FMV at the grant date, minus any amount paid for the option (IRC Section 83 Et al.). If a non-statutory stock option does not have a readily ascertainable FMV at the grant date, the taxpayer will recognize ordinary income at the time the option is exercised. The ordinary income recognized will be equal to the stocks FMV at the date the option is exercised, minus any amount the taxpayer pays for the option.

Example: Buffy works for a privately held start up tech company called WESEEU. On July 1, 2019 she is granted options to purchase 1,000 shares of WESEEU at $2 per share anytime prior to December 31, 2020. The options have no readily ascertainable FMV. On September 30, 2020 when the stock has an FMV of $12 per share, Buffy exercises her options and purchases 1,000 shares of WESEEU stock. Buffy will recognize $10,000 of ordinary income (1000 shares x the $10 spread per share).

In the case of an Incentive Stock Option, the taxpayer does not recognize income upon the granting or exercise of the option. Instead, gain or loss is recognized at the time of the sale of the underlying stock (IRC Section 421(a)). Gain or loss from the sale of stock resulting from an Incentive Stock Option is capital gain or loss assuming a certain holding period and other requirements are met. Obviously, most taxpayers will find Incentive Stock Options preferable over Non-Statutory Stock Options due to the probable delay in recognition of income, and favorable capital gain tax rates if and when the stock is sold at a gain.

As Mr. Kochansky discovered, love that is found can also be lost, and when such lost love involves marriage, there are often complex tax issues to resolve. In order to provide some measure of relief to divorcing taxpayers, Congress enacted Section 1041 so as to “make the tax laws as unintrusive as possible with regard to relations between spouses” (H.R. Ref No. 432, 98th Cong. 2nd Session. 1491 1984). Section 1041 was also intended to make the tax consequences of property transfers between divorcing taxpayers as uniform as possible, “notwithstanding that property may be subject to differing state property laws” (Id. At 1492).

It was in this spirit that IRS issued Revenue Ruling 2002-22. Like the Kochansky case, Revenue Ruling 2002-22 faces down the issue of when does income become property, and when does property become income. For purposes of the Assignment of Income Doctrine the ruling begins by acknowledging that the doctrine does not apply to every transfer of future income rights. In particular, it cites Hempt Bros., Inc. v. United States, in which the Court concluded that the doctrine should not apply to the transfer of accounts receivable by a cash basis partnership to a controlled corporation 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 a Section 351(a) incorporation of an ongoing business. It should be noted that here we have a case of codified legislation colliding with the Assignment of Income Doctrine, and the legislation came out the winner.

As with Kochansky, there have and will continue to be similar clashes between the Assignment of Income Doctrine and Section 1041 relating to property settlements in divorce. Even so, IRS acknowledges in Revenue Ruling 2002-22 that simply applying the Assignment of Income Doctrine to divorce cases to tax the transferor spouse when the transferee spouse ultimately receives income from the property that has been transferred would frustrate the purpose of Section 1041. The ruling unambiguously states, “… the transfer of Non-Statutory Stock Options between divorcing spouses is entitled to non-recognition treatment under [Section] 1041”.

However, the ghost of Kochansky will shortly arise to prove that the above is not always true, but in general, when a transferee exercises stock options, it is the transferee who must recognize gross income to the extent required by IRC Section 83(a). Revenue Ruling 2002-22 states that this applies in both community and non-community property states. The ruling further states that the same would hold true when an employee transfers a Statutory Stock Option (Incentive Stock Option) to a spouse or former spouse in connection with a divorce. This is because under Section 422(b)(5) and 423(b)(9), the transfer of the Incentive Stock Option would cause the option to be “disqualified”. Thereby transmogrifying it into a garden variety Non-Qualifying Stock Option. Hence, Revenue Ruling 2002-22 clearly leads one to believe that the treatment of all varieties of stock options transferred in divorce is identical.

This would seem simple enough, except for the fact that in 2007 the IRS issued (private) Letter Ruling 200737009. In this instance, the IRS ruled that the transfer of an Incentive Stock Option in a divorce will not disqualify the Incentive Stock Option (thereby automatically triggering Non-qualified Stock Option treatment) in instances when the Incentive Stock Option is community property. This ruling may put the tax practitioner in a bit of a quandary, as Private Letter Rulings (PLRs) only apply to the parties to whom they are addressed and not the public at large. However, PLRs do give us some insight as to how the IRS views a matter. Further, this position makes considerable sense, because if Incentive Stock Options were earned during the marriage, as community property, one-half of them are the property of the non-earning spouse by operation of state law. Why then should they violate the lifetime exercise requirement of IRC Section 422(b)5 automatically triggering non-qualified treatment with it’s associated harsh tax consequences? Section 422(b)5 provides that ISOs cannot be transferred by the person who was granted the option other than at death.

The position taken by the IRS in Letter Ruling 200737009 begs the question, would the outcome have been different for Mr. Kochansky had he argued early on that his wife’s share of the medical malpractice settlement represented her community property interest in joint income that was earned during the marriage, or at least her due portion of a community asset (the fee agreement)? Perhaps so, but likely not, for near the end of the Ruling we are given two exceptions. One is when Non-Qualified Stock Options that are unvested or subject to substantial contingencies are transferred between spouses in connection with divorce. In this case it is the position of the IRS that when the non-employee spouse exercises the options, it is the employee spouse who will be responsible for the tax burden. The other exception pertains to certain divorce agreements entered into prior to November 9, 2002, although in general Revenue Ruling 2002-22 is meant to be retroactive.

To provide some legal brace work for its stance, the IRS references (you guessed it) Kochansky v. Commissioner. The reader may note the irony here that the very arguments that Mr. Kochansky put forth in 1996 (substantial doubt, contingencies, etc.) are the same ones used by the IRS to turn the tax liability back on the spouse who “earned” the options in the first place.

Thus, like the hapless Mr. Kochansky, the transferor of unvested Non-Qualified Stock Options, will be stuck with the worst of both worlds – the payment of tax on money that went to somebody else. Practitioners should take careful note of this, as to do otherwise is a malpractice suit waiting to happen. Imagine a client’s reaction upon finding that he or she is responsible for the tax on a huge gain realized on stock options that were exercised by a former spouse, who in turn will be keeping all the cash. Such a situation would make the tax plight of poor Mr. Kochansky appear paltry, as at least he only had to deal with the Assignment of Income issue on the original earned income, and not millions of dollars (or more) in appreciation on some technology stock offering.

And so it appears that the ghost of the Kochansky case, not to mention Lucas v. Earl will be with us for sometime to come, forever reminding taxpayers that the line between income and property is not always well defined, particularly when it comes to dividing up the wreckage of love that was once found, but has since been lost, or in other words – divorce.

Have a question? Contact David Ellis, Ellis & Ellis CPAs, California.

“This article is  for  informational purposes  only  and  does not  constitute tax advice. No  advisor/client  relationship is  created  between  the  author  and  the reader  in the context  of  the viewing  this material.”

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David Ellis is the managing partner of Ellis & Ellis, CPAs, Inc. located in Pasadena, California. He has over 25 years of experience in the practice of Divorce, Trust/Estate, and other family tax matters. He is an advisor in matters pertaining to Trust, Estate, and Corporate Taxation to the Los Angeles County Office of the Public Guardian. The firm also provides other general tax services and IRS representation. He earned his Bachelor’s Degree from the University of Southern California in Communication Arts and Sciences. He is a frequent writer and speaker on various tax subjects, and has provided continuing education services to other CPAs and tax professional in the area of Divorce, Trust, and Estate Taxation. An article that he recently co-authored entitled The Tax Consequences of Dividing Marital Property can be found in the December 2014 issue of Practical Tax Strategies, a national professional tax publication.

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1 comment on “Tax Aspects Of Dividing Stock Options In Divorce”

  • When he sold his stock options, and if he had reported all of this gains/losses at that time, then if he would have written a check to his ex-wife, he could have 1099’d her as a nominee, and he would have only paid tax on his gains.

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