IRS Clarifies Non Qual Compensation Tax Status

June 7, 2004 ( - When an employee spouse transfers his or her interests in nonstatutory stock options and nonqualified deferred compensation to his or her former spouse in a divorce, the transfer does not generate certain federal taxes, the IRS has ruled.

In  Revenue Ruling 2004-60 ,   the IRS said such transactions do not result in a payment of wages for purposes of the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), according to a CCH report. However, when the options are eventually exercised or the nonqualified deferred compensation is paid or made available, there are FICA and FUTA tax consequences, tax officials said.

According to the new ruling, compensation realized on the exercise of stock options by the nonemployee spouse and deferred compensation made available to the nonemployee spouse generally are still subject to FICA and FUTA taxes as if they had been retained by the employee.

So nonstatutory stock options are subject to FICA and FUTA taxes at the time that the options are exercised by the nonemployee spouse who received them in the divorce. The options are taxed to the same extent as if the options had been retained and exercised by the employee spouse. Likewise any nonqualified deferred compensation is subject to FICA and FUTA taxes to the same extent as if the rights to the compensation had been retained by the employee spouse.

Although the nonemployee spouse receives the payments, the amounts relate to the employee spouse’s employment and are considered FICA wages of the employee spouse. The employer reports the payments as Social Security wages and Medicare wages and reports the Social Security tax and Medicare tax withheld on a Form W-2 issued to the employee spouse. The social security and Medicare taxes are reported on the employer’s Form 941 and the FUTA tax is reported on the employer’s Form 940.

With respect to income tax withholding, income realized by the nonemployee spouse upon the exercise of the nonstatutory stock options and amounts distributed to the nonemployee spouse from the nonqualified deferred compensation plans are considered wages subject to income tax withholding. The withheld amounts are deducted from the payments to the nonemployee spouse.

The new ruling is effective as of January 1, 2005. For periods before that date, employers may rely on a reasonable, good-faith interpretation of the rules, including the interpretations in the proposed rules in Notice 2002-31 and in the most recent ruling.