PLR Clarifies Taxes on Stock Options in Divorce

An IRS Private Letter Ruling (No. 200646003) clarifies the law with respect to the tax treatment of stock options that are distributed by constructive trust in divorce to the non-employee spouse. This PLR confirms that the non-employee spouse who directs the exercise of options in-the-money is responsible for the federal income tax and should receive a credit for the income tax withheld by the employer.

The important part of this ruling, however, concerns FICA taxes. In this PLR, it was decided that the employee spouse would be held responsible for FICA taxes resulting from the exercise, and the non-employee spouse would not be given credit for the FICA taxes withheld from the proceeds.

As a colleague from the East reminded me, there is an opportunity for settlement by recognizing that the non-employee spouse may be in a lower income tax bracket than the employee spouse, thereby maximizing the value of stock options distributed to the non-employee. On the other hand, there is no ability to shift FICA taxes from the employee spouse (unless he/she has already exceeded the FICA wage base at the time when options are exercised).