Not all stock options are the same, and the difference between an incentive stock option (ISO) and a nonqualified stock option (NSO) has direct consequences in a Texas divorce. The tax treatment at exercise is fundamentally different, and that difference affects how the options are valued for settlement purposes and who bears the tax burden when they are ultimately exercised.
The Basic Distinction
An incentive stock option is a type of stock option that meets specific requirements under Internal Revenue Code section 422. ISOs can only be granted to employees (not consultants or directors) and are subject to rules including a $100,000 annual limit on the value of ISOs that first become exercisable in any calendar year, a requirement that the exercise price be at least equal to fair market value on the grant date, and a requirement that the ISO be exercised within three months of termination of employment. If all conditions are met and the employee holds the shares for more than two years from the grant date and more than one year from the exercise date, the entire gain (the spread at exercise plus any post-exercise appreciation) is taxed as a long-term capital gain. The spread at exercise is not subject to ordinary income tax under the regular tax system, though it is an adjustment item for alternative minimum tax purposes.
A nonqualified stock option does not meet those requirements or, if it does, the holder elects to forgo ISO treatment. When an NSO is exercised, the spread between the exercise price and the fair market value of the shares on the exercise date is ordinary income, subject to income tax withholding and FICA taxes. Any subsequent appreciation from the date of exercise to the date of sale is a capital gain.
The ISO Transfer Problem
Here is where divorce creates a particularly significant problem. ISOs can only be transferred to a non-employee upon the death of the holder. A transfer of an ISO to a former spouse in connection with a divorce causes the option to automatically lose its ISO status and be treated as an NSO from the point of transfer. The former spouse who receives the option and later exercises it will owe ordinary income tax on the full spread, not the favorable capital gains rate they might have expected.
This conversion from ISO to NSO can represent a very significant difference in tax liability. If the underlying stock has appreciated substantially since the grant, and the exercise price is well below market value, the spread could be large enough that the tax difference between ISO and NSO treatment is worth hundreds of thousands of dollars.
For this reason, many practitioners recommend against direct transfer of ISOs to a non-employee spouse. Instead, the decree can require the employee spouse to hold the ISOs and, upon exercise, pay the former spouse their community share of the after-tax net proceeds. Alternatively, the community share of ISO awards can be offset against other assets, allowing the employee to retain the ISOs entirely while the other spouse receives an equivalent value in cash or other property.
NSO Transfers and the Assignment of Income Doctrine
The IRS has ruled that transfers of NSOs between divorcing spouses, pursuant to a divorce decree, are tax-free at the time of transfer under IRC section 1041. The receiving spouse takes on the employee’s tax attributes for the option. When the former spouse exercises the NSO, they recognize ordinary income measured by the spread on the date they exercise. Even though that income arises from an employment relationship that was the other spouse’s, the assignment of income doctrine does not apply because the transfer was made incident to divorce.
This means the employee spouse does not pay tax when the NSO is transferred. The former spouse pays ordinary income tax when they exercise. Given that the non-employee former spouse is a non-employee, there are no FICA withholding obligations. But they do owe income tax, and they must plan accordingly.
Our comprehensive guide to executive compensation and stock options in high-net-worth divorce covers the full range of equity compensation issues in depth.