Two stock option grants with the same number of shares and the same exercise price can be worth very different amounts after tax. Whether an option is an incentive stock option (ISO) or a nonqualified stock option (NSO) changes when tax is owed, at what rate, and what happens if the option is moved to a spouse in a divorce.

This guide explains the difference and what it means for executives and their spouses dividing options in a Texas divorce in Houston, Sugar Land, Katy, Pearland and the surrounding area.

ISOs and NSOs at a glance

	Incentive stock options (ISOs)	Nonqualified stock options (NSOs)
Who can receive	Employees only	Employees, directors, consultants
Tax at exercise	No regular income tax; the spread is an alternative minimum tax (AMT) adjustment	Spread is ordinary compensation income, subject to withholding and FICA
Tax at sale	Long term capital gain on the full gain if shares are held more than 2 years from grant and more than 1 year from exercise	Capital gain or loss on change after exercise
Key limits	Exercise price at least fair market value at grant; up to $100,000 of ISOs (by grant date value) may first become exercisable per year; generally exercised within 3 months after employment ends to keep ISO treatment	Set by the plan
Transfer in divorce	Loses ISO status; treated as an NSO from the transfer	Can be transferred if the plan allows; taxed to the former spouse on exercise

A sale of ISO shares before the holding periods are met is a “disqualifying disposition,” and part of the gain becomes ordinary income.

First, who owns the options

Tax rules decide what an option is worth after tax. Texas property law decides who owns it. Options granted during the marriage are presumed community property, and for options that require continued employment, Texas Family Code section 3.007(d) sets the separate and community fractions. See The Time Rule and Dividing Unvested Stock Options.

The ISO transfer problem

Under Internal Revenue Code section 422, an ISO may be transferable only by will or the laws of descent and distribution. The IRS has taken the position that transferring an ISO to a spouse in a divorce disqualifies it, so it is treated as an NSO from that point. The former spouse would then owe ordinary income tax on the spread at exercise instead of potentially receiving capital gain treatment.

For that reason, ISOs are usually not transferred. Common alternatives are:

• Offset. The employee keeps the ISOs; the other spouse takes other assets of equal after tax value.
• Deferred distribution. The employee keeps the ISOs and pays the former spouse the community share of net proceeds after exercise and sale, with clear terms on timing, AMT and who funds the exercise price.

Shares already acquired by exercising ISOs are different. Under section 424(c)(4), a transfer of those shares to a spouse incident to divorce is not a disqualifying disposition. The receiving spouse takes on the transferor’s position for later sale.

NSO transfers: what Revenue Ruling 2002-22 and 2004-60 say

• No tax on the transfer. Under Revenue Ruling 2002-22, transferring vested NSOs to a former spouse incident to divorce is not a taxable event for the employee.
• Former spouse taxed on exercise. When the former spouse exercises, he or she reports the spread as income.
• FICA still applies. Under Revenue Ruling 2004-60, the spread remains wages of the employee spouse for Social Security and Medicare purposes. The employer withholds income tax and FICA from the former spouse’s exercise, reports the income and income tax withholding to the former spouse on a Form 1099, and reports the FICA wages on the employee’s Form W-2.
• Scope limits. The rulings address specific facts. Transfers of options that are unvested when transferred deserve specific tax advice.

Settlement points to get right

1. Identify every grant as ISO or NSO from the grant agreement, not memory.
2. Compare offers on after tax values, including possible AMT on ISO exercises.
3. If the employee keeps the options, state whether the former spouse’s share is measured before or after tax.
4. If NSOs are transferred, confirm the plan allows it and coordinate the paperwork with the plan administrator.
5. Address what happens to options at termination, since ISOs exercised more than three months after employment ends are generally taxed as NSOs.

See also our posts on the tax implications of dividing executive compensation, underwater options and pre-IPO equity, where ISOs are common.

Work with a Houston divorce lawyer who understands stock options

Chidi Anunobi is Board Certified by the Texas Board of Legal Specialization and holds an M.B.A. from Carnegie Mellon University. We coordinate with our clients’ tax advisors to divide options on an after tax basis in high net worth divorces.

Our office is at 1415 North Loop West in Houston, and we serve Sugar Land, Katy, Fulshear, Pearland, Missouri City, Richmond, The Woodlands, River Oaks and all of Harris, Fort Bend and Montgomery Counties. Call 832-538-0833 or contact us. Our executive compensation guide covers the full package.

Frequently asked questions

Can incentive stock options be transferred to my spouse in a divorce? A transfer is possible only if the plan allows it, and the IRS treats a transferred ISO as losing ISO status. Most couples use an offset or deferred distribution instead.

Who pays tax when my former spouse exercises transferred NSOs? The former spouse pays income tax on the spread. FICA is still withheld as wages of the employee spouse under Revenue Ruling 2004-60.

Is transferring stock acquired from ISOs a disqualifying disposition? No. Section 424(c)(4) says a transfer incident to divorce is not a disposition for this purpose.

This article is general information, not tax or legal advice.