Don Read, Tax Law for Family Law Attorneys

Pension and Profit-Sharing Plans. Under ERISA, qualified pension and profit sharing plans are non-assignable, other than a transfer to an "alternate payee" by a "qualified domestic relations order" or ("QDRO"). Subsection (p) of Internal Revenue Code §414 defines what constitutes a "qualified domestic relations order." Pension plan distributions are taxable to the distributee. An alternate payee who is a spouse or former spouse is the "distributee" who is taxable when he or she receives benefit payments from his or her share of the plan.

Among other things, a QDRO must be issued pursuant to the state domestic relations law and must identify the alternate payee, the plan and the portion of the benefit under the plan that is to be transferred to the alternate payee.

If, for some reason (such as the death of the participant) another person (such as a new spouse) becomes entitled to the benefit before the QDRO is issued and delivered to the plan, the former spouse may lose his or her share of the benefits, despite his or her community property interest in the plan. Too often, the preparation of the QDRO is left to the end of the marital dissolution case and the QDRO expert has difficulty getting issues resolved (including issues with the employer and plan administrator) that could have been resolved earlier in the case. The QDRO preparer must become familiar with the terms of the particular plan, the benefits of the participant under the plan, and the plan's QDRO procedures.

american flag graphic Dealing with foreign employee benefit plans adds complexity because the tax and benefit rules of both countries and the treaties between them must be considered.

Individual Retirement Accounts. IRA's are generally governed by Internal Revenue Code §408 and are generally nontransferable without serious tax consequences (including a 10% penalty). However, with the right kind of written instrument an IRA may be transferred to a former spouse incident to divorce. See IRC §408(d)(6). The IRA custodian may have special procedures it will insist be followed.

Stock Options. Stock options come in two basic kinds: nonqualified stock options (NQO's) Treas. Regs. §1.83-7 and incentive stock options (ISO's) Internal Revenue Code §422. ISO's and NQO's have significantly different tax consequences on exercise, both for regular tax and alternative minimum tax purposes. ISO's are nontransferable (IRC §422(b)(5)) but NQO's may be transferable if the employer agrees. Howevever, stock received on the exercise of an ISO may be transferred to a former spouse without causing a "disqualifying disposition" that triggers ordinary income. See IRC §424(c)(4). In private ruling that Don Read obtained for California clients in 2005 (PLR 200519011) and 2007 (200737009) the IRS ruled that the nonemployee former spouse is taxable on his or her community property share of ISO and NQO income even if the options have not actually been transferred from the employee to the nonemployee former spouse. Unfortunately, only the taxpayer to whom a private ruling is issued is allowed to rely on it; and employers will report all the income on the employee's W-2 if the options are not actually transferred, so special adjustments have to be made on the former spouse's tax returns.

Nonqualified Deferred Compensation. Some retirement plans are nonqualified and not subject to the QDRO rules. Nonetheless, it may be possible to cause a non-employee former spouse to be taxable on his or her share of the income from the nonqualified plan. See Revenue Ruling 2002-22. Restricted stock and stock appreciation rights (SAR's) and performance shares are types of nonqualified deferred compensation to which these rules may apply. Caution is required to make sure that the rules of Internal Revenue Code §409A are complied with so that the penalty tax and retroactive high-rate interest imposed by that section will not be incurred.

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Donald H. Read - Attorney and Certified Tax Law Specialist     Cell Phone: (510) 409-4927     E-Fax: (413) 677-0609