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Exercise of Stock Options Taxable to Nonresident

This article is reproduced with permission from Spidell Publishing, Inc.

A Florida taxpayer was subject to California tax on exercised stock options received from her spouse as part of their divorce. The husband was a California resident when the options were granted and the services were performed in California. As part of the divorce proceedings, Carole Fiedler, a Florida resident, was awarded proceeds arising from the exercise of options to purchase stock in IBM. The options were originally granted to her ex-husband as an employee of IBM. The options were exercised and the stock was sold in the same year, and $11,434.76 of California tax was withheld.

Taxpayer’s arguments
Fiedler argued the income was not taxable because:

  • she was a nonresident of California who sold the underlying stock in a qualifying disposition. On this basis, she argued that she was not subject to income tax by California even though the services of her ex-husband that gave rise to the grant of options may have been performed in California. She quoted Franchise Tax Board (FTB) Publication 1004, Stock Options Guidelines, which states that an option exercised by a nonresident in a qualifying disposition is not taxable;
  • a court order stated that the options at issue were not subject to California income tax “because they were qualified incentive stock options (ISO’s)”; and
  • her Florida CPA gave her professional opinion (based on facts she provided) that she was not liable for California state income tax on her exercise of options for 325 shares of IBM stock.

What it an ISO?
The FTB asserted that Fiedler did not provide evidence showing that the stock options were ISOs and, therefore, this supported the FTB’s finding that the stock options were nonqualified stock options (NQSOs). The Board agreed that, as a general rule, income derived from the exercise of NQSOs is taxable by the state where the services were performed, not necessarily by the state where the taxpayer resides.

Regarding the court order, the order actually did not state that the options were ISOs, and it further noted that the taxpayer would be responsible for all federal and state income tax with respect to the options. Also, even if Fiedler could demonstrate that the options were ISOs, she had not shown that a qualifying disposition occurred. A Solomon Smith Barney confirmation statement shows that 325 stock options were exercised, and the underlying stock was sold on the same day.

Because the stock was not held for one year prior to the sale as required by the Internal Revenue Code Section 422, the options were NQSOs, not ISOs.

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