Stock Options, Executive Compensation, and Divorce
By Greg Gann
One of the most lucrative forms of compensation for corporate officers, managers, and other executives comes in the form of stock options and rights to restricted stock. The four most critical issues for executives awarded these financial instruments who divorce is whether these perks were marital, vested, a determination as to how they will be valued, and how will the tax considerations be handled.
A stock option is simply the right to purchase a stock at some future date at a stipulated price that is determined and offered in the present. If a stock option provides the right for the employee to purchase the stock at a stipulated strike price, say $50 per share at an assigned date in the future, this creates a significant economic windfall to the employee, if at the time of time of eligibility or vesting, the stock is trading at a price significantly above the strike price, say $100 per share. It should be evident that such forms of executive compensation are valuable property (assets), but they also comprise an income component. As such, not only are their valuations important in terms of equalization of marital assets, but they are also relevant in terms of assessing both alimony and child support.
If a stock option is awarded and vested during the marriage, then it is 100% marital. If the right to exercise the option vests post -divorce, the determining issue as to whether it is marital or not is whether the option was awarded based on past service which took place during the marriage or based on future performance which is to be measured after the divorce.
There are two types of stock options, and they are known as incentive stock options and non-qualified stock options. Incentive stock options (ISOs) have been phased out and are fairly rare today. ISOs when exercised do not require the employee to pay ordinary tax on the difference between the strike price and the fair market value of the shares issued. They may however be subject to the alternative minimum tax. If the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then any profit derived from the eventual sale of the stock is awarded capital gains treatment. In contrast, the difference between the strike price and the fair market value as of the date of exercise is taxed as ordinary income for non-qualified stock options, which are more commonly granted. If the stock purchased through the non-qualified stock option is held for 1 year or longer after the exercise date, then this resulting gain will qualify for capital gains tax treatment.
Unlike pension plans which can be distributed on an if as and when basis, very seldom do companies allow transfers from the employee spouse to a third party, including an ex- spouse. Therefore, to have an in-kind transfer of options from the employee spouse to the non-employee divorced spouse requires an agreement or constructive trust that mandates that the employee spouse will manage the options for the benefit of the non-employee spouse in accordance with what is established in the divorce decree.
If a pension is divided amongst the spouses, it can be effectuated through a fully executed and approved QDRO, which puts the burden of division on the plan administrator rather than the employee spouse. In contrast, the division of options generally fall outside the purview of the plan administrator. The burden continues to reside with the employee spouse. As such if options are transferred as opposed to valued and then offset with other marital assets, the couple remains financially entangled.
Financially disentangling themselves from each other is one of the main reasons for valuing and offsetting the options. An understanding of the company and its stock performance and growth prospects or lack thereof provides another justification. For whatever reason, if the options are not transferred in kind or exercised by one spouse on behalf of the other, they have to be appraised.
There are two main methods for valuing stock options, and they come with a great variability in terms of sophistication and can result in a great deal of discrepancy in terms of valuations. The most simplistic valuation method is to determine what is known as the intrinsic value. The intrinsic value is simply the difference between the current stock price and the price for which it can be purchased as specified by the language in the option. This is simple, and judges can easily wrap their arms around it. The problem with this simplistic approach however is that options inherently allow for purchases at dates out into the future.
If a stock’s value is likely to dramatically increase in the future (think Facebook or Apple option holders), the intrinsic value will not reflect or account for that potential appreciation. If I were valuing an option for a stock that was likely not to appreciate much over the life of the option period or were likely to decrease significantly in value (think Radio Shack), then I would want to use the intrinsic method.
So, again, if my stock options are for a company likely to appreciate significantly, it would behoove me to use the much more sophisticated valuation methodology known as the Black-Scholes model that factors in the strike price, the time for the option to mature as well as features of the underlying stock such as current price and historical price volatility adjusted to the risk free rate of return such as interest on a ten year U.S. Treasury. Fortunately, we have tools enabling us to make this calculation and argue for its efficacy.
The importance of scouring over employer plan documents as well as grant letters provided to the employee cannot be overstated when it comes to stock options. The most pertinent information to discern with respect to divorce is whether the options were awarded for past or future service. If there is consistency and a history of options being granted regularly to the employee, then there is a strong argument that the options should be treated as a normal component of compensation and therefore should be considered into child support and possibly spousal support as well. Additionally, a careful review of the documents underlying the options needs to be conducted to determine the execution price, the date of vesting, the date of each options grant, the number of options granted, as well as the expiration of each grant.
With respect to income taxes, prior to 2006, when granting options, companies could expense the transaction yet the employee did not need to immediately report the economic benefit. Because this no longer is the case, companies today are more likely to issue restricted stock or restricted stock units in lieu of stock options, but the most fundamental elements in terms of intrinsic values are shared by both.
Restricted stock refers to stock of a company which is not fully transferable until certain conditions are satisfied, such as continued employment for a stipulated period of time or achievement of reaching certain corporate financial milestones. The restrictions are removed on a certain number of shares at each vesting date. If employment is terminated before the vesting date, the shares are forfeited.
Restricted stock units act as a placeholder to be exchanged for the actual shares of stock at a later date. The major difference between restricted stock and restricted stock units is that restricted stock is actually issued to the employee and therefore impacts the total number of floating outstanding shares, which is not the case with restricted stock units. Restricted stock and restricted stock units are taxable in the year in which they vest as opposed to when they are exercised, and they are taxed as ordinary income. Any gain in terms of the market value of the restricted stock or units from the date of vesting until the sale of the stock receives favorable capital gains tax treatment provided that the sale took place at least a year after the vesting date.
Many times employees going through divorce do not even consider their stock options as compensation or an asset that needs to be apportioned. They may not even realize that it should be listed on a financial affidavit. However, box 12 of an employee’s W2 indicates if there is money going into stock options or restricted stock or restricted stock units. So, reviewing prior tax returns and accompanying W2s is most prudent.
Valuing an asset for divorce is most common when the asset’s value will be traded or offset with other marital assets. However, there are two significant challenges with respect to stock options or restricted stock or restricted stock units that need to be addressed even if the stock options or restricted stock are not be used as an offset, but are to be transferred from the employee spouse to the non-employee spouse.
The first is navigating some of the tax implications unique to stock options that complicate transference in divorce. Generally, the only party who can exercise options or restricted stock is the employee spouse. As referenced above, the employee spouse can commit himself to manage and execute on behalf of the non-employee spouse as a fiduciary. This means that the employee spouse will incur taxes which have to be factored into the transference. One way to do this is to offset the number of shares being transferred by the value of the tax liability. Alternatively, the receiving non-employee spouse can agree to reimburse the employee spouse for the taxes. In any event, the marital separation agreement has to specify how the taxation resulting from the transference of stock acquired through the options or restricted stock will be handled by both parties. Agreeing to offset the number of shares transferred from the employee spouse to the non-employee spouse has the advantage of minimizing the financial entanglements and communications between the spouses.
The other financial complication with respect to stock options and restricted stock in divorce relates to the fact that options granted during marriage may relate to employee service subsequent to divorce. Therefore, a calculation often needs to be applied to determine what percentage of the grant is marital versus non-marital. The Nelson formula is most widely accepted in this regard. The formula is expressed as a fraction, the numerator of which is the number of months between the grant date and the date of separation, and the denominator of which is the number of months between the grant date and the vesting date.
Executive compensation is a complicated subject by itself. How to handle valuation, deal with the tax consequences, and determine marital and non-marital percentages makes having a working understanding of these principles that much more tantamount in divorce.
The content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. This information is not intended to be a substitute for individualized tax or legal advice. Please consult your tax or legal advisor regarding your specific situation.
Gregory Gann has been an independent financial advisor since 1989. He is president of Gann Partnership LLC, based in Baltimore, Maryland. Gann Partnership provides objective, unbiased financial planning and active investment management for individuals, families, and businesses. (Securities offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.) Greg has also earned the distinction as a certified divorce financial analyst. A large portion of his practice is dedicated towards helping structure and analyze divorce settlements. He is trained in collaborative law and mediation.