Employee Stock Options and Divorce
As the stock market continues to rise, divorce attorneys are involved in more and more cases involving stock options. The grant of stock options to key employees is now common in high technology companies and is becoming popular in many other industries as part of an overall equity compensation strategy. Larger, publicly traded companies such as Pepsico, Starbucks, Travelers Group, Bank of America, Merck and the Gap now give stock options to almost all of their employees. Many non-high tech closely held companies are joining the ranks as well.
Traditionally, stock option plans have been used as a way for companies to reward top management and “key” employees and link (golden handcuff) their interests with those of the company and other shareholders. More and more companies, however, now consider all of their employees as “key.” As a result, there has been an increase in the popularity of broad-based stock option plans, particularly since the late 1980s. More than a third of large United States companies now have broad-based stock option plans covering all or a majority of their employees–more than double the rate that existed in 1993. In a 1997 survey of 1,100 public companies conducted by Share Data, Inc. and the American Electronics Association, it was found that 53% of respondents provide options to all employees. In companies having 500 to 999 employees, the study found that 51% offer options to all employees, as compared to 30% in Share Data’s 1994 survey and 31% in Share DataÕs 1991 survey. Forty-three percent of companies with 2,000 to 4,999 employees offer options to all, as compared to 10% in 1994. Forty-five percent of companies with 5,000 or more employees offer options to all, compared to 10% in 1994.
Since this trend shows no apparent sign of slowing down, matrimonial attorneys must be ready to address the unique issues that arise therefrom. This article will explain the basic nature of employee stock options, how they are valued, taxed and ultimately distributed incident to divorce.
What is an Employee Stock Option?
There is no question that “stock options” are assets subject to equitable distribution. However, simply to say that they are assets is not enough to guide the matrimonial litigator. We must first understand the basic nature and definition of a stock option. Basically, a “stock option” is “the right to purchase a specified number of shares of stock for a specified price at specified times, usually granted to management and key employees. The price at which the option is provided is called the “grant” price and is usually the market price at the time the options are granted.
Generally, stock options are an incentive to stimulate the efforts of key employees and to strengthen the desire of employees to remain in the employment of the corporation. Such incentives do not apply to retired employees. Stock option plans can be a flexible way for companies to share ownership with employees, reward them for performance, and attract and retain a motivated staff. For growth-oriented smaller companies, options are a great way to preserve cash while allowing employees a piece of future growth. They also make sense for public firms whose benefit plans are well established, but who want to include employees in ownership. (Note: By issuing stock options, a company potentially dilutes the value of existing shares.)
Whether a stock option is granted for money, for past services, as an incentive for future services, or for no consideration at all, an option holder must exercise the option within its terms or he is subject to the loss of his/her right to do so. In an option contract “time is of the essence.” Generally, expiration provisions and stock option agreements are strictly enforced. The courts reject the inevitable breach of contract and forfeiture claims that employees, former employees and other stock option holders press when they fail to timely exercise their options. Although this rarely becomes an issue in divorce litigation, it is something to keep in mind in order to avoid severe economic loss to either party or a potential malpractice claim.
Are there different kinds of stock options, and how are they taxed?
Generally, stock options come in two basic categories: (1) incentive stock options (commonly referred to as ISOs) which are qualified or statutory options and (2) non-qualified stock options (which are commonly referred to as NQSOs). Simply put, the difference between an ISO and a NQSO turns on its compliance with specific Internal Revenue Code requirements at the time of grant which ultimately effects how the option is taxed.
Incentive stock options are granted to individuals for reasons connected to their employment. As a result they may only be granted to employees. They must also be approved by the shareholders of the corporation and granted at fair market value.
NQSOs, on the other hand, may be granted to both employees and independent contractors, and their beneficiaries.
An employee will not realize any taxable income upon the grant or exercise of an ISO. Concomitantly the corporation is not entitled to a deduction upon the exercise of the option. If the employee sells the stock within two years after the option is granted and within one year after the option is exercised, ordinary income will be realized in an amount equal to the lesser of 1) the excess of the fair market value of the shares at the date of exercise over the option price, or 2) the excess of the amount realized on the disposition over the option price. If the individual holds the shares for two years after the grant of the ISO and one year after exercise of the ISO, the difference between the sale price and the option price will be taxed as a capital gain or a loss. If the stock is sold after the two-year/one-year period, that gain will also be an alternative minimum tax preference item subject to the26/28 percent tax rate.
Regarding a NQSO, the holder “employee” of a non-statutory option must recognize income at the time the option is granted if the option has a “readily ascertainable fair market value” at the time of grant. If the option is not transferable and does not have a “readily ascertainable fair market value,” no income will result to the individual upon the granting of the option. When the non-qualified stock option is exercised, the individual is taxed at ordinary income rates on the difference between the fair market value of the stock and the exercise price of the option. When the individual sells the stock, a capital gain or loss will be incurred on the difference between the amount received for the stock and its tax basis. Typically the tax basis is equal to the fair market value at the time of the exercise of the option. The capital gain would be either long term or short term depending on the length of the time the shares were held after exercise.
If the option is “actively traded on an established market” the code considers the option to have a “readily ascertainable fair market value.” If there is no “readily ascertainable fair market value” at the time of the grant, the optionee recognizes income at the time of the option either: (1) becoming “substantially vested” or (2) is no longer subject to a “substantial risk of forfeiture”. Any profit is a short term capital gain, taxable at ordinary income rates. The code establishes four conditions necessary for an option that is not “actively traded on an established market” to meet the “readily ascertainable fair market value” standard: (1) the option is transferable by the optionee (2) the option is exercisable immediately in full when granted (3) there can be no condition or restriction on the option that would have a significant effect on its fair market value, and (4) the market value of the option privilege is readily ascertainable. All four conditions must be met. Since these conditions are seldom satisfied, most non-qualified, non-statutory stock options not traded on an established market, do not have a readily ascertainable value.
There is another factor to consider that can apply to both incentive and non-qualified stock options. Some companies are offering options with a reload feature. A reload option provides for automatic grants of additional options whenever an employee exercises previously granted options.
If the stock that is received upon the exercise of the option is restricted property, the taxation is deferred until the restrictions lapse. Frequently employees receive restricted stock for services. The stock is not freely transferable and is subject to a risk of forfeiture based on the individualÕs performance or continued employment for a period of time. Pursuant to Internal Revenue Code Section 83(b), an individual can elect to recognize the fair market value of the shares, ignoring the restrictions, as income at the time of the award; if a Section 83(b) election is made, the holding period for capital gains purposes commences at the time of the election, otherwise the holding period begins to run at the conclusion of the restriction.
Based upon the foregoing, it may be appropriate to tax effect executive stock options for purposes of equitable distribution. This is because executive stock options have a fixed expiration date and therefore must be exercised and sold. The resulting tax is inevitable and therefore should be considered.
How are Stock Options Valued?
There are various methods to arrive at a present value for stock options. The two most popular are the “intrinsic value” and the “Black-Scholes” method. In 1995 the accounting profession formally recognized that executive stock options have value beyond their intrinsic value. In addition, the Black-Scholes Option Pricing Model was recognized as an appropriate method to calculate the value of executive stock options by the accounting profession. Interestingly, the Financial Accounting Standards Board (FASB) specifically stated that, “an employee’s stock option has value when it is granted regardless of whether, ultimately (a) the employee exercises the option and purchases stock worth more than the employee pays for it or (b) if the option expires worthless at the end of the option period.
In the intrinsic value method, the value of the stock option is equal to the difference between the option exercise price and the fair market value of the stock. For example, if you had an option to purchase stock “x” for $5, and the stock was currently trading for $27 per share, the intrinsic value of the option would be $22 ($27 – $5 = $22). However, the intrinsic value method does not consider the value to the holder of having the right to buy the stock at some point into the future at a predetermined price. It also does not consider the volatility of the underlying stock as well as the incumbent advantages and disadvantages of same. Moreover, it does not consider the advantages and disadvantages of the option holder not receiving the stock’s dividends as well as the opportunity cost of purchasing the stock and forgoing the lost interest on the acquisition funds.
One method that considers the above-referenced items is the Black-Scholes Method. You can see the Black-Scholes formula by clicking here.
The explanations of the letter designations for the other variables in the Black-Scholes formula are:
The first part of the calculation determines the expected benefit of purchasing the stock outright. The second part of the calculation determines the present value benefit of paying the exercise price in the future. The difference is the fair market value of the option.
However, an underlying problem with the Black-Scholes Method is that it makes assumptions concerning the volatility of the stock, future dividend rates, and lost interest. A change in these underlying assumptions can affect the value of the option calculated pursuant to this method.
The following table provides a summary of how a change in one of these assumptions will affect the value of the stock options calculated under the Black-Scholes Method.
A common misconception in the valuation of long term options is that an option value is best represented by its intrinsic value. In fact, based on the various Black-Scholes factors, stock options which are “out of the money,” i.e., the strike price exceeds the current fair market value, are actually traded with various dollar values. For example, a Dell Computer stock option with a strike price of $50.00 and a market value of $37.3125 as of May 24, 1999 traded for $8.75. This is so even though the option was almost $13.00 out of the money when the option was valued. The disparity in the value is due to investor optimism that the Dell shares would rise and be worth more than $58.75 before the expiration of the option.
How Are Stock Options Distributed In Matrimonial Matters?
Generally, the methods to distribute stock options usually fall into two categories:
(Where one party argues that a portion of the stock options are non-marital, then an issue arises as to what portion of the stock options whether distributed through method 1 or 2 above, should be granted to the non-employee spouse. This is dealt with in more detail under the next section of this article.)
Deferred Distribution Method
The Deferred Distribution Method is likely the most common manner in which options are distributed and was utilized in one of the earliest New Jersey cases dealing with stock options incident to divorce, to wit: Callahan v. Callahan. In that case, the trial court ruled that stock options acquired by a husband during the course of the marriage were subject to equitable distribution notwithstanding the fact that the options would terminate if the husband left the company within a certain period of time and the fact that they were subject to various SEC regulations. The court impressed a constructive trust on the husband in favor of the wife for a portion of the stock options owned by him in order to best effect the distribution of property between the parties without creating undue financial and business liabilities. It should be noted that all of the options were granted during the course of the marriage. However, although not specifically stated, it appears that some or all of the options were not fully vested since they were subject to divestiture under certain circumstances. This may have been why the wife was awarded only 25% of the options when they matured.” (See section below regarding determining distributive shares.)
Present Valuation Method
The second mode of distribution is the Present Valuation Method. In this method, the stock options must be valued with the non-employed spouse receiving her share of the marital portion in cash or cash equivalent. Such a method should use discounts for mortality, interest, inflation and any applicable taxes. The downside of this “off-set method” is that it may become inequitable in the event that the employee spouse is either unable to exercise the options or, on the date they become exercisable, they are “worthless” (i.e., the cost of the option exceeds the fair market value.)
A review of out-of-state authority indicates that matrimonial courts differ on the method of distribution of stock options depending upon the nature of the options themselves, whether they are vested or unvested, transferable or salable. If the options are able to be transferred to the non-employee spouse, that is the preferred method of distribution, since it effects a clean break between the parties; there is no need for further communication between the parties and there is no need to use valuation methodologies. However, transfer of stock options is rarely permitted by employee stock option plans. Some courts have devised other methods, including but not limited to allowing the parties to be tenants-in-common, or allowing the non-employee spouse to order the employee spouse to exercise his or her respective portion of the options, upon furnishing the capital to do so. This is similar to the constructive trust solution devised in the Callahan case previously discussed. Trial courts are accorded broad discretion in fashioning an approach to fit the facts of the individual case. (Caveat: all of these methods still assume that there is no exclusion of options based upon the argument that they are unvested or were otherwise not earned during the marriage.)
As a practice point, please note that when distributing options in kind, consideration should be given that neither party violates any insider trading rules. For example, it may be a violation if the participating spouse advises the non-participating spouse that he or she intends to exercise his options in the near future. Another concern about the distribution of options in kind is that they can lapse if the individual’s employment with the company is terminated, either voluntarily or involuntarily.
Determining the non-employed spouse’s distributive share
What happens when the employed spouse argues that some of the options are unvested or were otherwise “not acquired during the marriage” and therefore not distributable to the other spouse?
The New Jersey Approach
New Jersey courts have made it clear that it is necessary to balance the need for definitiveness embodied in the date of complaint rule (i.e., the cutoff date for determining which assets are subject to distribution) with the need for flexibility inherent in equitable distribution when addressing stock options incident to divorce. Whereas courts of many other states have employed the “time-rule formula” approach to determine what portion of stock options should be subject to distribution (see below), New Jersey courts have laid the groundwork in a more general fashion. Basically, assets or property acquired after the termination of the marriage, but as a reward for or result of efforts expended during the marriage, normally will be includable in the marital estate and thus, subject to equitable distribution. The law in New Jersey recognizes that assets acquired by gainful labor during the marriage or as a reward for such labor are distributable while assets acquired after dissolution due solely to the earner’s post-complaint efforts constitutes the employed spouse’s separate property.
The seminal case in the State of New Jersey regarding the distribution of stock options is the Supreme Court case of Pascale. In that case, the parties were married on June 19, 1977. A complaint for divorce was filed on October 28, 1990. The wife began her employment with the Liposome Company on April 14, 1987 at which time she was immediately granted the option to purchase 5,000 shares of stock in said company. As of the date of trial, the wife owned 20,069 stock options awarded between April 14, 1987 and November 15, 1991. 7,300 of the stock options were granted after the complaint for divorce was filed.
There were two blocks of stock options in dispute (i.e., 4,000 and 1,800), both granted on November 7, 1990. These were granted approximately ten days after the wife filed for divorce. (There was no indication of whether the options were vested in whole or in part, however, it is assumed that these options were “unvested”.) Her position was that these options were not subject to distribution because the 1,800 were issued in recognition of past performance and the 4,000 options were awarded in recognition of a job promotion that imposed increased responsibility on her in the future. The wife relied on the transmittal letters from her company to support her arguments. The trial court found that neither of the two blocks of options granted on November 7, 1990 could be excluded from equitable distribution and were to be divided equally.
However, the Appellate Division found that one of the two sets of options awarded on November 7, 1990 should have been included in the marital estate while the other should have been excluded. The Appellate Division based that decision on its interpretation of the facts, finding that the block of 4,000 options granted in recognition of a promotion in job responsibility and an increase in salary was “more appropriately … designed to enhance future employment efforts” and should not have been included in the marital estate. However, as to the block of 1,800 options, the Appellate Division found that these options were granted in recognition of past employment performance. Therefore, these options were properly includable in the marital estate notwithstanding the date of complaint rule.
In reversing the Appellate Court, the Supreme Court in Pascale concentrated on N.J.S.A. 2A:34-23 and the guiding principles enunciated in Painter v. Painter, that “property clearly qualifies for distribution when it is attributable to the expenditure of effort by either spouse during the marriage.” The Supreme Court in Pascale made it clear that the focus in these cases becomes whether the nature of the asset is one that is the result of efforts put forth “during the marriage” by the spouse jointly, making it subject to equitable distribution. To refute such a presumption, the party seeking exclusion of the asset must bear “the burden of establishing such immunity [from equitable distribution] as to any particular asset.”
The Pascale court concluded that “stock options awarded after the marriage is terminated but obtained as a result of efforts expended during the marriage should be subject to equitable distribution. The inequity that would result from applying inflexibility to the date of complaint rule is obvious.” Note that no distinctions were made as to vested or unvested options. Therefore, it appears that the Supreme Court agreed with the goals sought to be achieved by the Appellate Division, but did not agree with their conclusions based on the record below. The Supreme Court gave greater weight to the “credible finding” made by the trial court after listening to many days of testimony that the promotion came about as a result of the excellent service that the wife had provided to the company during the marriage.
Query, what would the NJ Supreme Court have done if it determined that a block of options were awarded for a mix of pre and post marital efforts? What if there is no clear indication as to why the options are granted? What if the options are unvested and require future work effort to fully vest? These circumstances often exist and are where things get murky. New Jersey has not adopted a clear and precise method to determine what portion of options which have yet to be fully earned should be distributed. New Jersey’s approach provides for a much more subjective analysis (and room for advocacy) than in other states which utilize various formulaic approaches including a coverture factor or time-rule usually taking into account vesting schedules.
The Out-of-State Approach
Like New Jersey, the majority of states in this country do consider unvested stock options to be property subject to distribution in marital dissolution proceedings. Such was the recent ruling of the appellate court in Pennsylvania in the case of MacAleer. The Pennsylvania Appellate Court addressed the issue of whether stock options granted to a spouse during the marriage, but not exercisable until after the date of separation, constitutes marital property to be divided during the divorce. That court’s reasoning parallels, to a large degree, the majority of the other states which hold that unvested stock options are marital property. Analogizing their prior decisions determining that unvested pensions were subject to distribution, the court noted that benefits resulting from employment during marriage are marital, since these benefits are received in lieu of higher compensation which would have been utilized during the marriage to acquire other assets or to raise the marital standard of living. Only a handful of states have specifically held otherwise. These states are Indiana, Colorado, Illinois, North Carolina, Ohio and Oklahoma. North Carolina and Indiana do not divide unvested stock options on the basis of the state’s statutory definition of “property.” Oklahoma does not consider unvested stock options to be marital property based on the common law foundation of the stateÕs statutory scheme. These states award the unvested stock options to the employee spouse as separate property not to be considered for equitable distribution. These decisions are distinguished upon the fact that they are heavily influenced by statutes which define property in those jurisdictions. However, the remaining states which have addressed the issue, do find unvested stock options to be marital property and generally follow the same procedure for determining how much, if any, of the options constitute marital property.
Many jurisdictions, like New Jersey, view the first consideration to be a determination of whether the options were granted for past, present or future services. However, most courts have learned that employee stock options are not usually granted for any one reason, and could be compensation for past, present and future services. As a result, these courts sought some structure to determining the distributable share.
Remember: The options that are clearly given to the employee spouse as compensation or incentive for future services are wholly non-marital property. The options clearly granted exclusively for past or present services are fully marital property. There is no need for the court to utilize a coverture factor or time rule fraction for either category in order to determine the marital interest since they are wholly marital or non-marital property as the case may be. The problems arise when the reasons are unclear, where the options are unvested or include an indiscernable mix of pre and post marital efforts.
“Coverture Factor” or “Time-Rule Fractions”
Most out-of-state courts which have addressed distribution of unvested stock options use a “coverture factor” or “time rule fraction” to determine how much, if any, of the unvested stock options constitute marital property. The most prevalent time rule fraction has evolved from that which was used by the California Court of Appeals in Hug. The trial court in Hug found that the number of options that were community property were a product of a fraction; the numerator was the period in months between the commencement of the spouse’s employment by the employer and the date of separation of the parties, and the denominator was the period in months between commencement of employment and the date when the first option is exercisable, multiplied by the number of shares that can be purchased on the date that the option is first exercisable. The remaining options were found to be the separate property of the husband.
The husband in Hug agreed that the options were subject to division according to the time rule; however, he contended that the trial court used an erroneous formula. He argued that the proper time rule should begin as of the date of granting the option, not the date of commencement of employment, since the options were not granted as an incentive to become employed. He argued further that each annual option was a separate and distinct option which is compensation for services rendered during that year, and as it was to accrue after the date of separation, it was totally his separate property. The court examined the various reasons why corporations confer stock options to employees, and found that no single characterization could be given to employee stock options. Whether they can be characterized as compensation for past, present, or future services, or all three, depends upon the circumstances involved in the grant of the employee stock option. By including the two years of employment prior to the granting of the options in question, the trial court implicitly found that period of service contributed to earning the option rights at issue. The appellate court found that this was supported by ample evidence in the record.
Various versions of coverture factors have evolved as courts addressed different factual circumstances. The recent Wendt case out of Connecticut entails a voluminous decision in which the court surveys the states which addressed the issue of division of unvested stock options, and notes the competing arguments and the most common numerators and denominators in diverse forms of the coverture factors. A brief summary of the Wendt court’s decision as to stock options is helpful to understanding the approach of many courts to the issue of unvested stock options.
According to the December 31, 1996 unaudited financial statement prepared by KPMG Peat Marwick, LLP, the husband owned 175,000 shares of General Electric Vested Stock Options and Appreciation Rights in the following amounts: 100,000 units granted November 20, 1992 with a $40 per share exercise price, 70,000 units granted September 10, 1993 with an exercise price of $48.3125 and 5,000 units granted June 24, 1994 with an exercise price of $46.25. The unaudited financial statements used the “intrinsic value” method, with a December 31, 1996 New York Stock Exchange price of G.E. common stock at $98 7/8 per share. On May 12, 1997, G.E. common stock split two for one and, thus, the number of options doubled to conform to the stock split. As of the date of separation, December 1, 1995, G.E. was trading at $72 per share. As of October 7, 1997, G.E. was trading at $72 per share in its split status or $144 per share at the pre-May 12, 1997 stock split number of stock options. Based on the facts found, the court divided the 175,000 vested stock options and appreciation rights based on the date of separation, December 1, 1995. In rejecting a Black-Scholes approach in favor of the “intrinsic value” method, the trial court valued the vested options as follows: 175,000 stock options at $3,200,000 for the November 20, 1992 grant; $1,658,125 for the September 10, 1993 grant and $128,750 for the June 24, 1994 grant for a total Ôintrinsic value” of $4,986,875. The court noted that this amount was before taxes. The court additionally noted that the options had no cash value until exercised at which point there would be tax due at short term capital gains tax rates, i.e., ordinary income tax rates. The court assumed maximum rates for the IRS, Medicare and Connecticut tax and calculated the net after tax of the intrinsic value to be $2,804,219. The court distributed one-half of that sum to the wife. The court found that the doubling of the G.E. stock after the date of separation was not due to the efforts of the wife, but that “she should share in the general increase in the investment community.”
The Wendt court then proceeded to address the 420,000 unvested stock options differently. The court had already concluded that only a portion of these unvested stock options was marital property. The court had also concluded that the unvested stock options were granted for future services. Therefore, a coverture factor was required. The coverture factor was determined by a fraction as follows:
Number of Months from the Date of Grant to December 1, 1995
Since there were eight separate dates of vesting, eight separate coverture factors had to be calculated. For example, the coverture factor utilized for the 70,000 units granted on September 10, 1993 which vested on September 10, 1998 was as follows:
27.7 / 60 = 44.5% x 70,000 units = 31,150 units to be divided.
The court then took the price of the G.E. common stock on the date of separation (i.e. $72 per share) to calculate the intrinsic value and thereby determine the dollar amount owed to the wife for the marital portion of the unvested options. This was represented as follows:
$72.0000 -48.3125 (exercise price) = $23.6875 intrinsic value per share x 31,150 units = $737,866
The “$737,866” represents the pre-tax dollar value of the marital portion of the unvested shares as determined by the coverture factor.
After all eight coverture factors were performed, the total dollar values of the marital portion of the unvested stock options was $1,626,273. The court then explored the various risk factors associated with the unvested stock options. It is helpful to review the various scenarios explored by the Connecticut court concerning what could happen to effect the unvested stock options.
The court had basically rejected the wife’s expert’s valuation methodologies (which included “Black-Scholes”) and opted to use the “intrinsic value” to obtain the appropriate value. Specifically, the court rejected the wife’s expert’s use of the Black-Scholes model which actually resulted in a value 10% lower than the “intrinsic value” ultimately used by the court. The court then determined the wife’s share of the intrinsic value of the unvested stock options (i.e., $1,626,273). The court noted that this amount was before taxes. The court proceeded to assume current maximum rates for the IRS, Medicare and Connecticut and found that the net after tax value of the gross intrinsic value would be $914,486. The court then proceeded to award the wife half of this sum. The court ordered the husband to pay the sum in cash and not in any portion of the options.
A similar approach was taken in the case of In re Marriage of Short. In this case, the court held that the inclusion of the unvested stock options in the pool of distributable assets depended on whether the options were granted to compensate the employee for past, present or future employment. The court held that unvested options awarded for past and present services were marital property regardless of the continuing restriction on transfer or vesting. Unvested options granted for future services were deemed to be acquired periodically in the future as the options vest and are subject to a time rule division to allocate the shares between marital (community) and non-marital (separate) property. A different time rule than in the Hug case was used to differentiate between vested options that are clearly separate property for which no time rule would be applied, and those which include both a community effort and separate effort.
Just recently, New York joined the substantial majority of states holding that “restricted stock and stock option benefit plans provided by a spouse’s employer constitute marital property for the purposes of equitable distribution, where the plans come into being during the marriage but are contingent on the spouse’s continued employment with the company after the divorce.” New York’s highest court, in a seven-judge panel, unanimously joined the majority of jurisdictions that use a time rule to divide such contingent resources. The DeJesus court laid out the following four-step procedure to guide courts in dividing such options:
The sum result will then be divided between the parties using the equitable distribution criteria.
This was the method utilized in Colorado in the case of In re Marriage of Miller. The DeJesus court was persuaded that the Miller type analysis best accommodated the twin tensions between portions of stock plans acquired during the marriage versus those acquired outside of the marriage, and stock plans which are designed to compensate for past services versus those designed to compensate for future services.
However, notwithstanding the complexity of these methods, the danger of rigidity and resulting unfairness from a blind application of a formulaic approach still exists. Such issue was addressed by an Oregon Court which stated that “No one rule will produce a just and proper result in all cases and no one rule will be responsive to many different reasons why stock options are granted.” This was, more than likely, the reason that New JerseyÕs Supreme Court ruled as it did in Pascale.
Can stock options be viewed as income to the employee for support purposes?
There is little doubt that stock options constitute a form of compensation earned by the employed spouse during the marriage.
In February of 1999, an Ohio appeals court agreed with Susan Murray, the former spouse of Procter & Gamble Company executive Graeme Murray, that unexercised stock options should be used in calculating the value of child support for the couple’s 16-year-old son. This decision was the first by an Appellate Court to say that parents cannot shelter income from their children Ð intentionally or unintentionally, by postponing the exercise of stock options until the kids are grown. Note that options granted in consideration of present services may also be deemed a form of deferred compensation. (See In Re Marriage of Short, 125 Wash.2d 865, 890 P.2d 12,16 (1995).
A Wisconsin Court of Appeals pointed out that a stock option is not a mere gratuity but is an economic resource comparable to pensions and other employee benefits. The Appellate Court of Colorado held that for purposes of determining child support, income includes proceeds received by father from actual exercise of father’s stock options. The Supreme Court of Colorado held, in the Miller case already referenced above, that “under the Internal Revenue Code, the optionee of a non-statutory employee stock option must recognize income at the time the option is granted if the option has a “readily ascertainable value” at the time of the grant. If the option does not have a readily ascertainable value at the time of the grant, the optionee recognizes income at the time the option becomes “substantially vested” or no longer subject to a “substantial risk of forfeiture,” which generally does not occur until the option is exercised.
The Miller Supreme Court found that unlike pension benefits, employee stock options may well be considered compensation for future services as well as for past and for present services.
It is clear that there is a growing trend among the courts of this nation to distribute unvested or non-exercisable stock options that were granted during the marriage. The key factor in such distribution is a determination as to the purpose for which the options were granted, i.e., whether the options were granted for past or future performance. Where an option is granted for a mixed purpose and/or requires continued employment past the termination date of the marriage (as determined by local law), many states are employing a time-rule fraction which may be modified by the trial court based upon the particular facts and circumstances of the case. Matrimonial practitioners must be aware of the various forms of time-rule fractions that can be used and the factors that can modify the fraction. Such factors include, but certainly are not limited to the following: (1) when the option was granted; (2) whether the option was granted for past or future performance (if “past” how far back); (3) whether or not the option was granted in lieu of other compensation; (4) whether or not the option was a qualified incentive stock option or non-qualified stock option; (5) when the options will expire; (6) the tax effect of the grant of the option; (7) the tax effect of exercising the option; (8) whether or not the option has a “readily ascertainable fair market value;” (9) whether or not the option is transferable; (10) whether or not the option is restricted property; (11) the extent to which the option is subject to risk of forfeiture; and (12) any other factors that the parties or court may deem fair and equitable to consider.
Since the majority of employee stock options are non-transferable and cannot be secured as with qualified pensions under federal laws such as ERISA, matrimonial attorneys should specifically tailor their language when drafting agreements concerning such assets. These agreements should include: (1) a list of all options granted and an explicit description of which options are marital and which are not; (2) if a Deferred Distribution Method is employed, a resortation of whether and under what terms the non-owner can compel the owner to sell options after they are vested; (3) provision for payment of the “strike price” by the non-employed spouse and taxes resulting from the exercise of options; (4) a description of how and when distribution is to be made to the non-owner spouse and (5) precise notification and document exchange provisions.
The matrimonial attorney involved in a case concerning stock options, especially when representing the non-employed spouse, should be sure to obtain the following information and documents: (1) a copy of the stock option plan; (2) copies of any correspondence or internal memorandum which were issued by the company at the time of the grant of any stock options; (3) a schedule of granted options during the employees period with the company; (4) the date of each option granted; (5) the number of options granted at each date; (5) the exercise price of options granted at each date; (6) the expiration date of each set of options granted; (7) the date of vesting for each set of options granted; (8) the date and number of options exercised; (9) all short term or long term employee incentive plans covering the employed spouse; (10) all Employment Agreements between the employed spouse and his or her employer; (11) all company plans, handbooks and option award letters related to stock options granted; (12) copies of the firm’s 10K and 8K for the entire period that the employed spouse is with the company; (13) dates of promotions and positions held by the employee; (14) a brief job description of each position; (15) the salary history of the employee indicating all forms of compensation; (16) the grant date of exercised options and (17) copies of any corporate minutes or proxy statements referencing the award of options. The information listed herein provides the core information from which option values can be calculated and agreements intelligently reached concerning their distribution.
As we enter the 21st Century, it is clear that matrimonial attorneys will need to become as knowledgeable as possible regarding this unique kind of asset. Hopefully, this article has given some insight into the complexities involved when dealing with Employee Stock Options and Divorce.
Charles F. Vuotto, Jr., Esq. is a family law attorney in New Jersey.