A stock option is a contractual right to purchase stock during a specified period at a
predetermined price. Increasingly, corporations are granting stock options to employees as compensation for services that have been, or will, be performed. The increasing use of employee stock options has translated into expanding litigation concerning whether stock options are marital property, and if so, how they should be valued and divided
Most states are equitable division states. However, analyzing how community property and equitable distribution work, and the differences, is helpful for parties going through a divorce with stock options. With equitable jurisdiction, to establish how to divide stock options in a divorce, the differences between separate and community (marital) property must first be established. The legal difference between marital and separate property is that separate property is yours and cannot be touched by your future ex-spouse. In the simplest of terms marital property is property you have acquired during the duration of the marriage. Missouri law defines the duration of marital property to be “property acquired by either spouse subsequent to marriage and prior to a decree of legal separation or dissolution of marriage.” This applies to both real property and personal property. A perfect example of this being applied is when Spouse A buys a car before marriage, Spouse B generally has no claim to that asset in a divorce. It should be important to note that Missouri Law assumes that all property is marital until it is proven that the property is not marital. It is also important to note that non marital property cannot be split up to married couples if the intent was not to commingle the separate property into marital property. Under Missouri law, and other equitable division states, there are some important examples of property that will usually be considered separate even if acquired during a marriage.
- A spouse receives a gift even from another spouse
- A spouse inherits an asset from a relative during the marriage
- “Property acquired in exchange for property acquired prior to the marriage or in exchange for property acquired by gift, bequest, devise, or descent”
- Property acquired by a spouse after a decree of legal separation
- Prenuptial agreement stating what is separate and what is marital
- The “increase in value of property acquired prior to the marriage unless marital assets including labor, have contributed to such increases and then only to the extent of such contributions”
In states with community property, community property is generally defined as “all property acquired by the spouses during the marriage belongs not to either spouse individually but to a third entity, marital community.” The fact that the legal title rests within the community; there is no future expectancy, which rests upon divorce or death. The community holds a real legal title interest.
When a divorce or death occurs, the community equally divides the property. Although this community is not an “entity,” the rationale for this equality is deeply embedded in the community. The principle behind this “equality” is that:
“All wealth acquired by the joint efforts of the husband and wife shall be common property… the marriage is a community of which each spouse is a member, equally contributing by his or her industry to its prosperity, and possessing an equal right.”
A jurisdiction that enforces community property law based on “equitable distribution” function in a different manner. In statutorily-mandated equitable distribution of community property, some courts permit a divorce distribution that substantially deviates from an equal split. The basis for an “equitable distribution” is evaluated on case by case basis. There is a possibility that the starting point for an equitable distribution starts with equal division, however, a divorce court has a discretion concerning such matter.
In Toth v. Toth, a husband took $140,000 of his separate property and purchased a home in a retirement community for the couple to live. The title was under both their names in joint tenancy with right of survivorship. A month after the marriage, the husband filed an annulment. There was only one possible community asset: the home. His former wife sought 50% of its worth. The trial court noted the parties differing ages, needs, health, and income, etc. and concluded that she is only entitled to $15,000. The former wife appealed, and the court concluded that a 50/50 split was justified only in the event of fraud. The Arizona Supreme Court affirmed the trial court’s decision, and stated that the legislature’s use of the word “equitable” rather than the word “equal” signaled the legislature’s desire to give divorce courts authority to decide in each case what constitutes an equitable distribution. The court said that, “equitable means just that it is a concept of fairness dependent upon the facts of particular cases.” Although the former wife did not engage in marital misconduct, she failed to contribute to the asset or to the community. In this case, equal is not equitable.
In In re Marriage of Flower, a husband changed the title in his home to community property with right of survivorship shortly after marrying. They lived in that house for about six months, until moving to the wife’s house (no title change). After a year of marriage, the husband filed for divorce. The trial court granted the husband the entire community property, and the wife appealed. Arizona Court of Appeals affirmed trial court’s decision. Citing Toth, the Arizona Court of Appeals said that the word “equitable” in the divorce distribution statute required trials courts to consider “fairness on a case-by-case basis rather than relying upon per se rules.” A divorce court has a wide discretion to consider not only the source of the funds use to purchase or improve assets in questions, but also any factor that has bearing on equitable division of marital property. Here, the wife’s lack of contribution to marital property, along with “a relatively short” marriage, justified the unequal distribution in favor of husband.” This case shows how much discretion trial courts have concerning decisions about “equitable division of community assets.”
In Kelly v. Kelly, the husband and wife had both worked for the federal government. A portion of the wife’s retirement was paid out through social security, while the husband was enrolled in the Civil Service Retirement System, which does not include social security, and would actually reduce his CSRS benefits if he ever received social security payments. Husband challenged the trial court’s decision that characterized his retirement plan as community property while classifying much of his wife’s plan as separate property. The Supreme Court of Arizona affirmed decision classifying much of wife’s retirement plan as separate property. Provision 42 U.S.C. § 407(a) has generally been interpreted to prevent social security from being divided by state courts at divorce. However, courts are able to treat CSRS benefits as marital or community property Court then employed Toth’s expansive interpretation of equitable distribution, and stated, “equitable means just that-it is a concept of fairness dependent upon the facts of particular cases.” Here, the husband was actually getting more than 50/50, which was justified since the wife had generated less to the community.
In Shafer v. Shafer, the trial court awarded Husband 94% of the marital assets. Wife requested the division the trial court entered, but had also requested a cash equalization payment. No equalization payment was ordered. The parties were married nine years. Wife was disabled and could not support herself. Husband contributed to the house the parties lived in, but refinanced and payments were made during the marriage. Husband acknowledged that Wife bought groceries and cleaned the house. One instance of physical abuse occurred between the parties on the day they separated. No evidence of added burdens to either party as a result was presented. The Court reversed, finding that the factors under § 452.330 did not favor the trial court’s judgment. The case was remanded for a just and equitable division of property.
On the other hand, in Plager v. Plager, the trial court did not err in awarding Husband 22% of the marital assets where the parties had relatively equal earning power, and Wife had contributed $44,000 of her non-marital funds to the purchase of the marital residence. The Court also found persuasive that though Husband lived in the marital home during the year of separation, he did not make mortgage payments, and the house was lost in foreclosure. Wife also contributed both parties’ marital vehicles. This same analysis supported the division of debt.
Toth, Flower, Kelly, Shafer and Plager show that courts may depart from a 50/50 split of the community worth by considering many different factors that include contribution and need. Contribution and need are both important concepts that are employed by divorce courts in common law equitable-distribution jurisdictions to arrive at a division of the marital assets and liabilities. Ultimately, however, little guidance is offered regarding how and when to consider need, contribution, and other factors.
Vested vs. Unvested Options and Vesting Date
A stock option is a contractual right to purchase stock during a specified period at a predetermined price. Increasingly, corporations are granting stock options to employees as compensation for services that have been, or will, be performed. The increasing use of employee stock options has translated into expanding litigation concerning whether stock options are marital property, and if so, how they should be valued and divided.
In evaluating whether an employee stock option constitutes a “property” interest, the standard is whether it is “vested.” A non-vested stock option is treated as a mere expectancy because the holder has no enforceable rights. Therefore, non-vested stock options are not “property” and are not subject to division, even though the ability to exercise the option is contingent on passage of time or continued employment. So long as the employer cannot unilaterally repudiate the option, it should be deemed “vested” and, therefore, “property” in divorce law. When the option-holder has the absolute right to exercise the option at any time by payment of the option price (or strike price), the option is said to be both “vested” and matured. Once an option is determined to be “vested,” and therefore a “property” interest, the next step is to classify that interest as either marital or separate property. On the other hand, an employee stock option granted in consideration of future services does not constitute marital property until the employee has performed those future services. Whether an employee stock option is characterized as being granted in consideration of past or future services depends upon the circumstances surrounding the grant and the effect of the option agreement. The determination may depend upon such factors as the flexibility and variety of option plans as well as the size of the company and its need to offer incentives to employees to remain as employees of the company. Options may be awarded as an inducement to lure an executive to a company.
Options are also an effective tool to provide incentives to an employee to stay with a company, especially in the competitive high technology industry. Options granted during a term of employment may be a reward or bonus for work well-done (i.e., for past services) or as “golden handcuffs” to keep an employee from accepting a lucrative offer elsewhere (i.e., for future services).
ISOs (Incentive Stock Options) vs. NSOs (Non-Qualified Stock Options)
The most common types of compensations when talking about stock options in shares of a company are Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO). It is important to note that you will not see an ISO as much anymore because of the taxation implications to employers. An ISO is a type of stock option where the options are taxed at a capital gains rate. It is not necessary to pay ordinary income tax on the difference between the grant price and the price you exercise the option. An NSO is a stock option where you pay “ordinary income tax on the difference between the grant price and the price at which you exercise the option” The NSO is simpler and more common than ISOs. They are called “Non-Qualified because they do not meet certain requirements of the Internal Revenue Code to be qualified as ISOs.
There are a couple things to emphasize when talking about ISOs and NSOs. The first is the overall structure of both option plans. The terms of an ISO plan is that it must be in writing which shows an “aggregate number of shares to be issued under options and class of employees eligible to receive options.” Additionally, the ISO plan must include number of shares “reserved for issuance” and it must be approved by the employer. An NSO has none of these restrictions. Second, the people who can acquire an ISO plan are only employees from employer. It is important to emphasize that the employee has to be employed on the date of the option to purchase the stock.
Additionally, determination of whether an employee is considered an employee depends on if the employer treats that person as an employee for tax purposes. NSO stock options are not limited to employees these can be granted to others such as “consultants, directors, and other people of that nature.” Next, the ISO plan has a 10 year time period for granting options after the plan is adopted or approved by stockholders, and NSO plans have no such limitations. The duration of the options for an ISO is dependent upon how much stock of the company you own. If you own less than 10% the options must be exercised within 10 years of the date granted. For 10% or greater, the option must be exercised within 5 years of the date granted. It is also important to note that the option “may not remain outstanding beyond three months” if the employee is terminated. Just like the other factors an NSO has none of these limitations. On ISO plans, the employee cannot exercise more than $100,000 of options a year. Any options in excess of that will be treated as NSOs, and NSOs have no limitations like ISOs do in this sense. The option is again dependent on how much you own in the company. For less than ten percent stockholders the option price must be “at least equal to the fair market value of the stock on the date the option is granted.” For 10 percent or more stockholders option prices must be at least 110% of the fair market value “on the date the option is granted. It should be noted that fair market value should be determined in good faith. A benefit of NSOs is the stock option prices can be granted at less than fair market value on the day it is granted. Vesting schedules for both are the same in that they can be permitted and can be based on time or completion of certain milestones or “objectives.”
The last and perhaps the most important is that ISOs are not subject to the “valuation requirements” of Internal Revenue Code (IRC) § 409A. Section 409A “applies to compensation that workers earn in one year, but that is paid in a future year.” NSOs has to strictly adhere to this regulation which for many companies can be expensive because of independent appraisals that are required for the NSO. ISOs does only have to be evaluated in good faith by the board of directors. There is a tradeoff for this because ISOs are highly regulated and must conform to many requirements under IRC § 422. The requirements are simply summarized from what has already been said:
- The ISO has to be non-transferable with the only exception being a stock option recipient at death.
- A maximum of $100,000 of the stock can be exercised every year. Anything over that and the stocks will be treated as NSOs. This requires a lot of planning to make sure one does not go over the maximum.
- If a stock option is owned by a person who owns more than ten percent of the company then the company must exercise their stock at a premium “over fair market value” which is at least 110 percent.
- ISOs are for employees only.
In both an ISO and NSO, when an employer gives an equity interest to the employee this causes the employee to contribute to the growth and success of the company. However, the “employer’s capital increases to the extent employees pay option price upon exercise of options.” Further, the offset for an employee is that their disposable income will be reduced because that person will be paying option price. There will also be a “dilution of voting rights” for existing stock holders, “dilution of employer’s earnings per share,” which is caused by an “increase in the number of shares outstanding after options are exercised.” The NSO is essentially the same, however, disposable income will be reduced more than an ISO because of the employee’s compensation equal to the amount “by which the fair market value of the stock exceeds the option price.” There will be a “double dilution of employer’s earnings” per share because of a charge against earnings. (Compensation expense which is charged against employer’s earning equal to the fair market value of the stock, measured on first day for which both the number of shares to be issued to the employee and the exercise price are known, exceeds the option price).
Restricted stock is shares of company stock given to an employee as either compensation for past performance or incentive for future performance. It is important to emphasize that getting the actual grant documents to know which the case is for your client is important. This makes a huge difference in determining how many shares are marital properties. Although there are some exceptions restricted stock is almost always given to executives who have insider knowledge of the company. Restricted stock has become more popular since the mid 2000s. Restricted stock comes in two forms: Restricted stock awards (RSAs) and restricted stock units (RSUs). Restricted stock awards are those that the employee receives in his own personal account; the numbers of shares are outlined in the restricted stock agreement. RSUs are simply a promise to deliver stock at a later date the amount of units represents how much stock is in each unit. Restricted stock has less risk than options and is rarely worthless. Marital portions can be quite difficult to come up with because of factors like: award dates, vesting schedules, and dates of marriage/separation.
Valuation Methods and Issues
One approach to assigning a value on stock options is to determine its intrinsic value, which is simply the market value of the stock, less the exercise cost of the option and any applicable financing costs. Courts and experts have also used more complicated mathematical formulae to determine a stock option’s present value. Two main types of models exist: econometric and theoretical. Econometric models, or empirical models, use “regression analysis of historical relationships among economic variables to estimate statistically the expected value of an economic variable,” in this case, the expected value of stock options.
The two most widely used econometric models to value stock options are the Shelton Model and the Kassouf Model. The Shelton model is especially useful for valuing stock options of closely held companies. Most models use a variable known as the volatility factor, which quantifies the historical fluctuations of the stock’s price. The Shelton model does not use this variable. The information needed to determine the volatility factor is often not available when dealing with options issued by closely-held companies. Use of the Shelton model in this situation eliminates the need for the costly analysis, or outright speculation, which would be necessary to compute a volatility factor for the stock of closely-held companies. Theoretical models, or statistical models, rather than being based on historical observation, “are forward looking and attempt to determine what the option should sell for in the market given the option terms and the underlying stock’s salient characteristics.”
These models are based on a number of assumptions, one essential assumption being “that the price of the underlying stock behaves in such a way that possible future prices can be accurately modeled by some probability distribution.” The other assumptions vary from model to model. The best known and most widely used, of the theoretical models is the Black-Scholes Model. Computer programs using the Black-Scholes Model are readily available. The Black Scholes Model accounts for the option price, the term of the option, the market value of the underlying security, a risk-free rate of return, and the underlying volatility of the stock option, in order to come up with a present value for the option. When using any of these approaches to value employee stock options, it is important to note that these models were generally designed to value marketable options. Usually, employee stock options are non-marketable, and a discount for lack of marketability should be utilized. Furthermore, valuation should not rely on use of only one model. Using at least two models will help to ensure that the valuation is relatively accurate. The practitioner should bear in mind that, if the circumstances do not warrant an immediate distribution because there are either insufficient assets to permit an offset or the present value is too difficult to ascertain, the trial court may use either the deferred distribution or reserve jurisdiction method.
The Taxable Event
A taxable event refers to any event or transaction those results in a tax consequence for the party who executes the transaction. There are certain types of tax effects on ISOs, NSOs, and Restricted Stock. With regards to the employee and non-employee spouses for ISOs and NSOs there are two dates to remember for tax purposes: when the option is granted and when the option is exercised. When the option is granted to the employee there are no tax implications for both with one exception for an NSO. That is when an option has “readily ascertainable value” so companies that are privately owned do not have this readily ascertainable value. When an option is exercised for an ISO there is readily ascertainable value “under regular computation of Federal income tax.” The amount which fair market value of “stock on the date the option is exercised exceeds the option price is included in alternative minimum taxable income in year of exercise.” Additionally, deductions of interest “incurred on money borrowed to acquire stock through exercise of option” are limited by the rules of interest deduction. In an NSO unless the stock is restricted the amount of the fair market value of the stock on the exercise date exceeds the option price is “taxable as compensation, at ordinary income rates.” It is also important to look at if the stock options have been disposed and both plans have distinct ways of handling these situations.
In an ISO, if the fair market value of the stock on the disposal date exceeds the option price then that is taxable. However, if the holding period, which is “2 years after the date the option is granted and 1 year after the date the option is exercised” has been satisfied, if disposition is because of death, or insolvency the amount will be taxable as capital gain. If disposition is premature, “the amount by which the fair market value of the stock on the date of exercise exceeds the option price will be taxable as ordinary income.” Any additional gain that the employee may have had will be taxed as either long or short term gain. If this is premature disposition of the stocks then “any tax paid on alternative minimum tax preference item when option was exercised may be a credit against ordinary income tax in the year the stock is disposed.” When talking about tax consequences for disposing stock options that are simpler. This is simply taxed as capital gain when the “fair market value of the stock on the date is disposed and it exceeds the fair market value of the stock on the date it was acquired through the exercise of the option.”
The tax consequences to employers are a little more straightforward for each of these stock option plans. For the ISO there are no tax deductions unless the employee disposes the stock option before the holding period is up. If a premature disposition occurs “the deduction will be equal to the amount employee recognizes as ordinary income.” For the NSO, employers are allowed to take deductions that are “equal to the amount of income which employee recognizes when exercising stock options.” This is conditional upon the employer following employment tax and withholding guidelines.
Restricted Stock is a little bit more complicated because restricted stock and RSUs are taxed differently. Restricted stock usually becomes taxable upon the completion of the stock’s vesting schedule. For restricted stock plans, the entire vested stock must go towards the ordinary income the year the stock vests. The amount that must be declared is found by “subtracting the original purchase or exercise price of the stock (which may be zero) from the fair market value of the stock as of the date that the stock becomes fully vested.” It is crucial that the difference be reported by the shareholder as ordinary income. It is also important to note that if the shareholder does not sell the stock at the vesting date and instead sells at a later date the difference between “the sales price and the fair market value on the date of vesting is reported as a capital gain or loss.”
Additionally, if shareholders of restricted stock would like to report the fair market value of their shares as ordinary income on the date that they are granted instead of when the restricted stock is vested they can choose to do so. However, the capital gains treatment will still be applicable in this situation and begins at the time of the grant. This move can reduce the amount of taxes that are upon this type of plan because stock prices at the granting period are usually much lower than when the stock vests. This strategy is the most useful when there are extended periods of time between the granting dates and the vesting date, usually five years or more.
The taxation of RSUs is a lot less complicated and more direct than restricted stock plans. Since there is no actual stock issued at the granting date, no IRC § 83(b) election is going to be implemented. This means that there is only one declaration date. The amount reported will “equal the fair market value of the stock on the date of vesting, which is also the date of delivery in this case.” This therefore means that the stock value will be reported as ordinary income in the year the stock vests.
Dividing Stock Options Formulas: Hug v. Harrison v. Nelson
There are a couple of methods for dividing stock options in cases. The first is the Hug Formula which was established In re Marriage of Hug. In Hug, the two parties were separated, and the stock options were exercised only after the two parties were separated. Under the Hug formula, the number of options found to be marital property is the product of dividing: the “total months between commencement of employment and the date of separation” over the total months between the commencement of employment and the date when each option vested.” This amount is multiplied by “the number of shares of stock which could be purchased on the date each option vested.” In Hug, the court found that stock options could be given for compensation for “past, present, and or future services” or it could be a combination of these. The court in Hug held that the stock options were “granted in part to entice the husband to leave his prior job and in part as an incentive to work hard in the future.” The Court found that the husband was earning the options from the date his employment started to the date the options vested.
The Harrison Formula equates the months between date of grant and date of separation over the months between date of grant and date that the stock fully vested and not subject to disinvestment. In Harrison, the employee had obtained incentivized stock options through his employer. The stock options were given by the employer to retain employees. This gave the employee the right to buy his employer’s stock in increments of twenty-five percent on specified dates over a period of four years. The employee’s stock contained options, such as forfeiture of the stock if the employee was terminated or left voluntarily without the employer’s consent. The employee’s spouse was concerned after separation the value of the stock that was under the employee’s control, since the employee controlled the options the spouse feared that she could lose value in the stock by his option to forfeiture his interests. The court used its discretion to allocate the employee-spouse’s stock options between community and separate property. The stock options did not unconditionally vest until after the date of separation and were therefore deemed primarily an incentive for future services.
However, when the Nelson formula is applied it tends to favor more separate property than marital property. The Nelson formula uses the equation: number of months from the date of grant of each block of options to the date of separation over the period from the time of each grant to its date of exercisability. In Nelson, the court recognized that the options in Hug “were designed to attract new employees and more generously reward past services.” However, in Nelson, “only prospective increases in the value of the stock could result in a profit to the employee option holder.” The Court therefore determined that it should place more emphasis on the period following the grant to the date of separation than on the employee’s entire tenure with the company up to the time of separation.
Transfer Taxes and Reporting Tips
The transfer taxes of stock options and the reporting of those options are relatively straight forward. As ISOs cannot be transferred the main focus are those of NSOs. The IRS released Revenue Ruling 2002-22 which addresses the issue of transfer of taxes. Section § 1041(a) of the IRC provides that “no gain or loss is recognized on a transfer of property from an individual to or for benefit of a spouse or, if the transfer is incident to divorce, a former spouse.” Section § 1041 (b) additionally provides that the “property transferred is generally treated as acquired by the transferee by gift and that the transferee’s basis in the property is the adjusted bases of the transferor.” Section § 1041 was originally put in place to reverse a Supreme Court decision in United States v. Davis. In that case the Court found that the transfer of property to a (former) spouse in exchange for the release of certain “marital claims” was considered a taxable event. This resulted in the former spouse recognizing gain or losses to the transfer. Congress’s hope for this statute was to eliminate differing federal tax treatment amongst community property states and non-community property states.
Additionally, the term property in IRC § 1041 is not defined in 1041, but the IRS has concluded congress intended IRC § 1041 to apply broadly to transfers of many types of property which includes stock options.
Under IRC § 1041, transfer is considered to be incident to divorce if it occurs within one year of the entry of the divorce judgment or if it is related to the cessation of marriage. Temporary Treasury regulations 1.1041-IT(b) creates a presumption that a transfer is related to cessation of the marriage if made pursuant to a divorce or written separation agreement within 6 years of entry of divorce judgment. If the transfer is more than 6 years after entry of judgment it is presumed to be related to the cessation of the marriage. This presumption, however, can be rebutted by showing transfer was made to effect the division of property owned by the spouses at the time of cessation, that factors happened earlier transfer of the property, and that the transfer was made promptly after the impediment was removed.
Having concluded that IRC § 1041 provides non-recognition treatment to the divorce transfers, the IRS then had to figure out who pays the taxes on the property that is being transferred between divorce couples. The big issue, however, is whether the income derived from transferred property and paid to the transferee is taxed to the transferee or transferor. This is where the Assignment of Income Doctrine comes into play.
The doctrine states that “income is ordinarily taxed to the person who earns it, and that the incidence of income taxation may not be shifted by anticipatory assignments.” Courts and the IRS have long recognized that this doctrine does not apply to every transfer of future income rights. However, the intent of IRC § 1041 led the IRS to come to the conclusion that by applying the assignment of income doctrine in these types of divorce cases to tax the transferor spouse when the transferee spouse receives the income from the property transferred in a divorce would contradict the purpose of IRC § 1041. The IRS additionally recognized that substantial burdens would be put on the transferor spouse in marital property settlements if the transferor spouse were to recognize “taxable income upon receipt of funds by their former spouse.” The IRS concluded that the assignment of income doctrine would be inappropriate in the context of property transfers during divorce.
There are a couple of specific provisions that govern non-statutory stock options. IRC § 83(a) provides in general that “if property is transferred to any person in connection with the performance of services, the excess of the fair market value of the property over the amount, if any, paid for property is included in gross income of the person performing the services in the first taxable year in which the rights of the person having the beneficial interest in such a property are transferrable or are not subject to a substantial risk of forfeiture whichever is applicable.”
In the case of NSOs that do not have a readily ascertainable fair market value at date of the grant IRC § 83 does not apply to the grant of the option. However, it does apply to property received upon exercise of the option or to any money or other property received in an arm’s length disposition of the option. Although a transfer of NSOs in connection with a marital property settlement may involve an arm’s length exchange for money, property, or other valuable consideration it would contravene the gift treatment proscribed in IRC § 1041to include the value of the consideration in the transferor’s income under IRC § 83. Accordingly, the IRS concluded that transfers of NSOs between divorcing spouses are entitled to no recognition treatment under § 1041. Based on the intent of 1041, the IRS determined that this result will be the same in both community property and non-community property states. The same treatment also results when a statutory stock option is transferred contrary to its terms, causing it to become non statutory.
Revenue Ruling 2002-22 ultimately held two things: taxpayers who transfer interests in non-statutory stock options to the taxpayer’s former spouse incident to divorce is not required to include an amount in gross income upon the transfer and the former spouse, and the taxpayer is not required to include an amount in gross income when the former spouse exercises the stock options.
There are a couple of reporting tips for both ISOs and NSOs that people should be mindful of. When an ISO is exercised, there will usually not be any tax consequences. However be mindful that a form 6251 will have to be used to determine if any alternative minimum tax (AMT) will be owed. AMT can be calculated by “computing taxable income eliminating or reducing certain exclusions and deductions, and taking into account differences with respect to when certain items are taken into account in computing regular taxable income and alternative minimum taxable income; subtracting the AMT exemption amount; multiplying the amount computed in the last step by the appropriate AMT tax rates; and subtracting the AMT foreign tax credit.
In an NSO you are liable for ordinary income tax on difference between price paid and current fair market value. The employer will also report the amount of your income on line 1 of the W-2 report since you exercised that option through your employer. This will be included when you file tax returns.
When selling stock there may be additional things you have to report. If you acquire a stock by exercising an option and then sell it at a higher price you have taxable gain. If the holding period is satisfied (keeping stock for 1 year after exercising option or 2 years after grant date of option) this will be reported as long-term capital gain. Any long-term capital gain will be reported on schedule D of a 1040 form. If the holding period is not satisfied then it is considered short-term capital gain and will be taxed as ordinary income. Short-term capital gain goes in Box 1 of W2 as ordinary income and should file it as wages on line 7 of a 1040 form.
There are additionally a couple of forms to keep an eye on when reporting stock options on tax. If any stock units were sold this should be put on W-2. Review box 12 and 14 “list any income included on form W-2 related to your employee stock options.” Additionally, a 1099-B form will be received in the year to sell stock units. It is important to review investments to make sure that the cost basis amount (CBA) is accurate. CBA is the “original value of an asset for tax purpose usually purchase price adjusted for stock splits, dividends and return of capital distributions.” It is imperative to still calculate and report the cost basis on your tax return.
3921 and 3922 forms are also important to keep track of. A form 3921 is issued when an ISO is transferred to the employee while 3922 is issued when the stock option is purchased but did not sell. Form 3921 includes information to properly report the sale of the units when a party want to do so. It is important to save this with your investment records. However, until somebody sells the units, one does not have to enter information from this form into a tax return. “Form 3922 is issued to report the income on your tax return when you sell units.” It is important to save this form with investment records. In this case since a party has not sold the stock and “the holding periods have not been determined.” The employer does not include this as compensation income on the W-2 as ordinary income.
Distributing the Options
The net present value approach results in immediate distribution to the nonemployee spouse. A lump sum that represents the net present value of the future benefit is determined and may be offset by the value of other property in the marital estate. If using this method, the trial court, guided by actuarial data, values the future benefit, considers a number of different factors, including certain risks, and accords a present value to the future benefit. The benefits associated with immediate distribution are compelling in those instances where the value of the stock options is minimal relative to the overall marital estate. The non-employee spouse exchanges future contingent post-dissolution enhancements for the benefits of immediate distribution, while the employee spouse reaps the benefit of potential enhancements that may occur post-dissolution. If the employee spouse foresees that the options may dramatically increase after the divorce, that spouse will want to “cash out” the non-employee spouse. The “Net Present Value” method serves the goal of finality and allows the parties to disentangle financially, providing some measure of closure. By immediately offsetting the value of the options with other marital property, the policy of judicial efficiency is served because the parties do not have to return to court at a later date. In circumstances where the marital estate is large enough to permit an offset with other marital property, the net present value method should be preferred.
Unlike the net present value method, the deferred distribution and reserve jurisdiction methods do not result in an immediate offset with other marital property. Under these approaches, the non-employee spouse will not receive any benefits until the benefits are actually paid to the employee spouse or the employee spouse becomes eligible to receive benefits. Under the deferred distribution method, the court pre-determines the percentage the non-employee spouse will be eligible to receive once the benefits are paid or the employee spouse is eligible to receive them. The percentage used is commonly based upon the “time rule” formula. The “time rule” formula was explicitly made applicable to the division of stock options in In re Marriage of Balanson.
One commentator has suggested that the time rule fraction should be as follows: Period of Employment During Marriage (numerator) Period of Employment From Hiring Until Vesting (denominator). No Colorado case has expressly determined whether the employee-spouse is required to exercise the options as soon as possible. Most stock options preclude the employee-spouse from transferring or assigning the option so that the trial court would not be able to simply order a division in kind. One solution under the deferred distribution method is to have the court require the employee spouse to make a payment in cash to the non-employee spouse, based upon the predetermined “time rule” formula, as soon as the options are exercisable, whether or not the employee chooses to retain the options. Another alternative is to order the employee spouse to exercise the options and then transfer the underlying stock or sale proceeds to the non-employee spouse. Each of these possible solutions involves potential future court involvement and issues of employer cooperation.
In Colorado, a court may also apply the “reserve jurisdiction” method of dividing stock options. Unlike the deferred distribution method, whereby the court predetermines the non-employee spouse’s share, the reserve jurisdiction approach is effectively a “wait and see” method. If the court reserves jurisdiction, the marital portion of the options may be divided and distributed at a later date when they are exercised.
In In re the Marriage of Chen, the Wisconsin Court of Appeals upheld the use of the “if and when” method. The case concerned stock options that had been granted during the marriage but were not exercisable until dates after the divorce. The options were not transferable or assignable and expired if employment terminated. The trial court found that no reasonably accurate value could be assigned to these stock options, and therefore an award of a fixed sum would not be practical. The court then held that the employee spouse could exercise the options “if and when” he desired, subject only to employer and SEC regulations. Upon sale of the underlying stock acquired via exercising the options, the employee-spouse was to pay the non-employee spouse one half of the net profit. If the stock thus acquired had not been sold within 18 months of the date of exercise, the non-employee spouse could elect to be paid using the stock price 18 months from the date of exercise, or she could choose to wait until the stock was finally sold. If no net profit was made, no additional monies were due either party.
The Maryland Court of Special Appeals, in Green v. Green, approved a similar method of division. Just as in Chen, the employee spouse’s stock options were not assignable and could not be sold. The court found that “although it is true that an unassignable, unsalable option has no fair market value, it is nonetheless an economic resource, comparable to pension benefits, to which a value can be attributed.” The court approved an “if, as, and when” approach to the valuation and equitable allocation of the unexercised options, which applied to both matured and immature options. The trial court was to calculate a value of the options as of the date of the divorce decree. The court could then determine a percentage by which the profits should be divided if, as, and when the options are exercised. The court felt this was equitable as the employee spouse is under no compulsion to exercise his options. At the same time, however, the non-employee spouse’s equitable interest in the options, if exercised, is protected.
In contrast to the Colorado appellate courts, the Illinois Court of Appeals in In Re Marriage of Moody, found that stock options do not constitute property until exercised. It directed the trial court to retain jurisdiction until such time as the options were exercised or expired. If and when the options were exercised, the trial court was permitted to use its discretion in allocating an appropriate share of any profit realized by the employee spouse. This “if and when” approach subsequently withstood an argument that the court should have retained jurisdiction to permit the non-employee spouse to compel the exercise of her share of the options.
In Smith v. Smith, the Missouri Court of Appeals upheld a trial court decree finding that the employee spouse had the right to decide whether or not to exercise his stock options. However, if the employee-spouse elected to exercise any of the options, he was to give the non-employee spouse 30 days’ notice before acting. During those 30 days, the non-employee spouse could provide the employee spouse with the cash necessary to buy a one-half interest in that option on her behalf. If she did not provide him with the cash, she forfeited her right to the one-half of that option. Each party was to pay a share of the income taxes on the options.
The “property” right at issue with regard to stock options is the right to choose whether or not to purchase stock shares which are offered at certain dates at specified prices. To divide this marital asset properly requires giving each spouse the right to choose whether or not to exercise the right to purchase the underlying stock. Because employee stock options are typically not assignable, and because division in kind is therefore not permissible, courts have developed alternative mechanisms to accomplish division. The “net present value” method of dividing stock options is the preferable method where the stock and the options are readily capable of valuation. In situations where the options are not capable of valuation, the deferred distribution or reserve jurisdiction methods more equitably serve to divide the options. Reserving jurisdiction to divide the options should be the last resort, since the goal of finality is contravened when parties will inevitably need to return to court to value and divide the options. Under most circumstances, the time-rule formula can pre-determine the non-employee spouse’s share when options become exercisable and therefore is preferable to reserving jurisdiction.
Simple Stock Options Hypothetical
Case law can be a good source of analyzing scenarios. In Smith v. Smith, Husband alleged the trial court erred in dividing the marital property when it inter alia awarded wife one-half of several stock options that were received as employment benefits because some of the stock options were not vested and by failing to sever the stock options. Wife also alleged the trial court erred in dividing the marital property when it inter alia failed to sever the stock options. Husband was involved in The Anheuser-Busch Companies, Inc. 1981 Incentive Option Plan, and also the Anheuser-Busch Companies, Inc. 1981 Non-Qualified Stock Option Plan. The plans contained the following options:
|Currently Exercisable Options|
|Future Options Available|
At the time of trial, only two options were exercisable, while the rest matured at various dates in the future. In order for Husband to exercise the option, Husband had to be employed by Anheuser-Busch on the option date. The trial court found that the options were marital property and one-half was to be given to each party. In the event that Husband exercised his option, he was to give Wife notice thirty days’ notice. Wife then had thirty days to provide Husband with cash to purchase a one-half interest in that option on her behalf and failure to provide the cash would forfeit her right to that option. For example, if Husband were still employed with Anheuser-Busch and was to exercise his option on December 23, 1985, to purchase 750 shares at a cost of $64.75, Wife would have to give Husband $24, 281.25 in order to assert her right in that option. Once Husband acquired the stock, Wife would receive her one-half interest in the property. Husband alleged that the future options which were not exercisable at the time of trial were not to be considered marital property. Husband asserted the future options were contingent upon his continued employment with Anheuser-Busch and therefore, the stock options were not vested and thus, his own separate property. Husband would be correct if it were a pension plan which is earned over the period of employment, however a stock option plan is already earned. The Court of Appeals found that because the property rights here were “contingent upon future conditions and events” the trial court provided a “plausible solution to the division of the stock options.” Furthermore, the contingency that Husband would leave his employ with Anheuser-Busch was planned for by the decree “which provide[d] for no distribution until such time as husband acquire[d] the stock.”
However, some other things to think about in hypothetical situations are as follows:
- In many cases, a set-off might be a possibility. In other words, after the value of stock options is ascertained by an expert witness, like a forensic accountant, the stock options can often be offset against other marital assets in the property division aspect of a divorce. Utilizing a setoff can sometimes do away with the headaches of having to divide the stock options.
- It is vital that a lawyer be competent and diligent when dealing with stock options. Thus, does your discovery (interrogatories and requests for production) ask about stock options and require that all documentation be turned over? If not, you will want to tweak your discovery in cases to request this information. Otherwise, your client will not have the information to make an informed decision.
- In some cases, you may need to subpoena the opposing party’s employer for information related to stock options when you cannot get it through a request for production. Employers often have materials and information about their stock option plans that a lawyer will need to obtain in order to advice their client appropriately.
- A deposition of the opposing party or the employer is another option to consider when you still do not have enough information.
Steven Buchwald, Stock Option: The Differences Between an ISO and an NSO, BUCHWALD & ASSOCIATES (October 20,2016), https://buchwaldlaw.com/2016/10/stock-option-the-differences-between-an-iso-and-an-nso.
William H. Schmidt and Amy L. Green, Tax Consequences Related To The Transfer of Stock Options In A Divorce, MASS BAR (July, 2014). https://www.massbar.org/publications/lawyers-journal/lawyers-journal-article/lawyers-journal-2014-july/tax-consequences-related-to-the-transfer-of-stock-options-in-a-divorce.
Davidson v. Davidson, 254 Neb. 656, 578 N.W.2d 848 (1998); see also, Wendt v. Wendt, 1998 WL 161165 (Conn. Sup. Ct. 1997); Murray v. Murray, 128 Ohio.App.3d 662, 716 N.E.2d 288 (1999), citing, Chammah v. Chammah, 1997 WL 414404 (Conn. Sup. Ct. 1997).
Katherine Jane French, The Difference Between the Hug and Nelson Formulas as Applied to Intermediate Stock Options, Avvo (Jul. 16, 2013), https://www.avvo.com/legal-guides/ugc/the-difference-between-the-hug-and-nelson-formulas-as-applied-to-intermediate-stock-optionsrsus
Nancy A. Garris and Jack Cochran, Transfers of Property Between Spouses or Incident to Divorce, 21 MOPRAC § 9:8(2019).
Andrew Littman, Valuation and Division of Employee Stock Options in Divorce, Stevens, Littman, Biddison, Tharp & Weinberg, LLC, (March 10, 2015), http://www.slblaw.com/2015/03/10/valuation-and-division-of-employee-stock-options-in-divorce/