What You Need to Know About Dividing Stock Options in Divorce

One of the more difficult items to divide in divorce is a stock option. An option is a specific type of employment benefit in which the employer company gives the employee an option to buy company stock in the future at a discounted or stated fixed price. So rather than simply offering the employee stock as a benefit, they are given the ability to purchase stock at an attractive price at some point in the future. Understandably, valuing and dividing stock options incident to divorce can prove quite challenging.

As an initial matter, it is important not to ignore the fact that a spouse has stock options. Just because this an option isn’t exercisable until the future, it is still often a source of tremendous wealth. If your spouse has stock options you certainly want to take the time to explore if any portion of the options are marital property and subject to division. If you do not know whether or not your spouse has options, be sure to obtain complete discovery showing all of his or her employment benefits.

Options have been a source of astronomical wealth for many people – consider for a Silicon Valley employee who was granted options in a software startup twenty years ago. Although they weren’t handsomely compensated at the time, many of these software engineers were granted options, and as the employer company’s wealth skyrocketed the options rewarded them with a serious payout.

Although the vast majority of North Carolina divorces will not involve Silicon Valley stock options, there are many local startups that may have offered stock options as an employment benefit. Getting full disclosure from your former spouse about each employment benefit is immensely important.

Marital v. Separate Property

If a spouse has unexercised stock options, the first step will be to determine which options, if any, are considered marital. One might assume that any options granted during the marriage are considered marital. However this assumption is not entirely correct. Options are often granted as a reward for past work and as incentive for future work. Granting options is a way for a company to ensure that an employee will stay, even if the company doesn’t have the funds to properly compensate the employee right away.

The concept that the option might have been granted in some capacity as a reward for past work can complicate the analysis of labeling options as marital or separate. Contemplate a situation where a spouse was granted an option after separation. If the option was in some part compensation for work completed during the marriage, at least a portion of the option would be considered marital. Similarly, if an option was granted shortly after marriage, for work done before the marriage, a portion of that option would be considered separate, and not subject to distribution.

In classifying stock options as marital or separate, first it must be determined what the option was granted for. If it was granted for services rendered during the marriage, it is marital. This can often be hard to determine, so be sure that you gain access to the employee handbook, employment contract, and all other documents that give insight into whether the option was granted for past work or for future work.

Vested v. Unvested Options 

In addition to determining whether the options are separate property or marital property, you will need to consider whether the options are vested or not. The vesting period refers to the amount of time an employee has to wait before he is able to exercise an option. For instance, an option may have been granted to an employee in 2005, but may not be exercised until 2015. That option will be considered “unvested” until 2015.

As you can imagine, a vesting schedule will complicate the division of stock options incident to divorce even further. Consider the above example where the option was issued in 2005 but not vested until 2015. Add the fact that the spouses were married in 2003 and separate in 2012? Can the unvested stock options be classified as marital property?

Yes. In North Carolina both vested and non-vested stock options are subject to distribution. So, if a spouse has unvested options those options must still be classified as marital or separate, valued, and divided. In the above example, a portion of the unvested stock options would be subject to distribution.

Valuing the Option

Once it has been determined that the options are marital, a value will have to be attached to them. This too, is a complicated process, and there are several methods that can be used.

The most common method used in North Carolina is known as the “Intrinsic Value Method.” The calculation used under this method subtracts the option strike price from the value of the current stock price, and then multiplies this by the number of options the spouse owns. This option is ideal when dealing with publicly traded stock. There are some detriments to this method, however. Because of the simplicity of the formula, there is no consideration given to the marketability of the shares, the fact that the value could drop before they could be exercised, and the risk that the options would never vest to name a few.

The Black-Scholes model is another approach to placing a value on a stock option. Unlike the Intrinsic Value Method, this model is complicated and typically requires a professional, such as a forensic accountant. This model produces a theoretical estimate of the value based on derivative investment instruments. It considers numerous additional factors, such as the historical price of the stock, the strike price, and the vesting schedule.

Although not a common method to value a stock option, a North Carolina court has held the “coverture fraction,” typically used to value qualifying retirement plans, may be used to value stock options. This formula divides the length of time a spouse was simultaneously married and contributing to the earning of the stock options by the total length of employment during which the options were earned.

A final approach to valuing stock options is to simply reach an agreement. The spouses can simply agree that the value of the marital portion of the options is a certain amount. This method obviously does not require the hiring of a forensic accountant, but it can be risky. If you agree that the marital portion of the assets is worth $50,000, but then later find out that this value is actually way less than the options are truly worth, there is nothing you can do to get your hands on the true value you were owed.

Dividing the Option 

After you have determined that the options are marital, whether or not they have vested, and you have come up with a value to assign to the marital portion, the work is still not over. At this point the way in which the value of the option will actually be distributed to the non-employee spouse will have to be addressed.

The easiest and most common method to divide stock options is to have the employee spouse who owns the option offset the agreed upon value of the option with another asset. For instance, if the option is valued at $100,000, the non-employee spouse is entitled to $50,000. Rather than actually attempting to split the option and potentially trigger adverse tax consequences, the non-employee spouse can agree to take the $50,000 she is owed by accepting another asset. She may prefer to get an the additional $50,000 in a lump sum cash transfer, or take title to a vehicle, jewelry, retirement account or other asset worth a comparable amount.

Sometimes the offset method above doesn’t work, however. Consider a situation where the employee spouse simply does not have an additional $50,000 in cash (or asset of comparable value) to transfer to his former spouse.

The deferred distribution model is a way to work around the aforementioned scenario. This model allows either the court, or the spouses, to decide on a formula that will prescribe how the non-employee spouse will be paid once the employee spouse has exercised the option. This distribution model eliminates the need to agree to a current value and allows for the valuation to be determined once the option is exercised – it is a “wait and see” approach. Essentially, the employee spouse will pay a prorated portion of the benefit to his former spouse once he receives the benefit.

If the deferred distribution model is the chosen method of distributing the value of the options, the non-employee spouse will want to make sure that the agreement prescribing this method of distribution contains language that protects the non-employee spouse. The following provisions are just a few of the many that should be included:

  1. Notice must be given to the non-employee spouse if his employment terminates.
  2. Notice must be given to the non-employee spouse if the employee-spouse exercises any options.
  3. Notice should be given to the non-employment spouse if the employer re-prices the options or grants replacement options.
  4. Notice should be to the non-employment spouse if the employer accelerates the maturity date (vesting schedule) of the options.

Finally, the employee spouse should hold the options in a constructive trust that specifies the process that should be followed when there are newly vested options.

As you may have noticed, actually dividing the ownership, or transferring the option itself to a former spouse is not mentioned as a potential distribution method. This is because the vast majority of employee stock option plans explicitly prohibit the assignment or transfer of rights in the options. Companies usually offer stock options as a benefit to incentive the employee to stay with the company longer, if the employee were able to transfer his right to the options to someone else, this benefit would be lost.

Tax Implications

Stock options that have value will result in the incurring of income taxes as soon as the value is realized. The tax implications will vary depending on what type of option is at issue, how the option is exercised and how much the option is worth. To further complicate the tax issues associated with the division of stock options, tax law is a moving target and may change in the future and the tax burden cannot be transferred to the non-employee spouse, so the employee spouse must be sure to anticipate any potential tax issues in advance.

The tax penalty that will occur when transferring stock options is a function of whether the options are “statutory stock options” (otherwise known as qualified stock options) or “non-statutory stock options” (otherwise known as non-qualified stock options).

The transfer of the latter type of option will result in the income being taxed at the usual rate upon the option being exercised. The employee spouse would be taxed when he or she exercised the option, and the non-employee spouse would be taxed once the shares were sold. These options can be transferred tax-free incident to divorce, and taxes will not be assessed until the option is exercised. Once these options are exercised they will be subject to withholding at the supplemental withholding rate and FICA taxes will be deducted.

Statutory stock options are treated differently, however. When statutory stock options are sold, the resulting consequence is capital gain treatment from the profits acquired when sold. When statutory stock options are transferred, however, they lose their status as statutory stock options and become non-statutory options. Statutory stock options have more favorable tax treatment, so it is advised that the receiving spouse consider ways to obtain the options without executing jeopardizing the favorable tax treatment of qualifying options. It is worth noting, however, that a different result occurs when instead of transferring qualifying stock options, the employee transfers the stock that is acquired once the qualifying option is exercised.

One option is to agree to a monetary value that the options will be worth once exercisable, and simply receive that amount as a lump sum from the other spouse. Another option is to include a provision in the separation agreement or court order expressing that the employee-spouse who owns the options will hold them on behalf of the other spouse. The spouse who is owed the options will have the authority to ask the other spouse to exercise the option at any time per his or her wishes. Because there will be a tax consequence when the options are exercised, the spouses should agree that the receiving spouse only takes the amount left after the tax penalty has been assessed. This transaction would not jeopardize the favorable tax status of qualifying stock.

Obviously, transferring stock options can create quite a headache from a tax standpoint. It is advisable to consult with an attorney or CPA before transferring any stock options so both spouses are fully aware of any tax consequences in advance.

 


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