Stock Options & Child Support: What You Need to Know
Stock Options as “Income” for Purposes of Child Support
Executive Editor, Divorce Litigation
This article is used by permission of the author.
The determination of income drives the child support calculation. Every possible source of funds is considered in the calculation. Last month, we examined “hidden sources of income” that are often overlooked, but are nevertheless considered income for purposes of child support. This month, we’ll turn to a form of compensation that is becoming increasingly popular: stock options.
WHAT ARE STOCK OPTIONS?
In recent years, stock options have become an increasingly popular benefit at all tiers of the corporate employment ladder. Yesterday’s file clerk in an internet start-up company is tomorrow’s millionaire because of stock options.
Stock options are the ability to purchase a specified number of shares of stock at today’s price at sometime in the future. The date on which the stock option may be exercised is the date of vesting. Thus, if today the price of a share of stock is $10, and on the date of vesting the price of a share of stock is $20, then the employee who exercises his option to purchase has instantly made $10 profit.
Brett R. Turner, in Equitable Distribution of Property § 6.15 at 381 (2d ed. 1994), described stock options thus:
Another type of employee benefit frequently involved in divorce cases is stock options. Stock options give the employee the right to purchase stock in the employer at a price less than fair market value. Frequently, options are restricted so they cannot be exercised immediately upon receipt. Instead, the employee must remain with the company for a minimum amount of time before the options vest. The purpose of the restriction, obviously, is to encourage the employee to continue working for the employer.
Employees like this form of compensation because in today’s stock market, it affords the ability to make a lot of money. The only thing the employee loses is compensation he gave up in order to receive the option, such as more salary or a bonus. Most employees don’t miss what they don’t see.
THE INCOME REALIZED FROM EXERCISING STOCK OPTIONS ARE CAPITAL GAINS, AND THUS INCOME TO THE EXTENT THAT CAPITAL GAINS ARE INCOME
When a stock option is exercised, as in the scenario above, the employee has realized a capital gain. To the extent that the capital gain is recognized as “income” under the child support guidelines, then the profit realized on the exercise of the stock options will be considered income. Capital gains are considered income when they are recurring; when they are a one-time event, they are not considered. The same rule is followed for stock options. Compare In re Marriage of Campbell, 905 P.2d 783 (Colo. Ct. App.1995) (exercise of stock options was income); Goold v. Goold, 11 Conn. App. 268, 527 A.2d 696 (1987) (exercise of stock options was income), with Yost v. Unanue, 109 Ohio App. 3d 294, 671 N.E.2d 1372 (1996) (exercise of stock options was not income because it was a one-time event).
THE POSSIBLE INCOME REALIZED FROM UNEXERCISED STOCK OPTIONS IS INCOME
In a case of first impression, the Ohio Court of Appeals in Murray v. Murray, No. CA98-08-097 (Ohio Ct. App. Feb. 8, 1999), addressed whether unexercised stock options should be included in “gross income” for purposes of determining child support, and if so, how to value the stock options.
Relying on the general principle that the definition of income is intended to be both broad and flexible, the court held that unexercised stock options are to be considered part of gross income. The court specifically analogized the unexercised stock options to retained earnings of a corporation where the parent is the majority shareholder. Williams v. Williams, 74 Ohio App. 3d 838 (1991). In both these instances, the parent should not be allowed to sit upon assets and hide behind the shield of a corporate business decision, depriving the children of an income stream they would otherwise enjoy. As to the value of the unexercised stock options, the court held that the best way to value stock options is to account for the options’ appreciation in value as determined on the grant and exercise dates of the options which fall into the income year at issue. By this method, the options are valued according to the underlying stock price on the date most important to the options’ holder, the date the options may be exercised and income realized.
The Murray case draws upon the long line of authority holding that that retained earnings will be considered “income” to the owner/parent if the parent has the ability or discretion to draw on the funds. Anderson v. Anderson, 60 Ark. App. 221, 963 S.W.2d 604 (1998) (allowing deduction from income for retained earnings of sub-chapter S corporation would encourage shareholders to favor their own long-term financial interests in their corporations over their children’s need for support by keeping most of shareholder income as retained earnings); Merrill v. Merrill, 587 N.E.2d 188 (Ind. Ct. App. 1992) (retained earnings of wholly owned close corporation are income to father); In re Crosser, 24 Fam. L. Rep. (BNA) 1343 (Iowa Ct. App. 3/27/98) (undistributed profits from sub-chapter S corporation is income); Campbell v. Campbell, 682 So.2d 312 (La. Ct. App. 1996) (retained earnings of closely held corporation was income to father, despite bonding company’s restrictions on how much father could take as salary); Roth v. Roth, 406 N.W.2d 77 (Minn. Ct. App. 1987) (profits of sub-S corporation must be attributed to chiropractor, as well as his salary); Morgan v. Ackerman, 964 S.W.2d 865 (Mo. Ct. App. 1998) (funds held by closely held corporation owned 100% by husband had to be considered, since he disregarded corporate structure throughout marriage); Boudreau v. Benitz, 827 S.W.2d 732 (Mo. Ct. App. 1992) (funds labeled as retained earnings were income to father where he had control over funds); Smith v. Smith, 197 A.D.2d 830, 602 N.Y.S.2d 963 (1993) (income for owner of sub-chapter S corporation must be all corporation’s gross receipts, including retained earnings); Barham v. Barham, 487 S.E.2d 774 (N.C. App. 1997) (obligor’s gross income includes sizable cash reserve held by corporation that is required to be deposited it, and is held by, creditor bank); Quamme v. Bellino, 540 N.W.2d 142 (N.D. 1995) (in computing income for self-employed parent, court must take into consideration retained earnings of business); Williams v. Williams, 74 Ohio App. 2d 838, 600 N.E.2d 739 (1991) (income for purposes of support includes retained earnings of corporation); In re Perlenfein, 216 Or. 16, 848 P.2d 604 (1993) (undistributed income of closely held corporation that is attributable to minority stockholder is income for child support); Ochs v. Nelson, 538 N.W.2d 527 (S.D. 1995) (retained earnings of corporation are income to father where he owned 80% of stock); Weis v. Weis, 215 Wis. 2d 135, 572 N.W.2d 123 (Ct. App. 1997) (applying same principals to retained earnings of a partnership); Bailey v. Bailey, 954 P.2d 962 (Wyo. 1998) (father had discretion to, and should have, set salary at $72,000 rather than $42,000 to take advantage of retained earnings); see also In re Marriage of Glueck, 913 S.W.2d 951 (Mo. Ct. App. 1996) (retained earnings should be included in income, where there was no evidence that earnings were not distributed); Rohrer v. Rohrer, 24 Fam. L. Rep. (BNA) 1520 (Pa. Super. Ct. 7/24/98) (retained earnings of corporation, if not considered income, must be considered as asset subject to equitable distribution and asset available for support). Cf., Huger v. Huger, No. 0303-96-3 (Va. Ct. App. 2/18/97) (unpublished) (court would not considered retained earnings of sub-chapter S corporation where could had already considered those same earnings as income to the obligor in the appropriate tax year).
On the other hand, if the parent is a minority owner, or if the retained earnings are essential for the continued existence of the business (as opposed to growth), then the retained earnings need not be considered. McTurner v. McTurner, 649 La. Ct. App. 1994) (trial court not completely erroneous to disregard retained earnings); In re Marriage of Wait (Greenlee), 21 Fam. L. Rep. (BNA) 1529 (Mont. Sup. Ct. 9.8.95) (profits from partnership that were retained by partnership to pay off mortgage debt would not be included in father’s income, where there was no evidence father had choice over use of funds); Roberts v. Wright, 117 N.M. 294, 871 P.2d 390 (Ct. App. 1994) (mother’s corporate earnings would not be considered income where mother reinvested earnings in business); Taylor v. Taylor, 118 N.C. App. 356, 455 S.E.2d 442 (1995) (sub-chapter S income not actually received and used by corporation for reinvestment should not be considered income); Riepenhoff v. Reipenhoff, 64 Ohio App. 3d 135, 580 N.E.2d 846 (1990) (retained earnings held by close corporation should not be considered part of income where obligor owned only 47% of stock and earnings were not available upon his request);Muir v. Muir, 841 P.2d 736 (Utah Ct. App. 1992) (reinvestment to maintain business in present condition would not be considered income; reinvestment to expand business would be considered income). Cf. King v. King, 390 Pa. Super. 568 A.2d 627 (1989) (retained earnings of husband’s partnership would be attributed to husband where evidence was insufficient to establish legitimate need of business to retain and use funds).
CONSIDERING INCOME FROM STOCK OPTIONS IS NOT “DOUBLE DIPPING”
Just because a particular item may be considered “property” for purposes of equitable distribution does not mean that same item cannot be considered “income” for purposes of child support. In the case of child support, there can be no “double dipping,” because the child never received any property in the equitable distribution award. Moreover, the income definition in the child support guidelines includes veterans’ benefits, insurance benefits, workers’ compensation benefits, pensions, annuities, capital gains, lottery or gambling winnings, and prizes or awards, all of which are property interests that may be equitably divided between the spouses.
This principle was stated most recently in In re the Marriage of Hokin, No. 98-3680 (Wisconsin Court of Appeals, October 21, 1999). There, the court stated that it is wholly proper to count as income retirement benefits the spouses receive as part of the equitable distribution award. There is no “double dipping” problem, because as between the parent and the child, the retirement pension is being taken into consideration for the first time; the child is not a party to the distribution award.
That the court may consider the retirement benefits as “income” for purposes of child support while at the same time considering them property for purposes of equitable distribution, and such does not constitute “double dipping,” is amply supported by case law from other jurisdictions. For example, in In re Marriage of Klomps, 286 Ill. App. 3d 710, 676 N.E.2d 686 (1997), the court specifically considered the “double dipping” argument, and held that a military pension, which had been equitable divided between the parties, could and should be considered income for purposes of child support. There can be no “double dipping” when it comes to child support, because the child never “dipped” into the pension for purposes of equitable distribution to begin with. The same result was reached in Loving v. Sterling, 680 A.2d 1030 (D.C. 1996) (support obligor’s veterans’ disability benefits can be treated as “income” for purposes of child support guidelines); Delassio v. Delassio, 409 Mass. 821, 570 N.E.2d 139 (1991); Cook v. Cook, 208 Wis. 2d 166, 560 N.W.2d 246 (1997) (military pension is income for child support, and consideration of such does not constitute double dipping); and Bollig v. Bollig, 919 P.2d 136 (Wyo. 1996) (pension is income for child support and is not double dipping).