Splitting stock options in a divorce

In recent months, many otherwise reputable corporations have made the news for "backdating" various stock option grants to maximise value to the recipients while minimizing costs to the issuing company. At least 150 companies are under investigation, and so far, more than two dozen executives have resigned their posts.

Among them: Bruce E. Karatz, the chief executive of KB Home, Andrew J McKelvey, the founder of Monster Worldwide, which runs Monster.com; and Edward Y. Snowden, chief executive of Boston Communications Group.

As this story of stock option greed unwinds in the financial pages, consider how often stock options create difficulty and even litigation for otherwise well-meaning, peaceable couples who decide to part ways.

Unlike the IRA or the Porsche--assets that are easy to identify, value and transfer upon divorce--unexercised stock options granted during a marriage, or even immediately after a marriage ends, can be the source of headaches, not only for the divorcing parties themselves but, in some cases, even for the companies granting those options.

Historically, stock options (contracts to purchase an amount of stock within a certain period of time, for a specified sum of dollars per share) were granted to "key" (read: important) employees as additional compensation for past performance and present diligence, and as an incentive for future work and loyalty. Stock options are a particularly effective way to keep employees happy when a company doesn't have sufficient cash to properly compensate them, or to ensure their commitment, at least till the options vest.

As any Silicon Valley software engineer from the early 1990s could tell you now -- from his helicopter, perched aboard his multimillion-dollar yacht in the Riviera--stock options "in the money" (i.e., shares worth more when exercised than when granted) can make you very, very wealthy if you remain with the company long enough to for them to be "exercisable." Therefore, as a divorcing spouse, you should have a keen interest in receiving your rightful share of these spiffy, if somewhat esoteric, assets.

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All states consider "vested" stock options (belonging to the employee and subject to forfeiture only upon expiration) property subject to distribution in divorce. These options are not too difficult to deal with, especially if the shares are publicly traded.

Moreover, most states regard non-vested stock options as property too. There are, however, a minority of states that currently prohibit the distribution of non-vested options in a divorce case. So, it's important to check with a lawyer to determine your state's position on this vesting/non-vesting matter.

Plus, even if your state does allow for the distribution of contingent options, the question of whether the options are marital comes into play, particularly if it's clear from the timing of the stock option grant that at least a portion of it was meant not to reward past or present (read: marital or community) service to the company but, rather, to secure future service to the company--service that will occur long after the divorce.

So what's a nonemployee spouse to do? First, obtain complete discovery regarding all your spouse's employment assets. Carefully review the summary documents and handbooks for all employee stock purchase plans (look out for long-term incentive and supplemental retirement plans, too).

Then, get copies of all employment contracts; stock grants (look for "reload" provisions); Securities and Exchange Commission filings for relevant employment periods; and any other documents, letters or memorandums that touch upon your spouse's employee benefits and compensation.

To confirm the facts, consider working with an experienced forensic accountant who can speak with staff in the human resources department to verify that all employee-granted stock options, deferred plans and executive perks have been disclosed.

Once you know how many unexercised stock options exist, you have to identify them as either statutory stock options (aka incentive stock options, ISOs), options from Employee Stock Purchase Plans (ESPPs, aka "423 plans" for the tax code provision giving them qualified status) or nonqualified stock options, also known as non-statutory options (NSOs).

ISOs are generally awarded to important employees, while options from ESPPs are available to employees of all levels. Both receive favorable tax status. NSOs are more common and may be awarded to nonemployees, but they bear an immediate income tax liability on any price break upon exercise.

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After identifying the ISOs, the ESPPs and the NSOs, your best bet is to have everything valued by a professional using one of many accepted protocols, from the relatively simple "intrinsic method" to the positively arcane Black-Scholes process. After reaching a value that accounts for whether the unexercised stock options are fully marital or not, you can agree to receive an immediate payout from the employee spouse to buy out your "share" of these options.

For example, assume that everyone (i.e., you, your spouse, your respective forensic accountants, attorneys and perhaps a judge) agrees that you are entitled to half of your spouse's aggregate, unexercised marital stock options, and together they have a net present value of $200,000 (considering appropriate discounts for taxes that would be paid and other contingencies, like employment termination, that might have value).

You could choose to receive your share ($100,000) as a cash lump-sum payment at the time of your divorce, or as an offset against another marital asset that you would like to own individually (think country house, brokerage account or CDs).

If you can't agree to a net present value for the unexercised statutory options, then you have two choices: deferred distribution via formula or court retained jurisdiction. Under the deferred distribution model, at the time of your divorce, the court or the couple will come up with an appropriate formula by which you will be paid when your employee spouse exercises "his/her" stock options.

The ratio by which these options will be distributed in the future (known in some jurisdictions as a "time-rule formula" or a "coverture fraction") will reflect your spouse's years of service to the company, the years of your marriage, and the time lapse between granting and vesting, multiplied by 50 per cent in a community property state (more or less, if you reside in an equitable distribution state), and applied to the number of shares at issue. The resulting figure will represent your rightful share of the marital component of the options, once they are exercised.

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The other distribution model requires a court to retain jurisdiction of the case into the future, so that it can decide what you'll receive, "as, if and when" those qualified options vest and are exercised or exercisable. Though this judicial method might sound reassuring to those who like to, if you'll pardon the phrase, keep your options open, it's not great when you want a clean, final break from your former life and spouse, not to mention freedom from litigation.

Both of these choices will require that your employee spouse--soon to be your ex--hold "your share" of his statutory options in trust, because under current law, only employees can exercise them. Thus, they cannot be "transferred" to a nonemployee spouse upon divorce without losing their favorable tax status (no income tax payment due on the "price break" or "bargain element"--the difference between the option strike price and the market value--when the shares are purchased, i.e., "exercised"). So, no matter which model you follow, you will have to depend on your ex to do the right thing as your fiduciary.

Though NSOs are not favored under the tax code--you will have to report the "bargain element" as income the year in which the options are exercised--they can be transferred to a nonemployee spouse incident to divorce, without a taxable event. In this case, after transfer of the NSOs to you, you'll have control over when to exercise the options, consistent with the initial option grant.

Make sure you have an expert draft the document (a qualified domestic relations order, or QDRO) that transfers the NSOs to you. Also, when you exercise your shares, be prepared to have federal and state income tax withheld, as well as whatever FICA and Medicare taxes apply.

You'll also receive a 1099 from your ex's company reflecting this payment and the federal/state income tax withheld from your proceeds. Interestingly, your ex will be credited with the payment of the FICA and Medicare taxes on his W-2, as the government continues to view the NSOs proceeds (called the "compensation element") as a form of wages that your ex earned. Moreover, depending upon the price per share and holding time, you could be taxed again on the sale of these very same shares after you exercise (buy) them.

No matter the kind of options you receive--outright or in trust--it's best to have a professional scrutinize the proposed distribution to minimize the overall tax exposure and avoid any nasty surprises (think alternative minimum tax).

Finally, since 1999, many state courts have held that stock options might, in some circumstances (when they are vested and exercisable), be considered "income" for the purpose of establishing or modifying a support award. So, take stock--as it were--and don't forget this important, added aspect of the multifaceted stock option.

Marlene M. Browne practices family law in New Jersey, Massachusetts and Colorado. She is also the author of several books on marriage, divorce and family law, including 'Boomer's Guide to Divorce' and 'The Divorce Process: Empowerment Through Knowledge'.