Volume 18, Number 2
March 2001


Windfalls and Other Employment Benefits

Considering Stock Options, Capital Gains, Royalties, and Dividends

By Laura W. Morgan

In recent years, stock options have become an increasingly popular benefit at all tiers of the corporate ladder. Yesterday’s file clerk in an Internet start-up company is tomorrow’s millionaire because of stock options.

Stock options offer the ability to purchase at some time in the future a specific amount of stock at today’s price. 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 is $20, then the employee who exercises the purchase option has instantly made a $10 profit. Employees like this form of compensation because today’s stock market affords them the ability to make a lot of money. The only thing the employee loses is any compensation offered in lieu of stock, such as more salary or a bonus. Most employees don’t miss what they don’t see.

When a stock option is exercised, the employee realizes a capital gain. To the extent that the capital gain is recognized as "income" under the child support guidelines, profit realized on the exercise of the stock options is considered income. Capital gains are considered income when they are recurring, but not when they are a one-time event. The same rule applies to stock options. In Murray v. Murray, a case of first impression, the Ohio Court of Appeals addressed whether unexercised stock options should be included in gross income in determining child support and, if so, how to value it. 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 part of gross income. The court compared unexercised stock options to retained corporate earnings when a parent is the majority shareholder. In both instances, the parent should not be allowed to sit on assets and hide behind the corporate shield, depriving children of an income stream they would otherwise enjoy.

As to unexercised stock options, the court held that the best way to value them is to account for their appreciation in value as determined on their grant and exercise dates, which fall into the income year at issue. By this method, 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. Since Murray, other cases have held that unexercised stock options constitute income.Retained earnings. Murray draws the long line of authority holding that retained earnings will be considered income to the owner/parent if he or she has the ability or discretion to draw on the funds. However, 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), the retained earnings need not be considered.Inheritances. There is little question that income derived from interest in an estate, including inheritance, is considered income for child support purposes. In fact, some child support guidelines include interest earned from an inheritance in the definition of income. Thus, in the absence of explicit language in the guidelines, inheritances will most likely be treated as gifts.Royalties. Most courts have had little trouble holding that royalties (i.e., comprising income from patents, trademarks, copyrights, and other intellectual property) are income from self-employment. Thus, there is nothing to prevent a court from considering royalty as income for purposes of child support.Interest and dividends. Interest and dividends on investments are income under the plenary definition of income in all states’ child support guidelines. A sharp split has arisen of late, however, as to whether the interest earned on an Individual Retirement Account (IRA) or 401(k) should be considered "income" for purposes of child support. Meanwhile, some courts have held that interest should not be considered because of the penalties for withdrawing funds from an IRA.

The better argument is not to treat the interest as income. In many states, reasonable contributions to a retirement plan are not considered income. The interest is part of that contribution; retirement income and security are determined and planned through contributions plus interest. Earned interest constitutes part of a legitimate retirement-planning decision. The law should not hold that a parent needs to bankrupt his or her retirement to support a child. The law should be flexible enough to hold that reasonable contributions to a retirement plan and the interest generated are not income for purposes of child support.

Laura W. Morgan is an attorney with the National Legal Research Group in Charlottesville, Virginia.

- This article is an abridged and edited version of one that originally appeared on page 13 of Family Advocate, Fall 2000 (23:2).

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