You think it’s a fairly simple case. Both spouses are W-2 wage earners; there are no closely held businesses to value, no rental properties, no unusual investments. The parties have a marital home, a vacation home, and a substantial amount of liquidity in bank and brokerage accounts. Simple, right?
Not so fast. The wage earners could also participate in executive compensation plans that could impact the marital estate and/or the income available to pay support. Where do you look to find and identify the details of the plans? What are the different types of plans out there? How do you classify, value, and distribute the plans? This article will help you answer the where, what, and how of executive compensation plans to help you navigate through what can be rough seas.
Where do you look to find and identify the details of the executive compensation plans?
All divorces cases begin with discovery. Knowing what to include in the interrogatories and the initial discovery request (IDR) to unveil the existence of executive compensation plans is critical. Interrogatories should pose questions about the existence of the plans. The following is a list of some key items to include in a discovery request to further ensure that you unveil all executive compensation and benefits and all their details.
- Individual income tax returns
- IRS Forms W-2, 1099, and K-1
- Pay stubs
- Personal financial statements
- Agreements, plan documents, summary plan descriptions, and summaries of material modifications of employment, compensation, retirement, deferred compensation, stock purchase, stock options, employee benefit, and other plan agreements and documents
- Grant letters
- Employee handbook and, policy manuals
- Company financial statements and annual reports
- Board of directors’ minutes
If the party’s employer is public, some of the above information might be available in the public domain. You can do your own investigation by researching the employer’s proxy statement, also known as Securities and Exchange Commission (SEC) Form Def 14a, and other SEC filings, such as SEC Forms 8-K, 10-K, 10-Q, S-1, and S-3.
Boxes 11 through 13 of Form W-2 are especially useful, as is the employee’s pay stub/earnings statement. Note how much information can be obtained from an earnings statement like the one provided below on page 14. This employee participates in a restricted stock plan and a nonqualified option plan and gets an annual and quarterly bonus. She also defers a percentage of her salary and bonus in a deferred compensation plan and further participates in a 401(k) plan. Finally, there is evidence that there is an employee stock purchase plan (ESPP) in place.
What types of executive compensation plans are there?
Just about all executives in medium to large companies receive compensation in the form of base salary and bonus. Beyond these forms of compensation, many executives also receive other, more complex forms of remuneration. In order to understand various types of plans, it is first important to be able to distinguish between qualified and nonqualified plans. A qualified plan is one that must follow IRS and ERISA regulations. The most common types of qualified plans are profit-sharing plans (including 401(k) plans), defined benefit plans, and money-purchase pension plans. Employee stock purchase plans can also be qualified plans.
Short-Term Compensation Plans
Salary and bonus are the most common and simplest form of short-term compensation. Other types of short-term plans include ESPPs and deferred compensation plans.
An ESPP is usually characterized as a short-term plan. It is a company-run program in which participating employees can purchase company shares at a discounted price. Employees contribute to the plan through payroll deductions that build up between the offering date and the purchase date. These plans are often qualified plans. Under a qualified ESPP, payroll deductions used to purchase the shares are taxed at ordinary income tax rates. Upon sale of the stock, the discount is taxed at ordinary income tax rates and the remaining gain is taxed at capital gains rates. If the ESPP is nonqualified, the entire gain is taxed at ordinary income tax rates when sold.
The most common types of deferred compensation plans include 401(k) qualified plans and 409A nonqualified plans. Examples of 409A nonqualified plans include supplemental executive retirement plans (SERPs), supplemental 401(k) plans, and other excess benefits plans. For federal tax purposes, all of these plans are nontaxable until the funds are redeemed, at which time they are fully taxable at ordinary rates.
While one should be aware of the existence of these types of plans in a marital dissolution setting, there are fewer issues in valuing, dividing, and distributing these types of plans than there are in the more complicated, long-term, often nonqualified plans.
Common Long-Term Compensation Plans: Options, RSUs, Performance Awards, and SARs
Stock options and restricted stock units (RSUs) are the most widely used form of long-term compensation.
A stock option provides the owner the choice or option to buy stock at a discounted or stated price (the exercise or strike price) within a certain period of time (i.e., through the expiration date). When the stock is purchased, the option is said to be “exercised.” One would only exercise an option when the stock is expected to be “in the money,” that is, when the fair market value of the stock is greater than the exercise price. The intrinsic value or spread is the difference between the current fair market value of the stock and the exercise price.
Stock option plans come in many shapes and sizes. They can be granted under a qualified or statutory plan in the form of incentive stock options or ESPP options. All other stock option plans are nonqualified. Qualified plans are much more strictly regulated, and they receive tax treatment that is different from that accorded nonqualified stock option plans.
Generally, stock option grants to employees are for past performance; however, the options vest over time, meaning that they cannot be exercised until the end of the vesting or holding period. Vesting periods usually range from three to five years.
RSU plans are typically nonqualified and offer outright stock grants, with no purchase price. Like stock options, they also have a vesting or restriction period of three to five years, during which time the stock cannot be sold. Often the same employee will have both stock options and RSUs. Nonqualified stock options and RSUs are not taxed upon grant. Stock options are taxed at ordinary income tax rates on the spread at the exercise date. RSUs are taxed at ordinary income tax rates based on the stock price at the vesting date. Often, RSU plans will withhold the tax from the stock distribution by reducing the number of shares distributed. Similarly, upon exercise of the stock options, the plan may reduce the stock distributed by the tax and the exercise price. This is referred to as a “cashless exercise.”
Performance share awards (PSAs) are also grants of company stock, but the number of units/shares ultimately awarded is based on future companywide performance targets. So, for example, an executive would be granted a target PSA of 500 shares on January 1, 2017, based on company performance during 2019. After the end of 2019, the award would be adjusted upward or downward based on the evaluation of the prescribed performance criteria during 2019.
Another fairly commonly used tool is stock appreciation rights (SARs). With a SARs plan, the employee shares in the appreciation of the value of the company stock from the grant date, but not in the historical share value. The award can be settled in cash or in an equivalent-value stock grant.
Other Types of Compensation
Other types of long-term executive compensation plans that we often see include profits interests, phantom stock plans, and other similar company performance-based awards. A profits interest is an interest that gives the employee the right to receive a percentage of future profits, but not any current capital. Phantom stock plan awards are based on the company’s performance, which is often measured by the increase in value of the company’s stock without the executive’s actual ownership in the stock.
In private equity, venture capital, and real estate investment firms, a large part of the remuneration paid to the key executives, usually general partners, is typically paid in a carried interest and promote structure. Under these payment schemes, the general partners who generally own a very small percentage of the investment fund itself are paid a disproportionate share of the profits of the fund after the limited partners are repaid their invested capital and a predetermined preferred return.
Other types of executive compensation to be aware of are forgivable loans, retention bonuses, change of control bonuses, and severance.
How do I treat the executive compensation plans in my particular divorce case?
With the knowledge you have gained with regard to the “where” and “what” of executive compensation plans and perhaps assistance from an expert, you have now identified what plans your client’s spouse participates in; when each of the awards was granted; when they vest; how the value of the award will be calculated upon vesting; the current intrinsic value, if applicable; how and when they are taxed; and other information about the plans. The toughest question remains: How should each grant or award be treated in the subject divorce proceeding? This section will address issues as to whether the awards are martial or nonmarital and whether each should be treated as income or an asset. It will further address division and distribution.
Marital or Nonmarital?
A knee jerk reaction to the question of whether an element of executive compensation is marital or not would be: “It is marital if it was ‘earned’ during the marriage.” The answer is seemingly simple. However, when getting into the details, it might become less clear. While most short-term compensation arrangements such as salary, bonus, deferred compensation, and the like are pretty clearly earned prior to when they are granted, it is less clear for many long-term plans. As discussed above, most long-term plans have vesting provisions and/or are based at least in part on the future performance of the company and/or the employee. While most states do follow the “earned during the marriage” proposition, the definition of “earned” seems to vary. The differences, in part, often have to do with vesting.
For example, in Pennsylvania, there is pretty clear case law that indicates that if an award is granted prior to the cutoff date and is for prior services, the total award should be marital property, despite the future payout being subject to vesting. See MacAleer v. MacAleer, 725 A.2d 829 (Pa. Super. 1999); Fisher v. Fisher,769 A.2d 1165 (Pa. 2001). Other states, like New York and New Jersey, have case law that supports the theory that if the employee must continue to work to monetize the award, it is not “earned” until it vests, and, therefore, the use of a coverture fraction in determining the marital value of the award is appropriate. See DeJesus v. DeJesus, 90 N.Y.2d 643 (1997); Marx v. Marx, 265 N.J. Super. 418 (1993).
The coverture fraction allocates the award as marital and nonmarital based on the vesting schedule, with the numerator being the time period from the date the award was granted to the cutoff date and the denominator being the period from the date of grant to the vesting date. As an example, if a tranche, or portion, of 300 RSUs was granted twelve months before the cutoff date and has a three-year (thirty-six-month) vesting schedule, the coverture fraction will be 12/36. One-third or 100 of the RSUs would be marital. Awards are often divided in tranches that vest at different times, so each tranche would have its own coverture.
Colorado case law (see In re Marriage of Balanson, 25 P.3d 28 (Colo. 2001)) indicates that awards granted “in consideration for future services of the employee, where such services have not yet been completed, do not constitute marital property.” Generally, in that state, when it is determined that the award is “for future services,” the full award is out of the marital estate and no coverture is used.
Because the award documents are rarely clear as to whether the award is for past or future services, there is often disagreement between the parties as to when the award was earned. Where these awards are significant to the marital estate, this disagreement often leads to litigation.
Additional complications can arise when an award is granted just after the cutoff. An argument can be made that a portion of it should be marital, as it was for services prior to the date of separation or complaint. This argument would seem to be more palatable in states where the grant date determines if the award is marital than for those that employ a coverture. However, case law being lacking on the direct point, arguments can be made in favor of either treatment.
Further difficulties arise when awards are granted prior to cutoff but are adjusted after cutoff based on company and/or individual performance, as in the PSAs described previously. These awards are something of a hybrid; they are for both past and future services and the future award is unknown. As will be discussed later, creativity is often needed in determining a fair way to allocate, divide, and distribute such hybrid compensation awards.
If an award is determined to be nonmarital either due to the coverture calculation or because it is deemed to be earned after cutoff, consideration should be given to including the award in the income available to pay alimony and/or child support. Caution must be advised: the same award or portion thereof should not be counted twice, or “double-dipped.”
One must also not lose sight of the fact that for longer-term alimony and child support calculations, consideration must be given to all forms of executive compensation that the payor spouse will or could earn based on what has historically been earned. A question can arise as to when the award becomes income. The answer is almost always: when the award can be monetized, which is generally when it vests or is available to the employee.
Problems can arise in this regard because there is discretion as to when stock options are exercised. Accordingly, it is common for vested but unexercised awards to be included in income available for support. Though the underlying stock or option can be monetized, if it in fact has not been monetized, one result may be an award for alimony or support that the obligor does not have the immediate liquidity to meet. Further, attention should be paid to the provision for income taxes, particularly in cases where shares were withheld for tax payments, as in the cashless exercise situation described above.
Division and Distribution of the Marital Award
Once it is determined what portions of the various awards are marital, a method of division and distribution must be contemplated. What percentage of the marital portion of the award is owed to the nontitled spouse involves a myriad of factors that are often state-specific and based on circumstances of the subject state. When the award is a hybrid of past and future performance, as in the PSA scenario described above, other factors come into the mix. A possible solution in this instance would be to award a declining percentage of the awards as they vest over time, to account for the titled spouse’s increasing future efforts.
Once division is decided, the next hurdle is how the asset will be distributed. One alternative is to value the assets currently and provide an offset with other assets to the nontitled spouse, as we normally see done with business interests. This method allows for a clean break and protects the nontitled spouse from circumstances in which the awards might not vest, such as termination of employment. However, there are also problems in doing this. Often, there is not enough liquidity or assets with enough value to accomplish an offset. Further, the assets are often difficult to value, especially when they are in private stock, stock options, PSAs, SARs, and the like. Because of this, in-kind distributions are often recommended. Unfortunately, the nonqualified plan instrument is rarely transferable.
When the instrument is nontransferable, a private agreement can be structured to establish the terms of the transfer. This can be in the form of a constructive trust, partnership agreement, or other agreement or vehicle. In New Jersey, this type of agreement is commonly referred to as a “Callahan trust.” The agreement or trust must be detailed as to assets included, vesting dates, distribution dates, percentages distributed, stock option exercise protocol, taxes, etc. It must also address events such as mergers, change of control, termination of employment, and death and disability that could impact the monetization of the award. The agreement might also include a release and authorization allowing the company to release information regarding the plans to the nontitled spouse.
Marital estates involving complex executive compensation can seem overwhelming. However, with a thorough understanding as to where to look to identify the elements of the parties’ compensation and what different types of awards are out there and how each works, the attorney, client, and expert can make informed recommendations and decisions regarding how such assets should be divided and distributed for a fair resolution in marital dissolution cases.