A black robe does not come with a crystal ball. No one, not even a judge, can predict the future. Yet that is what judges and divorce lawyers must do when they attempt to divide stock options, restricted stock, and other forms of incentive compensation in a divorce or support proceeding.
The Challenges of Incentive Compensation
Incentive compensation presents special challenges for divorcing spouses who are dividing property or resolving alimony and spousal support claims. Stock options, restricted stock, and appreciation rights that have no ascertainable value today may become valuable in the future. The divorcing spouse of an employee who receives incentive compensation may want to share the benefits. On the other hand, an employee might not want to pay a divorcing spouse today for a share of benefits that might never become valuable. Lawyers and judges must understand how incentive compensation is valued and divided in divorce.
An employer pays incentive compensation when it wants employees to have a monetary stake in the growth and success of the company. Executives, consultants, and professionals may be eligible for incentive compensation in the form of stock options, restricted stock, restricted stock units, or stock appreciation rights. Incentive compensation is different from wages and salary because its value may depend upon the passage of time, the future performance of the employee, the financial success of the company, and even the fluctuations of the stock market and national economy.
Generally, incentive compensation is granted as part of an incentive compensation plan. Some plans contain a formula or objective criteria for determining an employee’s incentive compensation. In other companies, and particularly in those that are small employers, there might be no objective criteria. Instead, discretionary decisions are made by a compensation committee, a manager, or the owners of the business. Learning the details of an incentive compensation plan may make a big difference in a divorce. In most jurisdictions, marital and community property is limited to what has been acquired during the marriage. If incentive compensation is granted prior to the marital separation, it may be characterized as marital or community property, regardless of when it vests or may be exercised.
Spotting the Employee’s Benefits
An incentive compensation plan may contain important details about the nature of the benefits that are available to employees, the criteria for earning the benefits, the conditions for redeeming the benefits, and sometimes the purpose of the benefits. While they might seem dense and technical, incentive compensation plans are basically contracts between an employer and employee, the provisions of which govern an important aspect of the employment relationship. It is necessary to study an incentive compensation plan closely whenever its benefits might be treated as property or income in a divorce or support proceeding.
Restricted stock is like the publicly traded common stock of a company, except that it cannot be sold immediately. Restricted stock is limited by a vesting schedule, which sets the earliest date it can be sold. If an employee resigns or is terminated before the vesting date, the employee forfeits the stock. This creates an incentive for the employee to keep working until the vesting date. Frequently, restricted stock generates dividends, which are paid to the employee shareholder even while the restricted stock is unvested. Generally, the employee must recognize taxable income when dividends are paid and when the restricted stock vests, whether or not it is simultaneously sold. The taxable income is equal to the market price of the stock on the vesting date, which is subject to federal income tax, payroll taxes, and, in some jurisdictions, state and local income tax. Usually, the plan withholds some of the employee’s shares on the vesting date to apply toward federal income tax and payroll tax. The fair market value on the vesting date establishes the tax basis of the employee’s restricted stock. If it is sold at a later date, any gains or losses are measured from the tax basis, resulting in taxable capital gains or losses. Restricted stock may be encumbered, particularly in privately held companies, by transfer restrictions that prevent their sale or transfer to third parties.
Restricted Stock Units
Restricted stock units (RSUs) are contractual promises made by an employer to deliver shares of stock to an employee at a future date, as defined by the incentive compensation plan. Employees do not receive dividends from unvested RSUs. When the RSUs vest, the shares of stock are issued to the employee or a trust maintained by the plan for the benefit of its employees. Taxable income must be recognized by an employee on the date when RSUs vest, regardless of whether the units are simultaneously liquidated. RSUs are generally nontransferrable to third parties.
Like restricted stock and RSUs, stock options are also limited by a vesting schedule. Stock options are the right to purchase stock at a particular price, called a “strike price.” Stock options become valuable when the market price exceeds the strike price. An employee can exercise the option to buy stock at the strike price and immediately sell it at the market price to earn a profit. This is known as a “cashless exercise” of options. So, for example, an employee might be granted an option to purchase 100 shares at $10 per share (the strike price) in thirds: 33 shares on the first anniversary of the grant date, 33 shares on the second anniversary, and 34 shares on the third anniversary. If the market price were $10 per share on the grant date, all of the options would be worthless. If the market price were still $10 on the first anniversary, the options would still be worthless. If the stock were trading at $11 on the second anniversary, the employee could exercise the options that vested on the first and second anniversaries (these are referred to as “tranches”) for a profit of $1 per share times 66 shares. If the employee resigned before the third anniversary, the third tranche would be forfeited.
Instead of cashless exercise, an employee could exercise an option to purchase stock and keep it, without selling immediately. Or an employee could wait beyond the vesting date. Eventually the option would expire if it is not exercised.
Employers may offer one of two types of stock options: nonqualified stock options (NQ options) or incentive stock options (ISOs). ISOs must meet certain legal criteria to qualify for favorable tax treatment. For instance, the strike price must be equal to the market price on the grant date. ISOs are not taxable to an employee until the underlying stock is sold, so an employee may exercise ISOs and hold the stock without incurring taxes. On the other hand, when NQ options are exercised, the employee must recognize taxable income, regardless of whether the stock is held or sold immediately in a cashless exercise. ISOs are nontransferrable to third parties, including spouses or former spouses. NQ stock options may be transferrable to family members or a trust unless prohibited by the incentive compensation plan.
Stock Appreciation Rights
Stock appreciation rights are similar to options because they focus on the profit that may be earned when the market price exceeds the strike price. When appreciation rights are vested and the market stock price exceeds the strike price, an employee can exercise the rights for a profit without ever buying or selling stock. The owner of appreciation rights does not own the stock, which is generally held by the plan. Stock appreciation rights are likely to be nontransferrable to third parties.
Defining the Value of Incentive Plan Benefits
In divorce litigation, incentive compensation may be treated as property that can be divided or as a source of income for paying spousal support, child support, or alimony. That’s why divorce lawyers and judges are interested in their value. It may be difficult to predict how valuable these items might be in the future because their value depends on the market price of the stock at a future date. Nevertheless, the valuation industry has developed techniques for valuing stock options that might be worth more in the future than they are today—even options that are unvested or below market price. Valuation of incentive compensation plans has been guided by accounting standards for companies that must issue public financial reports.
The “intrinsic value” of incentive compensation is easy to ascertain. The intrinsic value of restricted stock and RSUs is zero until the stock or units are vested, and then it is equal to the market price. The intrinsic value of vested stock options or appreciation rights is equal to the market price of the underlying stock minus the strike price, which is the price at which the options or rights may be exercised. If the strike price and market price are equal (as they typically are on the grant date), the intrinsic value is zero. When the market price exceeds the strike price, the option is said to be “in the money.” When the market price falls below the strike price, the option is “under water.”
Fair Market Value
The divorce courts are generally more concerned with fair market value (or, in some states, fair value) than intrinsic value. The fair market value standard recognizes that incentive compensation has a value derived from its future benefits (just like a pension or business), even when it is unvested or under water. In many cases, the mere passage of time and continued service of the employee are all that is needed to realize the value of incentive compensation. Fair market value is measured by calculating or predicting the future monetary benefits of incentive compensation. Valuing incentive compensation, then, is similar to valuing businesses and pensions: their worth is equal to the present value of future economic benefits.
Marital or Community Property
In some jurisdictions, incentive compensation may be designated as marital or community property if it was earned during the marriage, regardless of when it is vested or liquidated. Experienced family lawyers know that performance bonuses are paid by many employers in the first quarter of the year based upon an employee’s job performance in the previous calendar year. Performance bonuses may be viewed as being “earned” in the previous year. If the bonus was paid after separation but earned prior to separation, then the bonus may be designated as marital or community property in some jurisdictions.
When divorce courts attempt to determine when incentive compensation was “earned,” they might examine factors such as the grant date or the vesting schedule, but other factors may come into play. An incentive compensation plan may contain language and provisions that will help to decide when benefits are earned. If the plan contains quantitative factors to measure the employee’s historical performance in determining the nature and amount of benefits earned, then it may be viewed as a reward for past performance. If a plan contains language emphasizing the need to retain employees and motivate their future performance, it may be viewed as forward-looking. When addressing these issues in litigation or settlement discussions, it is critical to have a complete copy of the plan as evidence.
Dividing the Value in Divorce Proceedings
Since most forms of incentive compensation are nontransferable under the law or the terms of an employer’s plan, divorce courts and lawyers must determine the price at which an employee will buy the other spouse’s share of the benefits. If the restricted stock, units, options, or appreciation rights can be liquidated—immediately or in the foreseeable future—then it becomes a matter of dividing the net proceeds after taxes, and sale expenses are deducted. Rarely, these items can be divided in kind. Other cases call for a professional valuation of incentive compensation to be performed by a forensic accountant.
Restricted Stock and RSUs
Intrinsic value—the market price of the stock at the valuation date—may be an appropriate value to use for restricted stock and RSUs in divorce, particularly if the restricted stock or units are vested. The valuation date might be the date of separation or date of trial or otherwise, depending upon the law of the jurisdiction. The income tax consequences must be considered, particularly if the stock or units cannot be transferred in kind to the nonemployee spouse. The divorce court may deduct the income tax liability incurred by the employee spouse upon vesting and any capital gains income tax that might accrue from the date of vesting to the date of sale. The income tax liability can be measured by applying the “with-and-without” method, in which an accountant prepares two tax returns: one in which the restricted stock or units are included as taxable income and one without the income.
Restricted stock and units that are unvested at the time of divorce may be treated like vested stock if spouses appreciate and accept the risks. The market price of the stock might rise or fall prior to the vesting date, for instance. If the employee spouse terminates his or her employment or dies or becomes disabled, the employee may not be able to recover the payment given to his or her former spouse in exchange for the unvested stock or units. If the divorce court treats unvested stock as mixed property, having components of separate and marital or community property, a coverture fraction (or time-rule fraction) can be applied. When taxes are considered, a forensic accountant should prepare a “with-and-without” analysis for each year in which a tranche of stock or units will vest.
Alternatively, the net proceeds derived from the future sale of unvested restricted stock and units may be divided in kind if and when they are realized. Prior to the vesting date, the stock or units may be held in constructive trust by the employee, who may have fiduciary duties to the other spouse. The court order or marital settlement agreement must specify the nonemployee spouse’s share as a percentage or number of shares or units and define the employee’s obligations to give notice when the stock or units may be sold, liquidate the spouse’s share when instructed by the other spouse, and promptly pay the net proceeds of the spouse’s share after deducting income taxes and sale expenses. The court order or agreement might specify the consequences if the employee resigns before the vesting date or is terminated for cause. The in-kind division of net proceeds may be desirable in cases where the spouses do not accept the assumptions associated with valuation methods or do not wish to incur the expense of an expert report or do not have resources from which to make a buy-out payment at the time of divorce.
Stock options, or their proceeds, can also be divided in kind if and when the options or appreciation rights are exercised and liquidated. On the other hand, many divorce courts and lawyers have engaged forensic accountants to set a buy-out price. The valuation methods used for stock options and appreciation rights are well recognized but might be less widely accepted than the typical business valuation and real estate appraisal methods.
Estimating the Value of Options
The Black-Sholes method is a statistical model developed by a group of Nobel Prize economists, using a mathematical formula. The formula considers the current market price of the stock, its dividend yield, the stock option strike price, its expiration date, the interest rate on risk free securities, and “beta,” which is the expected volatility of the stock’s market price, a statistic that is published for publicly traded stocks. The Black-Sholes method is relatively easy to use because it is a simple mathematical calculation. Most of the inputs are easily researched and objective in nature. Still, the calculation should not be performed by a layperson, who may not grasp the limitations and nuances of the formula. Furthermore, the Black-Sholes method suffers from certain shortcomings that might justify the use of an alternative method.
The Black-Sholes method was created to estimate the value of European-style options, which can be exercised and sold only at their expiration date. The Black-Sholes method assumes that stock options will be exercised on a fixed date. Most American companies, however, issue stock options that can be exercised and sold at any time from their vesting date until their expiration date. To compensate for this variable, some variations of the Black-Sholes model use a weighted average to estimate the expected exercise date. In practice, many employees exercise stock options as soon as they can, without waiting for market prices to increase subsequent to the vesting date. This has led to criticism of the Black-Sholes method for valuing American-style stock options, particularly if the stock option is not a “plain-vanilla” type. Some stock options have complex restrictions related to company performance, market conditions, or blackout periods that make it more difficult to predict just when the option can be exercised, and the Black-Sholes method may not be the most appropriate method in such cases.
Another method of valuing stock options is the lattice model, also known as the binomial method. While it is similar to the Black-Sholes method, it is more flexible because it may consider more mathematical variables than the Black-Sholes formula. Instead of assuming a fixed date for exercising stock options, the lattice model usually considers alternative dates. In fact, each of the variables in a Black-Sholes equation can be expressed in alternatives.
Because the lattice model is not as static as Black-Sholes, it might be more accurate, particularly for stock options that contain nonstandard restrictions. Still, the more variables that are considered, the more complex the calculation becomes—up to the point when it becomes unwieldy. When a lattice model is used, the family lawyer must work closely with the forensic accountant to understand the underlying assumptions that are used to build the model. Lattice models can be constructed to reflect the value of stock options that are more complex than the garden-variety options.
Monte Carlo Simulation
Monte Carlo simulation is a statistical method named after the world-famous casino because it relies on generating a large number of random outcomes, like games of chance, and then evaluating their probability. The Monte Carlo method generates a scatter plot of values, to which a software application can apply statistical principles to determine the most likely future value of stock options. Monte Carlo simulation is effective because it does not rely upon predetermined assumptions that might skew the results. It is not necessarily more accurate than other methods for pricing garden-variety stock options. Certain types of options and restricted stock awards, such as “total shareholder return” awards, may lend themselves more readily to this method.
Deploying the Best Strategy for Clients
Immediate Offset or Deferred Distribution?
When resolving cases involving incentive compensation, divorce lawyers and the courts face the same choices we make when addressing defined benefit pensions. An incentive compensation benefit may be divided by immediate offset or deferred distribution. In most cases, the courts strive to sever the economic ties between divorcing spouses. An immediate offset severs those ties. The employee must pay his or her spouse, or trade other assets, to retain the restricted stock, units, options, or appreciation rights. A valuation may be performed to set the price to be paid by the employee. Still, some divorce lawyers and clients may have limited faith in the valuation methods that are applied to incentive compensation benefits. Also, some cases present a fact pattern in which a buyout solution is impractical, whether due to a lack of estate liquidity, an inability to borrow, or an employee’s desire to retain other assets (like the house) that might be traded.
When an immediate offset is appropriate, divorce lawyers must pay attention to the tax consequences. Incentive compensation benefits are generally taxable when they vest, if not when they are granted, and some may be subject to capital gains income taxes if they are held beyond the vesting date. If an employee is paying cash or trading after-tax assets to retain his or her incentive compensation benefits, the lawyer should ensure that the price paid by the employee considers the after-tax value of the benefits.
Divorce lawyers who represent employees must also avoid double-dipping. An incentive compensation benefit may be treated as an asset, but it also creates income that is reported on an employee’s W-2 or tax return. Depending upon the law of the jurisdiction, the courts may be prohibited from treating that income as a source for paying alimony or support after it has been divided as marital or community property. Keep in mind, however, that an employee might also have benefits that are separate property providing income that can be used as a source of alimony or support without double dipping.
Division Upon Liquidation
Many lawyers prefer to divide incentive compensation benefits (like nonqualified retirement benefits) by dividing them if and when they are liquidated. Strong, effective language is required in marital settlement agreements and court orders to protect the employee’s spouse in these instances. The agreement or court order might contain a coverture fraction to distinguish between the separate and marital or community property components of the benefit. The order or contract must address the tax liability that will arise when the incentive compensation benefits are vested and liquidated. The agreement or court order may also contain language to prevent double-dipping.