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May 06, 2024 Feature

Complex Compensation: Asset, Income, or Both?

Beth Garrett

One of the most challenging aspects in wading through the financial matters of a divorce can be the salaries, employee benefits, and specialized retirement assets earned during the marriage but perhaps not accessible in the near term. Below are some examples:

  • Stock options and restricted shares are a favorable way for companies to reward employees while also incentivizing them to stay and continue to create value for the company.
  • Deferred compensation allows an employee to defer a portion of their current income to retirement when it is typically paid out over a set time period.
  • Forgivable loans act as a kind of signing bonus where an employee gets a lump sum payment upon starting employment. The lump sum is considered a loan but forgiven over a set period of years as the forgiven amount is included in the employee’s compensation.

This article will discuss some of the intricacies of these types of benefits that could represent a significant portion of the parties’ assets as well as an employee’s present and future compensation.

During the divorce process it is important to identify any assets that have been granted and remain outstanding, determine their character as separate or marital property, and consider how to divide them in a manner that best benefits both parties. During the discovery process, the following documents should be requested:

  1. Complete paystubs for at least the year prior to the divorce. W-2 Forms do not provide the level of detail that is necessary to identify assets that may be granted and vesting over time.
  2. All plan documents for any employee benefit plan or incentive compensation that may exist for the employee. This would include information about the award date, the vesting schedule, purpose for the award, terminating factors, and the ability of the benefit to be divided in the event of a divorce.
  3. Complete and detailed vesting schedules or amortization schedules for any benefits that have been granted but vest or amortize over a period of years.

Stock Options and Restricted Shares

These benefits are easiest explained together because, while there are some differences, the tax treatment and divisibility in a divorce is very similar. A stock option represents the option to purchase stock at a specified price, or strike price, over a certain period of time. The difference between the fair market value and the strike price at the time of exercise represents compensation to the employee at the time of exercise. A restricted share unit (RSU) is the award to an employee of shares of the company. In the case of an RSU, the entire fair market value would be included in the compensation of the employee at the time of vesting.

Most frequently, an employee is not given rights to exercise the stock options or RSUs immediately after they are granted. Exercise rights are often tied to a specific period time, known as the vesting period. It is important to look at the specific stock option plan to determine whether the options vest in set portions over the vesting period or in their entirety at the end of the period because this could affect the characterization of the award as a marital or separate asset. Once a stock option has vested, there is generally an expiration date whereby the option can no longer be exercised. It is important to pay attention to the fair market value compared to the strike price and the expiration date when holding options or dividing them in a divorce. RSUs may be additionally restricted beyond their vesting, during which time an employee may not sell the shares; however, once those restrictions lapse the shares are owned outright and do not expire.

A very important aspect to remember is that the expiration date on an option is often 10 years from its grant date. This means that just because an option is currently underwater does not mean it is worthless, and the necessity of dividing it should still be considered.

Is the Stock Option or Restricted Share a Marital Asset?

The issue of whether such benefits should be considered marital assets is complicated when unvested awards exist at the valuation date. An unvested award introduces some uncertainty into whether the employee will actually receive the asset in the future. The most important tools in determining whether a stock option or RSU award should be considered a marital asset can be the actual language of the plan and your particular state law. Such language can detail the reason for the award and the vesting period. For example, if an award was made very close to the time of the divorce and the options are not scheduled to vest for several years, it will be important to determine whether the options were awarded in recognition of past services rendered or in expectation of future services in order to determine if a portion of the options, which are still unvested, should be considered marital.

In addition, a plan may dictate whether unvested options vest immediately upon an employee leaving the company or are terminated and forfeited upon leaving the company. If the latter is the case, the nonemployee spouse may negotiate to include a clause in the settlement agreement that they would receive a portion of any signing bonus acquired by the employee spouse upon joining a new corporation as compensation for options forfeited by leaving the prior corporation.

State law should also be considered in determining the marital or separate nature of the benefit. State courts have different interpretations of the steps that are taken to convert separate property into marital property. Case law could also give insight as to how unvested options should be treated and whether a coverture fraction should be used.

If it is indeed determined that a portion of the unvested options or RSUs should be considered a marital asset, the next step will be to determine what that portion should be. The most common method for completing this calculation is through the use of a coverture fraction. A coverture fraction determines the marital portion of the award through the following calculation:

  1. For awards prior to marriage:
    Date of Grant – Date of Marriage
    Date of Grant – Date of Vesting
  2. For awards during the marriage:
    Date of Grant – *Date of Marital Estate Valuation
    Date of Grant – Date of Vesting

That percentage is then multiplied by the total number of options or RSUs to determine the marital portion of the award.

*Depending on state law, this date could be the date the complaint for divorce is filed or the date of the final judgement and decree. This date could also be agreed upon by the parties during settlement negotiations.

How to Divide the Benefits

The ability to divide the options or RSUs is dependent upon the type of option held and the language in the stock option or RSU plan. Some plans allow options to be divided between the employee and an ex-spouse. In this case, the nonemployee spouse will be issued a W-2 or 1099 for the options at the time of their exercise and will be taxed at ordinary income rates; however, the FICA portion will still be taxed to the employee spouse.

However, the majority of employer plans still do not allow options or RSUs to be transferred. Therefore, if the options are to be divided in a divorce, it must be through the use of a constructive trust. This implies that the employee holds a fiduciary duty to their spouse with regard to the asset but does not necessitate the forming of an actual trust. With such an understanding, the options would continue to be held by the employee spouse but would be exercised by that spouse upon the direction of the nonemployee spouse, assuming the plan allowed for exercise at that time. In the event of a constructive trust, the parties would have the following two options for distribution to the nonemployee spouse upon exercising the options

  1. The employee spouse exercises the option and then transfers the underlying stock to the nonemployee spouse. The nonemployee spouse would be responsible for reimbursing the employee spouse the exercise price and paying any taxes due upon exercise.
  2. The employee spouse exercises the option and immediately sells the underlying stock. The exercise price and any taxes would be withheld from the proceeds, and the net income would be remitted to the nonemployee spouse.

If a constructive trust is utilized, it is important to specifically lay out the responsibilities for each party in the settlement agreement. This includes notification of any blackout periods, mergers or buyouts that may alter the character of the option, and the desire to exercise the options. The specifics of the transfer and the tax ramifications should also be discussed in the agreement.

The same considerations and constructive trust can be utilized in the division of RSUs. However, a company may have regulations in place dictating how much stock an executive should own in the company at any given time. This may impair the ability to divide RSUs at the time of vesting. The same tax considerations should be utilized as with the options because the employee will be taxed on the fair market value of the RSUs at the time of vesting.

There is also the option of determining the current value of the marital portion of the unvested asset and agreeing that the employee spouse will retain the entire asset. In exchange, the nonemployee spouse would receive other marital assets of similar value. This method, while representing the simplest and cleanest version, poses risks to both parties. The employee spouse is risking that they do not continue employment through the vesting period and ever actually receive the asset. Both parties are accepting the current fair market value of the asset while the actual value could increase or decrease substantially during the vesting period. The relative value of the assets in question compared to the entire marital estate as well as the complications of calculating tax effects at the time of a future exchange should be weighed when determining whether a buyout is worth it to the divorcing parties.

Deferred Compensation and Other Nonqualified Plans

Traditional methods of deferred compensation, such as a 401(k) plan are routinely divided in a divorce through the use of a Qualified Domestic Relations Order (“QDRO”). However, valuable employees or executives of a company may be offered an additional benefit in the form of a nonqualified retirement plan such as deferred compensation plan or Supplemental Executive Retirement Plan (SERP).

Similar to a 401(k), deferred compensation defers a portion of the employee’s compensation to be paid (and taxed) at a later date. However, there is no regulation about the amount that can be deferred or the method of payout in the future. The payout date and timing should be clearly defined in the plan agreement for the compensation. Such compensation has been fully earned by the employee; however, there could still be terminating factors such as the employee being fired for cause.

SERP plans are retirement plans paid to top executives that are often based on a percentage of their salary paid for the remainder of the employee’s life following their retirement. The complication for these types of plans arises in that the final monthly annuity amount may be unknown at the time of the divorce. The SERP has a risk of forfeiture and is often tied to the employee spouse’s continued employment as a “golden handcuff.” The argument is also often made that the plan is “unfunded” and therefore uncertain and should be considered possible future income rather than a set marital asset.

It is important to look at the plan documents in the case of a SERP to determine on what basis and at what point the monthly annuity is calculated. Similar to a coverture fraction, the marital years of service and total years of service should be calculated so that the marital portion of the plan can be ascertained.

As the “nonqualified” description suggests, these types of benefits cannot be divided through a QDRO. As with stock options and RSUs, some employers have provided for the division of such a plan in the event of a divorce. This greatly simplifies any division as the nonemployee spouse would directly receive their specified share of the benefits and be individually responsible for the taxes on what they receive. This is possible in the case of deferred compensation, but highly unlikely in the case of a SERP. If such division is not allowed, the parties will likely be tied together into the future as the payments typically do not begin until retirement and last for a specified period of years. The nonemployee spouse would receive their share of payment at the time the employee spouse does. The gross amount would be reported on the employee’s tax return in the year of receipt and a calculation would need to be done to determine the nonemployee spouse’s portion of the taxes due on the amount they received.

Absent specific valuation concerns or high risk of forfeiture, if it is possible to have the employee spouse retain the nonqualified asset and offset with assets either in the name of the nonemployee spouse or which can be readily transferred to them at the time of the divorce, this would be preferred.

Forgivable Loans

A final tool that is being used as an incentive for employee retention is the payment of a lump sum as a form of “signing bonus” when an employee is invited to join a company. Rather than including the full amount in the employee’s compensation at the time of payment, a promissory note and stated interest rate is issued, outlining the employee’s responsibility for paying back the loan over a term of years. As the time for repayment arrives, the annual amount is forgiven and included in the employee’s compensation. This results in inflated “phantom” income as the employee is responsible for paying taxes on this compensation while no actual cash is received at that time.

It must be determined the amount of the lump sum that should be included in the marital estate. While the entire amount has already been received by the employee, there also continues to exist an outstanding loan, which would be required to be paid back to the employer if the employee does not remain through the forgiveness period. If the entire lump sum is included in the marital estate, any remaining outstanding loan should also be considered in the division of assets and liabilities.

The Asset Has Been Determined, What about Income?

For each of the items discussed above, the existing benefits are considered assets, whether marital or separate. However, it also must be determined what element should be included in the current and future income of the employee for support considerations. The argument would be that the items that have already been granted are included as assets; however, the employee will continue to receive these items in the future which should be considered for alimony and child support.

The amount and value of incentive compensation can fluctuate greatly based on an employer’s performance and overall incentive strategy as well as the employee’s performance and compensation level. Many employers provide their employees with a total compensation summary which outlines their annual benefits including cash compensation, cash bonuses, stock option and RSU awards, and qualified and nonqualified deferred compensation. Each of these items should be considered when calculating the employee’s income for support purposes.

An outlier to calculating total compensation could arguably be the forgivable loan. This is a prime example of phantom income because nothing is actually received by the employee at the time tax is assessed, and the entire amount has been considered as an asset. However, the offsetting loan will ultimately be reduced and not paid back as a liability to the employee, which could be an argument for including it as income. In addition, some companies are choosing to use this as a form of a retention bonus, continuing to award these lump sums into the future as performance continues. As with many factors in a divorce, there are arguments both for and against including the amounts in current income.

The most apparent thread in reviewing and understanding these complex compensation examples is that the calculations surrounding them are complicated and can be a huge factor in the marital estate. The assistance of a financial expert who is familiar with these types of assets and their intricacies is highly recommended as you navigate them for your clients.

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Beth Garrett

Frazier & Deeter

Beth Garrett is a partner in the Divorce Litigation Support Practice at Frazier & Deeter, primarily assisting high-net-worth individuals and corporate executives with divorce, tax, and accounting issues. She helps with the division of financial and real estate assets through mediation. Beth also works with family practice attorneys through all financial aspects of divorce and child support matters, including uncovering hidden assets and income and preparing business valuations. She also prepares individual, partnership, and fiduciary tax returns, specializing in divorce taxation.