Deferred compensation, which can be in the form of additional cash and/or non-cash compensation, is a common vehicle for companies to compensate employees in addition to their base salary or wages. Depending on the type of deferred compensation issued to the employee, it may be reported differently than W-2 income, resulting in different tax consequences, which attorneys must be aware of when determining how to treat and divide such compensation. There are many forms of deferred compensation, including, but not limited to, (i) restricted stock units (RSUs), (ii) stock options, (iii) deferred cash compensation, and (iv) 401(k) plans. This article focuses on RSUs and will discuss how to identify RSUs, standard terms every attorney should be familiar with, necessary discovery to request, approaches to dividing RSU awards, and tax implications.
Issued by a company to its employees, RSUs are a form of equity compensation and one type of deferred compensation. Employers issue RSUs for several reasons, such as:
Grant – The award of a certain number of restricted shares of company stock. Commonly, at the time of the award, the employee does not fully own the stock; instead, the employee is subject to vesting requirements.
Time-Based Vesting – This is the process through which the employee earns the right to receive RSUs over a specified period, typically set on a vesting schedule.
Vesting Schedule – The timeline over which RSUs vest. Common vesting schedules are as follows:
Milestone-Based Vesting – The process through which the right to receive RSUs is earned when specific goals or milestones are achieved. Examples include, but are not limited to, individual performance metrics, product launches, profitability targets, sales targets, and other individual and/or company-wide targets.
Single Trigger Vesting and Double Trigger Vesting – Vesting conditions that require one condition or two conditions to occur, respectively, resulting in an employee’s RSUs immediately vesting before the normal vesting schedule is satisfied. A typical single trigger vesting condition is a change in control of a company (i.e., a liquidity event). Double trigger vesting may occur when the aforementioned condition, i.e., a liquidity event, occurs in addition to another condition, such as an employee remaining employed with the company for a certain period.
Vesting Date – The date on which the RSUs vest and the employee is entitled to full ownership of the vested shares. On this date, the vested shares are assigned a fair market value and are considered taxable income to the employee.
Delivery Date – This occurs on or after the vesting date. On this date, the vested shares are delivered to the employee, who can now exercise full control over the shares and sell them.
Fair Market Value (FMV) – The market value of the company’s stock on a specific date, typically the vesting or delivery date.
Forfeiture – The loss of RSUs if an employee does not meet their vesting requirements. It is important to know what happens to the employee's unvested shares if they leave before satisfying all vesting requirements. As counsel, you must consider this when dividing RSUs and treating them for alimony or property division purposes.
Do not assume a spouse will be forthcoming about their awarded RSUs. Sometimes, it may even be your client who is unaware or forgets that they have received or will be receiving an award. Therefore, it should be standard to request documents and information that will facilitate the identification of any RSUs that have been awarded. Whether you represent the payor spouse or the recipient payee, to understand the implications of the RSU award, the discovery request should seek any and all documentation related to the granting, vesting, forfeiture, and tax implications of the RSUs. The following documents should be requested:
In addition to the documents identified above, you can request and review the party’s earning statement and Form W-2, specifically box 12 on Form W-2, as RSUs that have vested, and other deferred compensation may be identified separately from wages and other items reported on these documents. Do not rely only on the party’s Form W-2 and/or their earning statements, as if a party has unvested RSUs; you would not be able to identify those simply by reviewing their Form W-2 or earning statement.
After RSUs are identified and analyzed, determining how to equitably distribute this asset is the next step. First, determine if the RSUs will be treated as income for purposes of alimony, assets for property division, or a combination of the two, depending on the specific circumstances. One approach is to suggest that any economic benefit produced by this asset is shared on an if, as, and when basis in the future. Another is that the RSUs are valued and included in the overall marital estate that is subject to equitable distribution. However, more commonly, the employee spouse may be able to distribute the RSUs in-kind to the recipient spouse, however the transferability restrictions applicable to the subject RSUs must be reviewed before considering this option.
One argument you may encounter is that generally, the vesting conditions require post-filing date/post-divorce efforts of the employee spouse and that any economic benefit derived therefrom is not subject to equitable distribution. However, there may be a portion of the award that was earned during the marriage through the efforts of the employee-spouse. With the help of your financial expert, you can identify the discrete portion of an award that was earned during the marriage and the portion that was or will be earned after the relevant date (i.e., date of filing, date of divorce, etc.) by applying a coverture fraction. With respect to RSUs, the coverture fraction is as follows:
The following example illustrates the application of a coverture fraction to RSUs:
(366 Days)/(730 Days)=50.1%
50.1% ×5,000 Unvested RSUs=2,505 RSUs Earned During the Marriage
When determining the treatment of RSUs, as counsel, you should be knowledgeable of the tax implications. RSUs are taxed when they are vested, not when they are granted. The FMV of the vested shares on the vesting date is taxed at the employee’s ordinary income tax rate (i.e., the same tax rate as wages and cash bonus compensation). This FMV is now considered the employee’s cost basis of the vested shares.
If the vested shares are sold after the vesting date, any recognized gain is taxed as well. The amount of the gain is determined by subtracting the employee’s cost basis from the FMV on the date the vested shares are sold. Any gain recognized upon the sale of vested shares sold within one year of the vesting date will be taxed at short-term capital gains tax rates, which are the same tax rates as ordinary income. However, if the vested shares are sold beyond one year past the vesting date, any gain recognized upon their sale will be subject to the long-term capital gains tax rates, which are more favorable than ordinary income tax rates. Below are examples of the various tax consequences:
Not considering the tax consequences associated with RSUs can create a legal misstep when calculating when and how to pay a recipient spouse. The attorney should consider (i) who will be responsible for paying the taxes, (ii) can the amount of taxes be determined prior to division, and (iii) can you provide for a true-up if there is an under or overpayment. Furthermore, can the stock itself be transferred and not the cash equivalent value, and if so, what are the tax consequences to the recipient spouse? By considering the tax implications and distribution options, counsel can effectively advise clients with respect to RSUs and their equitable distribution.
Do not assume RSUs are “simple” to divide or consider only for alimony/maintenance purposes. Make sure that you understand all aspects of the asset, such as (i) the number of unsold vested shares on the relevant date (i.e., date of filing, date of divorce, etc.), (ii) the number of unvested RSUs, the applicable coverture fraction, and the proposed number of RSUs earned during the marriage and earned after the relevant date, (iii) any forfeiture provisions associated with the unvested RSUs, (iv) tax consequences, and (v) the transferability of the unvested RSUs. By adequately understanding the complexities and nuances discussed above, you can work towards an equitable division of RSUs in divorce proceedings.
