This is the third of a three-part series on executive compensation. In our previous articles How Executive Compensation Impacts Divorce and How Executive Compensation is Divided in Divorce, we identified the prominent forms of executive compensation, discussed why they are important in divorce and what makes them so complicated, and how they are generally divided. The purpose of this article is to discuss some of the nuances of how the more common types of executive compensation are valued and divided in divorce
OPTIONS
Stock Options:
There are two types of options: incentive stock options (ISO’s) and non-qualified stock options (NSO’s). ISO’s are a type of compensation that can be granted only to employees (not to board members or consultants). They offer certain tax advantages under the U.S. tax code. Internal Revenue Code. NSO’s are the right to buy company stock at a predetermined price without tax advantages.
Taxes:
ISO’s and NSO’s are not taxed when granted, but the difference between the exercise price and the fair market value at exercise is taxable. As for ISO’s, the difference in exercise price and fair market value is considered a preference item for the Alternative Minimum Tax (meaning it is not subject to income tax but is included in the calculations for the Alternative Minimum Tax). For NSO’s, the difference is taxed at regular income rates, including Social Security and Medicare taxes. For both ISO’s and NSO’s, capital gains taxes are paid when the stocks are sold. The holding period for determining short-term versus long-term gain starts on the exercise date.
Note that several limitations on ISOs can affect taxes: 1) The value of ISOs that first become exercisable in any one year cannot exceed $100,000 per employee (based on the grant date value). Tax purposes treat any options exceeding this limit as non-qualified stock options (NSOs). 2) Employees who own more than 10% of the company’s stock cannot receive ISOs unless the exercise price is at least 110% of the fair market value on the grant date and the term of the option is no more than five years. 3) ISOs typically must be exercised within 10 years from the grant date, or five years for 10% shareholders. If terminated, employees must exercise ISOs within 3 months after termination. If terminated because of death or disability, they must be exercised within 1 year. ISOs can be transferred to the non-employee spouse upon death.
Valuation and Division in Divorce:
ISO’s are not transferable and most NSO’s are also not transferable from the employee spouse to the non-employee spouse. Those which are transferable can be transferred upon vesting to the non-employee spouse and upon exercise the non-employee spouse pays taxes based on their own tax rates. Those not transferable can be exercised by the employee spouse after vesting and the after-tax value based on the employee’s marginal tax rate can be paid to the non-employee spouse.
When it is possible to transfer NSO’s and they are part of a qualified retirement plan, a QDRO will be required to divide the assets between spouses without triggering immediate tax consequences for the recipient spouse.
For NSO’s and ISO’s, the employee spouse can keep all his/her options by valuing the options and offsetting with other marital assets. However, option valuation is not straightforward.
Easiest to comprehend is the option’s intrinsic value, which is the difference between the value of the stock at separation and its strike price (the value at which the stock can be purchased at exercise). Intrinsic value, while easy to comprehend, does not consider future price volatility or dividend rates.
The Black-Scholes method is the most widely used method for calculating option values. It assumes the employee does not exercise the option until the last day possible and it accounts for future price volatility and dividends.
Last the Binomial Method take the Black-Scholes method and creates a tree of possible option values as well as early exercise. It tends to produce a slightly lower valuation than Black-Scholes. It is not widely used nor understood.
STOCK
Restricted Stock:
Shares granted to executives that are subject to certain restrictions, such as vesting periods or performance conditions. Once the restrictions are lifted, the executive fully owns the stock.
Taxes:
Taxed as ordinary income at vesting (unless an 83(b) election is made), with capital gains tax on any subsequent appreciation.
Division in Divorce
Once vested, restricted stock can be transferred in divorce. If not yet vested, the employee spouse can transfer the stock upon vesting but the taxes will be paid by the employee spouse. Thus, it is important to account for the marginal taxes that will be paid upon vesting in their value at transfer.
Valuation in Divorce:
It is sometimes desirable to value the non-vested restricted stock at the time of divorce rather than wait for division at vesting. In this case, valuation will depend on the projected future stock price of the company. There are two methods for valuing restricted stock.
- 1) Intrinsic Value Method: This method involves calculating the current value of the restricted based on the current stock price, discounted for any remaining time until vesting. The formula might look like this: Intrinsic Value = Number of Restricted Stock Shares x Current Stock Price x Probability of Vesting x Discount Factor. The discount factor accounts for the time value of money.
- 2) Projected Value Method: This approach first uses a coverture fraction to determine the portion earned during the marriage relative to the total vesting period (unless the restricted stock was granted based on past performance). It then estimates the future value of the restricted stock when they are expected to vest. Projected Value = (Time from grant date to separation date / Total vesting period) x Number of shares x Projected Stock Price at Vesting x Probability of Vesting x Discount Factor and then delete the third point altogether. Note: future stock price projections are often speculative and need careful consideration.
Restricted Stock Units (RSU’s):
RSUs are a promise to deliver shares of stock (or the cash equivalent) at a future date, once certain conditions (like vesting) are met. They do not represent actual shares upon grant. Once vested, the RSU’s convert into actual shares. Dividends may be paid on unvested units and some plans accrue dividends and pay at vesting.
Taxes:
Employees are taxed when the RSUs vest and convert into actual shares. The fair market value of the shares at vesting is considered taxable income. Unlike restricted stock, there is no 83(b) election available for RSUs.
Division in Divorce:
RSU’s are generally not transferrable. The employee spouse will have taxes withheld at the time of vesting. There is precedent that allows the employee spouse to issue a 1099 to the non-employee spouse. This is so that the non-employee spouse can later pay taxes at his/her rate. It is based on a number of cases where taxpayers obtained a private letter ruling from the IRS that approves this practice. However, exercise caution, as the practice may not hold up in an audit. Also, if an employee spouse issues a 1099 for the amount of stock transferred, the employee spouse must still pay the social security and Medicare taxes. They should be compensated for that by the non-employee spouse.
Valuation in Divorce:
Same as for restricted stock.
Performance Stock:
Shares granted based on the achievement of specific performance targets. These targets can be financial metrics, such as earnings per share (EPS), or non-financial metrics, such as customer satisfaction scores.
Taxes:
Same as with restricted stock units.
Division and Valuation in Divorce:
Same as with restricted stock units.
Performance Stock Units:
Similar to restricted stock units but vesting is based on meeting performance standards, not the passage of time.
Taxes:
Same as with restricted stock units.
Division and Valuation in Divorce:
Same as with restricted stock units.
Deferred Compensation:
Earnings that are set aside to be paid out at a later date.
Taxes:
Taxed as ordinary income in the year of payment.
Valuation and Division in Divorce:
You must calculate the present value of future payments, and then either offset the value or defer the distribution to the non-employee spouse until the payments go to the employee spouse. In an offset, and in cases where you consider after-tax asset values, you should adjust the present value based on the non-employee spouse’s expected marginal tax rate at the time of distribution.
Summary and Conclusion
Executive compensation can represent a substantial asset in divorce. Future executive compensation can also be a sizeable amount of income on which to base support. Thus, it is crucial to understand whether various compensation types exist. When they can be transferred, how they will be taxed at transfer. And how they might be valued if they are not transferable or if waiting for a transfer is undesirable. Adding a Certified Divorce Financial Analyst® that is trained and experienced in identifying and valuing executive compensation to the divorce team is critical. Whether they work directly with a client as a mediator or consultant or in conjunction with the client’s attorney.
Take Control of Your Future
When you consider divorce, one of the biggest realities for those in the divorce process is the financial settlement and financial analysis post-divorce. Get the assistance of Berni Stevens, a Mediator and Certified Divorce Financial Analyst® (CDFA®.)
Berni provides step-by-step guidance on matters related to divorce. With a wide range of experience and expertise related to divorce issues. Berni will simplify the process and provide much-needed clarity in areas such as long-term tax consequences, asset, and debt analysis, dividing pension plans, continued health care coverage, stock option elections, protecting support with life insurance, and much more.
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