The Nuances of Executive Compensation Division and Valuation

by | Aug 27, 2024

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.

Schedule Your Complimentary Divorce Strategy Session Today!

You can read more divorce related articles, news and resources here. Don’t forget to follow along on social media for helpful divorce tips and resources!

How Executive Compensation is Divided in Divorce

by | Aug 7, 2024

 

 

In our previous article, “How Executive Compensation Impacts Divorce,” we presented the types of executive compensation that should be considered for purposes of marital property division, as well as future income that should be included for support calculations. This article will examine the basics of dividing executive compensation. We begin by identifying several key aspects of executive compensation in divorce.

Identifying the Marital Portion

In most cases involving divorce, we must first determine to what extent the compensation is marital and subject to division. In all cases, if the compensation was awarded and vested during the marriage, they are 100% marital. If awarded but not vested, we must first determine the extent the award is based on past service vs. future performance. To the degree based on future performance, that portion would be considered separate property. To the extent that there are no plan-specific rules regarding the division of benefits, coverture fractions are used to determine the percent marital. 

Applying Coverture Fractions

Coverture fractions based on past performance are based on the Hug formula. The numerator (marital service credit) represents the total number of years or months during which the retirement benefits were earned or accrued while the spouses were married. This includes the period from the date of marriage to the date of separation or divorce filing, whichever is applicable. The denominator (total service credit) represents the total number of years or months that the spouse worked or accumulated service credit that counts towards the retirement benefit. Up to the present date or retirement date. Calculate the marital coverture fraction by dividing the numerator (years of marital service credit) by the denominator (total years of service credit).

Coverture fractions based on future performance are based on the Nelson formula. The numerator (period of marital service) represents the period during which the spouse earned or accrued retirement benefits while the marriage was intact. This typically starts from the date of marriage to the date of separation or divorce filing, depending on state laws. The denominator (total period of service) represents the total period during which the spouse worked or accumulated service credit that counts towards the retirement benefit up to the present date or anticipated retirement date. Calculate the marital coverture fraction by dividing the numerator (period of marital service) by the denominator (total period of service).

Divide or Offset?

Most executive compensation cannot transfer directly to the non-employee spouse. Even if it can be, it may not be advantageous to transfer it at the time of vesting or payment. In these cases, we need to be able to provide a value for the portion earned during the marriage so that the employee-spouse can keep the compensation while the non-employee spouse receives other assets to compensate. Valuation, however, is not always a straightforward exercise. 

Tax Considerations 

When transferring to a non-employee spouse, we need to adjust for the taxes paid at the time of vesting or exercise. Depending on the plan, the recipient’s marginal tax rate applies to some transfers when exercised. Only the employee spouse can exercise others, using the employee spouse’s marginal tax rate at vesting or exercise.

Attorneys may subpoena the employee spouse’s company or the employee spouse can provide documents that are necessary to determine if the executive compensation is based on past or future performance, granting conditions and vesting schedules. Request the following documents:

  • Compensation plans and all amendments 
  • Grant agreements and all amendments 
  • All correspondence (letters, memorandum, emails) relating to grants
  • Summary plan descriptions
  • Annual statements of employee benefits
  • Employee manuals the describe employee’s right to benefits
  • Employment contract or offer letter
  • Beneficiary designation forms
  • Employee’s employment file
  • Valuations conducted for IRC Section 409(A) purposes or other purposes
  • Employee’s W2’s

In our next article, we will look at some of the nuances of handling executive compensation across the more common types of executive compensation. 

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.

Schedule Your Complimentary Divorce Strategy Session Today!

You can read more divorce related articles, news and resources here. Don’t forget to follow along on social media for helpful divorce tips and resources!

How Executive Compensation Impacts Divorce

by | Aug 1, 2024

In our previous article, “How Executive Compensation Impacts Divorce,” we presented the types of executive compensation that should be considered for purposes of marital property division, as well as future income that should be included for support calculations. This article will examine the basics of dividing executive compensation. We begin by identifying several key aspects of executive compensation in divorce.

Identifying the Marital Portion

In most cases involving divorce, we must first determine to what extent the compensation is marital and subject to division. In all cases, if the compensation was awarded and vested during the marriage, they are 100% marital. If awarded but not vested, we must first determine the extent the award is based on past service vs. future performance. To the degree based on future performance, that portion would be considered separate property. To the extent that there are no plan-specific rules regarding the division of benefits, coverture fractions are used to determine the percent marital. 

Applying Coverture Fractions

Coverture fractions based on past performance are based on the Hug formula. The numerator (marital service credit) represents the total number of years or months during which the retirement benefits were earned or accrued while the spouses were married. This includes the period from the date of marriage to the date of separation or divorce filing, whichever is applicable. The denominator (total service credit) represents the total number of years or months that the spouse worked or accumulated service credit that counts towards the retirement benefit. Up to the present date or retirement date. Calculate the marital coverture fraction by dividing the numerator (years of marital service credit) by the denominator (total years of service credit).

Coverture fractions based on future performance are based on the Nelson formula. The numerator (period of marital service) represents the period during which the spouse earned or accrued retirement benefits while the marriage was intact. This typically starts from the date of marriage to the date of separation or divorce filing, depending on state laws. The denominator (total period of service) represents the total period during which the spouse worked or accumulated service credit that counts towards the retirement benefit up to the present date or anticipated retirement date. Calculate the marital coverture fraction by dividing the numerator (period of marital service) by the denominator (total period of service).

Divide or Offset?

Most executive compensation cannot transfer directly to the non-employee spouse. Even if it can be, it may not be advantageous to transfer it at the time of vesting or payment. In these cases, we need to be able to provide a value for the portion earned during the marriage so that the employee-spouse can keep the compensation while the non-employee spouse receives other assets to compensate. Valuation, however, is not always a straightforward exercise. 

Tax Considerations 

When transferring to a non-employee spouse, we need to adjust for the taxes paid at the time of vesting or exercise. Depending on the plan, the recipient’s marginal tax rate applies to some transfers when exercised. Only the employee spouse can exercise others, using the employee spouse’s marginal tax rate at vesting or exercise.

Attorneys may subpoena the employee spouse’s company or the employee spouse can provide documents that are necessary to determine if the executive compensation is based on past or future performance, granting conditions and vesting schedules. Request the following documents:

    • Compensation plans and all amendments
    • Grant agreements and all amendments
    • All correspondence (letters, memorandum, emails) relating to grants
    • Summary plan descriptions
    • Annual statements of employee benefits
    • Employee manuals the describe employee’s right to benefits
    • Employment contract or offer letter
    • Beneficiary designation forms
    • Employee’s employment file
    • Valuations conducted for IRC Section 409(A) purposes or other purposes
    • Employee’s W2’s

In our next article, we will look at some of the nuances of handling executive compensation across the more common types of executive compensation. 

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.

Schedule Your Complimentary Divorce Strategy Session Today!

You can read more divorce related articles, news and resources here. Don’t forget to follow along on social media for helpful divorce tips and resources!

11 Costly Financial Mistakes in Divorce Settlements

by | May 20, 2022

 

11 Costly Financial Mistakes in Divorce Settlements

Divorce is expensive even without mistakes and getting comprehensive guidance on divorce financial planning is critical. Read on to learn of the top eleven most common financial mistakes made in divorce.

1. Mis-Specifying Marital vs. Separate Assets

What’s considered marital property and subject to division? Most will say that any comingling of assets (e.g., depositing the funds in a joint account or using marital funds to pay the mortgage) constitutes an asset as marital. And in some states and counties, even if a portion of an asset that was separate on the date of marriage will, over the years, transition to marital. This can impact considerations of real estate, retirement, inheritances, and more.

2. Dividing Each Asset 50/50

Too often, lawyers, hearing officers, and judges take the easy way out by forcing division of each asset equally. Why? It’s easy and not easily challenged. This approach, though, fails to consider the needs and wants of each spouse, as well as the tax consequences of and administrative effort in dividing each asset.

3. Not Considering an Alimony Buyout

No one likes alimony. Payors hate writing the check and the recipient hates depending on it. Plus, if the payor dies or is disabled, the payments stop (an example of why insurance is important post-divorce). Instead, if there are sufficient assets to cover it, calculate the present value of the stream of anticipated payments at an appropriate discount rate and build it into the division of assets.

4. Errors in Valuing Executive Compensation

If there’s one financial topic that befuddles many, it’s how to treat deferred compensation, including stock options, both qualified and not qualified, as well as restricted stock and restricted stock units. Are they marital or separate? Are they based on past or future performance? Can they be transferred to a spouse/former spouse? What is the correct valuation method: intrinsic value, Black-Scholes, or the binomial method? How are taxes accounted for?

5. Not Considering the Possibility of Hidden Assets

Given the opportunity and motive, many a spouse will start stashing away funds in anticipation of a divorce, whether for financial security, sense of ownership, or vindication. Tax returns, W-2’s, credit card statements, and bank account statements are all sources to identify diverted funds. Even when not suspected by a client spouse, a quick review of these documents may reveal otherwise unidentified assets.

6. Not Looking at Creative Settlement Options to Meet Each Spouse’s Unique Needs

What if a spouse wants to keep the house for and can’t get approval for a mortgage buyout? It’s easy to just say “sell” and move on, but there are ways to facilitate the desire of a spouse who wants to remain in the home for a period without undue legal or financial burden to the co-owner spouse. As another example, maybe retirement funds are of utmost concern and alimony/cash flow not so much? A skilled divorce financial expert will come up with alternative settlement options to address the unique needs of each spouse.

7. Mistakes in Retirement/Pension Valuation and Division Orders

Retirement plans, and especially pensions, are widely misunderstood in divorce. The one who’s name is on the retirement plan thinks they are the rightful owners. Some incorrectly think the “current value” on a pension statement is the value of the pension. Pensions of all kinds, and especially military and federal pensions, require an expert for valuation and drafting of appropriate orders for submission to the custodian.

8. Failing to Consider Tax Consequences

All assets are not alike when it comes to splitting them in divorce. $250,000 in a 401k is not the same as $250,000 of equity in a house. The former is taxed at an ordinary income tax rate upon withdrawal while the latter may be largely excluded from any taxation and otherwise taxed at the capital gains rate.

9. Allowing One Spouse to Keep the House When it’s Not Financially Feasible or Beneficial

The marital home is an asset laden with emotion and sentimentality. It’s common to want to keep the house for emotional stability without consideration of the impact on future financial health. Houses don’t necessarily appreciate significantly over time, maintenance expenses are often overlooked or discounted, and a house is not a liquid asset. An objective evaluation is critical before deciding to keep or sell the marital home.

10. Not Properly Accounting for a Closely Held Business

If a spouse owns a business, is it a source of income, an asset to be valued and divided, or both? If a source of income, do we just look at the tax returns for the business? If to be valued, do you pay a business valuation expert thousands of dollars to get an accurate figure? Get the advice of a divorce financial expert is necessary if one of the spouses owns a business.

11. Not Accurately Budgeting for Your Post-Divorce Life

Do you have a good hold on where your money goes? Have you really assessed how much you will need post-divorce? Your choice in divorce settlement options needs to be balanced between short-term cash flow needs and long-term net worth.

Work with a qualified divorce financial professional, i.e., a Certified Divorce Financial Analyst® (CDFA®) to help you avoid costly mistakes in divorce. You only get one chance to get it right.

Take Control of Your Future

 

When you consider divorce, or if you know someone who is contemplating 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.

Schedule Your Complimentary Divorce Strategy Session Today!

How to Win in Divorce

by | Jan 4, 2022

In a recent post, I addressed the notion of “winning” at divorce. There are many lawyers who claim they can do just that, and they will be happy to take your hard-earned money while they fight your war for you. The reality is, in the vast majority of cases, you’ll wind up no better off than if you’d negotiated to begin with, and all the while you’re funding your lawyer’s kids’ college education instead of your own. 

Winning might instead be viewed as getting through this divorce transition with integrity, keeping more of your own money, and maintaining your and your children’s emotional health throughout. Ideally, you’ll do this without ever stepping foot into a courthouse or even speaking to an attorney. 

So, how do you get better outcomes, at a lower cost and without judges, courts, or even lawyers? If you have minor children and marital assets, don’t attempt a do-it-yourself divorce unless you want to risk costly mistakes that cannot later be reversed. If you want an easy, affordable, and legal solution, seek a qualified divorce mediator. 

You will want to find a mediator who has the knowledge, skills, and experience to guide you and your spouse to a financially optimized settlement agreement and, if applicable, with a parenting plan that preserves the integrity of your family. A mediator with the divorce financial expertise of a Certified Divorce Financial Analyst (CDFA®) is ideal.

How, though, to address the legal piece of your divorce? You will find that legal agreements and divorce papers are straightforward in a mediated case. These can be easily facilitated by your mediator so that you never even have to work directly with an attorney to process your divorce. (It’s never a bad idea, though, to have an attorney review your agreements before they are finalized, and this can be done at a minimal cost.)

Rationally approaching your divorce, along with a dose of grace, can result in a lower-cost and faster process while addressing your financial needs and preserving your family’s emotional well-being. Now, wouldn’t you agree this would be a “win” at divorce?