Employee stock option division in divorce is a confusing and complex area troubled with tax complications and imprecise valuation methods. But as more and more companies use stock options to lure and reward employees, these assets have become a larger part of the marital asset pool. Therefore, it is crucial to understand the ins and outs of the different stock option plans.
It’s important to start with the fact that a stock option is not a share of stock. This is often misunderstood, even by the people to whom an option has been granted. Rather than a share of stock, an option is a privilege that gives the owner the right, but not the obligation, to buy a stock at an agreed-upon price within a certain period or on a specific date.
Employee stock options come in two basic flavors: non-qualified stock options and qualified, or incentive stock options (ISOs). With non-qualified stock options, the recipient owes no tax when the options are granted. Rather, they are required to pay ordinary income tax on the difference, or spread, between the grant price and the stock’s market value when they purchase (exercise) the shares.
Qualified or incentive stock options are qualified because they receive special tax treatment from the IRS. No income tax is due at grant or exercise as long as the stock shares acquired through the option exercise are held for the later of two years from the date of grant or one year from the date of exercise. If the owner follows suit, the tax is deferred until the sale of stock…at which point the entire option gain is taxed at long-term capital gains rates.
In addition to knowing the different types of employee stock options, divorce professionals need to understand the two methods of distribution between an employee spouse and a non-employee spouse. Under the deferred distribution method, only non-qualified stock options can be transferred to a non-employee spouse. The transfer of incentive stock options (qualified) would require the option to lose its special tax status and be transformed into a non-qualified stock option.
With the present valuation method, the stock options are valued using one of three valuation methods (Intrinsic Value, Black Scholes & Binomial) and the non-employee spouse is allocated compensating assets in lieu of the stock options. Unfortunately, none of these valuation methods takes into account the potential tax effects of exercising the options.
Even though the IRS allows transfers of non-qualified stock options as a non-taxable transfer between spouses, not all employee stock option plans allow for such transfers.
The following documentation should be obtained in cases concerning employee stock options:
- The stock option and subscription agreements
- A grant schedule showing:
- Date of each option granted
- Number of options granted at each date
- Exercise price for each option
- Expiration date of each set of options
- Date of vesting for each set of options
- A transaction history of options that have been exercised showing the date and number of options exercised
Because employee stock options is a complex arena, people working through divorce ought to have professional help. A divorce professional that understands the ins-and-outs of employee stock options, in addition to the documentation to be obtained, will best help their clients to make sounds financial decisions.