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The Professor Nedley Series

The Shifting Tides of Marital Property

Stock Options – Property or Income?

March, 2002

To understand options in a marital dissolution, there are three different concerns for the trial court and two types of options.  It is an area of concern that has diminished somewhat as we head into the late 00's since the "New" economy has changed the desirability of stock options.  The "dotcom" era seems to be a thing of the past and the war has made the future uncertain.  But they're still out there somewhere.

            a.  Overview:

                         1.  The Concerns for the Court:

a..                  Existing options as community property or separate property.

b..                  Future options as compensation.

c..                  Taxability of options.

2. Types of Option Plans: 

a.                  Option Plans (Non-Qualified).

b.                  Option Plans (Qualified).

b.  Options Generally

Stated simply, an option is the right to buy or sell property at a stipulated price on or before a specified date.  Gain or loss is recognized on the exercise of an option (Internal Revenue Code § 1256) (unless otherwise specified all code citations are to the Internal Revenue Code and the Regulations).

             Options may be statutory or qualified options.  These are granted                under specific Internal Revenue Code sections.

 Options may also be non-statutory or non-qualified stock options, which are governed under the more general code principals of compensation and recognition of income.

 Either option is held in an agreement under which the “holder” has the right but not the obligation to buy the stock at a fixed price under a range of dates.  (Reg. § 1.421 – 7(a)(1)).

 Qualified options are governed by Internal Revenue Code Section 421-424.  Non-qualified options are mere agreement without statutory tax benefits. 

c.  Non- Qualified Options;

 A non-qualified option is taxable upon the granting of the options if it has a “readily ascertainable fair market value.”  The tests are:

            1.                  Is it transferable?

2.                  Is it immediately exercisable upon grant?

3.                  Is there a condition or restriction on sale?

4.                  Is the FMW ascertainable?

 If these conditions are not met, then the option is NOT taxable upon “grant.”

 If there was no ascertainable market value, then the option is taxable upon “exercise.”  Since a price is then established, the income recognized at this point is the value of the stock purchase minus the cost of the stock.

 i.e.       In August 2000, in a non-statutory stock options plan, Qualcomm offers an option to buy shares in a spin-off company, price conditioned upon the actual startup.  The options are given to all top executives.  The company starts up and on September 1, the options become exercisable through December 31, 2000.  On November 1, 2000, “E” exercises the options and buys the stock for $100.  The fair market value is $150.

 If the value was ascertainable at the time of “grant,” then there is a taxable event at that moment.  The gain is the value of the stock minus the cost.

 i.e.       Fair market value is $150 and the cost to the employee is $75.  Upon the “grant” of the options, there is ordinary income of $75.

NOTE:            There is no tax at the time of the “exercise,” – when employee actually buys the stock.

There will be another tax when the employee sells the stock, assuming that  it goes up in value.  The gain on that will be the price over and above the “grant”  price, i.e., he sells the stock for $200, there is a $50 gain.  Losses may also be  recognized.

 In summary: 

a.                  He paid for the first $75

b.                  He was taxed on the next $75

c.                   Leaving the last $50 not yet taxed at the time of sale.

 So is there a significant tax benefit to non-qualified stock options?  Probably not unless the company is a start-up company without ascertainable fair market value, in which case there is a deferral of taxation until the option is exercised.  (Note:  There is a correlative loss in the event an option is taxed at “grant” and then not “exercised.”)

 d.  Qualified Options;

Qualified options may only be exercised by an employee.  The stock must be in the employing corporation.  The employee must remain an employee until three months before the exercise of the option.  Once a plan is adopted, the options must be “granted” within 10 years.  Thereafter the options must be exercisable within 10 years.  The options price must be the fair market value of the stock at the time of the “grant.”  The option is non-transferable.  There is a two-year “holding period” from the “grant” and a one-year period from the “exercise.”  There is a maximum ownership interest of 10 percent of the corporation.  All full-time employees must be included in the plan.  No one employee can acquire more than $25,000 in options each year.

 In summary, the ISO is a powerful tax and profit incentive for an employee in that very real compensation may be given to an employee and the tax on that compensation may be deferred for long periods,.

     e.  Stock Purchase Plans: Stock purchase plan rules (§423) apply to the exercise of an option granted under an employee stock purchase plan if:

                         1.                  Stock is held for two years from the “grant” or one year from the “exercise” of the option.

             2.                  The employee must remain an employee until three months before the exercise of the option.

                         3.                   A stock purchase plan may be only for employees. 

4.                  Shareholder approval is required.

                         5.                 All qualified employees must be included.

                         6.              The option price must be 85 percent of FMV

 

f.  Dividing Community Property Options;

Stock options that have been “exercised” as of the date of separation are clearly divisible as community property.

 

Stock options that have been “granted” as of the date of separation also represent a viable property right which can be divided either directly or indirectly.

 

The community property interest is that which is attributable to services rendered during marriage. 

 

There are no hard and fast rules.  The Court has broad discretion to gather the facts and review the options and to adopt any “equitable method” of allocation. In Re Marriage of Nelson (1986) 177 CA 2150; In Re Marriage of Hug (1984) 154 CA 3d 780.

 It is important to understand that the option and stock purchase plans are often “adopted” long before the employees are offered an opportunity or even a deadline by which to apply for the exercise or purchase of the options.  The difficulty in the dissolution case is the determination of when a specific tangible right in an inchoate benefit became sufficiently vested to constitute marital property.

 The purpose of the option must be considered.  Is it deferred compensation for present services or an incentive for future services or a combination. 

If it is deferred compensation, then it must be apportioned and divided in accordance with the marital status at the time earned.  Hug. 

 If it is compensation for future services, then that component would be separate property.  For example, where the grant of the options is clearly tied to remaining with the company, it may well be for future services, where there is a conditional grant with a cutoff date in the event of termination, In Re the Marriage of Walker (1989) 216 CA 3d 644.

 Where there are a series of options granted over a time period, then the Court should consider using the “time-rule.”  Thus, options that don’t vest until after separation are separate property.

 In summary, there are a variety of options or stock purchase plans, and what the Court must look for is when did the option become viable property that could no longer be taken away from the employee.  In making this consideration of “vesting,” the Court must consider the type of option plan that is offered by the corporation.  Is it statutory or non-statutory.  If it is statutory, is it an incentive stock option (ISO) under IRC §422 or is it a stock purchase plan under IRC §423.  The rules vary slightly.

 g.  Exercised Stock Options As §4058 Income;

 Prior to 1999, there was little law on the topic of options and support.  The Hug and Nelson cases, which were the primary stock option cases of the day, dealt more with property division issues and the characterization problems created by the type and timing of the options.

 

In 1996, a San Diego trial court judge known more for instinct than intellect ruled that stock options received after the date of separation were a part of the Husband’s overall compensation package.

 

The employee received a relatively modest salary from Qualcomm, but, in addition received and exercised stock options each year that considerably upped the family’s standard of living.

 

The trial court ordered if as and when the options were granted and exercised that the employee was to pay to his former spouse a specified percentage for spousal support and a specified percentage for child support.  The percentages were equivalent to the percentage of child support and spousal support stemming from his base salary.  A percentage was used because the amount that would be exercised in the future was unknown.

 

At the Appellate Court in In Re Marriage of Kerr (1999) 77 CA 4th 87, Judge Joseph, a former Family Law Judge sitting by assignment, upheld the basic premise that options were to be included as compensation in guideline and spousal support calculations.  He reversed the portion of the order using an uncapped fixed percentage of realized income from the exercise of options.  His ruling was prescient in that shortly thereafter Qualcomm commenced its meteoric rise into the stratosphere.

 

The trial court’s original order would have distorted the amounts beyond all comprehension.

 

The appropriate order would have been to base the amount on the actual historical exercise of option during the marriage.  This could be devastating to the paying spouse if option purchase or exercise programs were discontinued.

 

Finally, the Court could periodically review the parties’ incomes or the Court could have put a dollar cap on the amount to be paid out of any actual exercise of options.

 

h.  Unexercised Stock Options;   

 There are no California cases on this topic and there are a variety of questions that arise.  First, would be whether the option is, in fact, immediately exercisable or is delayed by a condition?

 If it is exercisable and the employee elects not to exercise his/her options at this time can they be forced to and/or can the Court place a value on the unexercised option?  If so – what value?

 What if it is presently exercisable but terminates at a future point if not exercised? 

What about straight, old run-of-the mill income imputation rules?  See In Re Marriage of Murray (1999) 128 Ohio Appellate 662.

 There is at least one case in San Diego where the trial judge has set a specific dollar amount to be paid upon the actual granting of the options.  Is that fair?  Should it be deferred to exercise?  To sale?

 I.  Summary of Taxability;

 a.      Non-Statutory/Non-Qualified Options

 Essentially, a non-statutory option is simply the right to purchase stock.  It has no meaning other than that given by terms of the option agreement, thus it has no tax consequences other than by the terms of the option.

For example, the right of an employee to purchase stock at market value provides no compensation benefit to the employee and is, therefore, not taxable at the time of the grant nor is the employer entitled to a deduction of any sort.

 If the stock goes up in value and the employee “exercises” his/her option, there is an immediate tax on the benefit conferred on the employee over and above the purchase price.

i.e.:  If the grant of stock options was $50 per share and value is now and 75, the employee will be immediately taxed on the $25 capital gain. 

If it is taxed and sold, the gain or the “sale” is the same as the gain from the exercise. 

If the employee continues to hold the stock and it continues to go up, it will again be taxed at the time of sale.  This time the tax is based on the sales price minus the exercise price.

 i.e.:  If he now sells the stock (which he now owns outright with a basis of $75) for $125 he will pay capital gains on an additional $50.

 The employer’s deduction comes only at the time the employee exercises the option and only for the difference in the “grant” price and the “exercise” price.

b.      Statutory Stock Options

 Statutory options have certain transfer restrictions, but have highly beneficial tax results for the employees. 

No income results to the employee at the time of transfer (nor a correlative deduction to the employer) and no income results at the time of the exercise of the options even if the value has significantly increased. 

The only tax to the employee will be on the capital gain recognized at the time of sale.  Therefore, gain is deferred and converted to capital gain.