The Marital Estate: Stock Options and Restricted Stock

While each state has its own set of rules, as the case law developed, many states “borrowed” decisions from other states simply because many of the issues were of “first impression” – the court had no decisions of its own to rely on, and had to look to other jurisdictions for precedents. Thus over time the decisions throughout the country became more uniform. The primary and universal determining factor became the period of time the employee spouse “earned” the stock option. If the options were earned entirely during the marriage they were entirely marital property. If not, then an analysis was needed to determine what portion of the options was earned during the marriage. This resulted in a “time rule” where the option was granted for purposes of retaining the employee. Under the time rule, the portion of the option that is granted during the marriage and vests during marriage is marital property; the portion that vests after final separation is not. Any portion partially vested is pro-rated.

Where the option is granted, in whole or in part, for purposes other than retention, the vesting period is often ignored. An option granted as a “signing bonus” is held to be given for accepting employment, and thus “acquired” at the inception of employment. If the employee is married at the inception of employment the option is marital property. If the employee is not married at the inception of employment then the option is not marital property. Another less frequent purpose of an option grant is to “reward” the employee for past services to the company. If the services were performed before the marriage, the option is not marital property; if the services were performed during marriage, the option is marital property, and if the services were performed both before and after marriage, the option is part marital and part non-marital property.

Purpose of the Grant

Perhaps the most difficult issue to be resolved is the purpose of the grant. Most stock option plans contain a “plan purpose” statement. Unfortunately, these statements are bound to have been revised from time to time, and list multiple factors as the plan purposes. In most large companies, the recipient's immediate supervisor decides whether a grant is going to be made, and if so, at what number of shares. There is usually a dearth of record keeping on the decision. By the time the issue arises in the context of marriage dissolution, the supervisor has often left the company. Even if the supervisor can be found, he or she will most likely have no recollection of the reasons behind the option decision, which was sometimes made many years before the dissolution proceeding. The courts look to the circumstances surrounding the grant as well as any documentation that exists. For example, if an option was granted coincident with a promotion, the argument can be made that the grant was, at least in part, a reward for the past performance of the employee, the spouse continues to own the portion of the option awarded to the non-employee spouse for his or her benefit. The agreement or decree provides that the employee spouse has to exercise the portion held for the benefit of the other only on the other spouse's direction. The non-employee spouse is liable for the taxes paid by the employee spouse.

How the Tax Is Figured

Most stock options are “non-qualified,” meaning they do not qualify for the special tax treatment of “qualified” options. Non-qualified stock options are not taxed when granted, or even when vested. They are taxed only at the time the option is exercised. The tax is at “ordinary” income tax rates, just like wages. The tax is figured on the difference between the exercise price, the price of the stock at the time the option is exercised, and the strike price, the amount paid for the stock. In addition to income tax, there is also a Social Security and Medicare tax due on the difference. The difference between the strike price and the exercise price is subject to the minimum withholding rules, so a minimum of 20% of the difference must be withheld by the employer, along with the employee's share of the Social Security and Medicare taxes, just the same as on a wage or salary check.

'Paperless' Transactions

Because of the large amounts involved, stock options are frequently exercised in a “paperless” transaction through a brokerage firm. The process starts when the employee gives notice of exercise of an option. The employer provides the number of shares of stock involved, the brokerage firm sells the stock on the open market and gives the employer the amount equal to the strike price; the employer withholds income tax, Social Security and Medicare taxes, and the balance of the stock sale proceeds goes to the employee. If the employee is exercising the option at the direction of the former spouse, then the employee simply forwards the funds.

Sometimes the employee will use available cash to acquire the stock. When this is done, the employee, after giving notice of exercise of the option, simply pays the employer the amount of the strike price, plus the amount of the minimum withholding for income tax and the amount of the Social Security and Medicare taxes. The stock is then issued to the employee. If the employee is exercising for the former spouse, the funds are paid to the employer by the former spouse and the employee transfers the stock to the former spouse when issued.

Non-vested stock Options

Stock options that are not vested are difficult to value, as no one can predict what will happen to the stock price between the valuation date and the date on which the option vests. Stock options can be valued simplistically by obtaining the current price of the stock and computing the after-tax proceeds if the option were to be immediately exercised. Since the vested options can be exercised immediately, one can argue this valuation is valid. However, this simplistic method does not take into consideration the value of holding the stock with absolutely no money paid toward the purchase, with the chance the stock will increase in value before expiration of the option. Of course the simplistic method can be applied to unvested option as well — and frequently is — but is less reliable because the options holder cannot exercise the option. Various models have been developed by economists, most notable the Black-Scholes method (a very complicated process requiring the use of judgment by the valuation expert). However, all such methods require the use of judgment by the valuation expert. Many cases eliminate the valuation issue by awarding the marital stock options fairly equally.

What Happens Now?

The thrilling stock option ride came to an abrupt halt in March of 2000, when the bubble burst on the stock market, sending the tech stocks to levels far below their previous prices. Since the strike price for options is set at the price at the time of the grant, after the market crashed many employees found themselves with options that were “under water,” which means that the market price of the stock was less than the strike price. Many options have since expired, never regaining a price above the strike price. Others issued before March 2000 that have not expired have failed to regain any value. Because the number of new companies declined drastically after March of 2000, fewer employers have been issuing options. As a result, fewer and fewer marriage dissolution cases have significant stock option issues to decide.

Just as Microsoft led the expansion of stock option usage, offering options to many employees, not just senior executives, it may be leading a similar expansion of the use of restricted stock. Microsoft recently announced that it was terminating the grant of stock options, and starting a new plan called Stock Awards. Though not an option plan, it has many similarities, and many of the rules on stock options will carry over to the new restricted stock award plans.

The Stock Awards plan at Microsoft will award shares of Microsoft stock to employees. The employee's manager, the same person who made those option decisions, will make the decision as to which employees will receive awards and if so, how many shares. However, the stock will be “restricted” in that a) the shares will “vest” at the rate of 20% per year over 5 years, with the first portion to vest on the first anniversary of the grant, b) the employee must still be employed when the stock vests, and c) the stock will not be entitled to dividends until vested.

The Stock Awards plan differs from the option plan in the method of taxation. As with options, there is no tax at the time of the grant. The tax on the restricted stock occurs at the time the stock vests. The amount of income recognized by the employee is determined by the market price at the time of vesting. The same withholding rules apply, and the company will keep a sufficient number of shares to cover the minimum withholding for income tax and Social Security and Medicare taxes.

At the time of vesting, the restricted stock is converted to common stock, shares are issued, and may be traded as any other listed stock. After vesting, dividends will be paid on the stock. Once the vesting has occurred and the stock is converted to common shares, the holding period for long-term capital gain tax treatment commences.

Just as there were few cases with options a number of years ago, there are not many cases dealing with the issues presented by restricted stock in marriage dissolution. However, the existing cases indicate that the same analysis will apply to restricted stocks included in the marital estate that was used for stock options, with the emphasis on the purpose or purposes of the award, and the period of labor associated with the award. There are some cases that hold that restricted stock, though still unvested at the time of the final separation of the spouses, is marital property. There is emphasis on the attributes of ownership, such as whether or not the stock is entitled to dividends and whether or not the stock allows the employee to vote the shares. Where these factors are present, it is more likely that the fact the stock is not vested at the time of final separation will be ignored.

Valuation issues are easier, because when vesting occurs the common stock is issued and valued just as other common stock. The same valuation problems exist with unvested restricted stock as with unvested options.

Conclusion

It is anticipated that stock award plans will become more prevalent and thus become a growing issue in marriage dissolution. It is also anticipated that the stock option cases will be further analogized to the restricted stock cases, as has already occurred.

Stock options became a large part of many marital estates involved in marriage dissolution during the “bubble” of the late 1990s. As one would expect, the courts struggled with the issues this new situation presented, primarily what options were to be included in the marital estate. The following possible scenarios indicate the complexities:

• Stock options received prior to marriage and vesting during marriage;
• Stock options granted prior to marriage and vesting during marriage;
• Stock options granted during marriage and vesting during marriage;
• Stock options granted during marriage and vesting after marriage.

Other complicating factors created more issues. Courts were faced with situations where non-marital property was used to pay the strike price on community options. Most stock plans do not allow the non-employee spouse to own stock options. Consequently, terms of beneficial ownership of the options by the employee-spouse for the other spouse had to be created. Some stock options were granted as a reward for services performed in the past and in part to retain the employee in the future. This further complicated the determination of whether or not the stock options were marital property.

Stock options and restricted stock have been a part of executive compensation for many years. However, it was not until the late 1980s, with the mushrooming of new companies in the technical computer and science industries, that these forms of compensation, primarily stock options, became popular and available to a broad range of employees, not just senior executives.

Evolving Case Law

While each state has its own set of rules, as the case law developed, many states “borrowed” decisions from other states simply because many of the issues were of “first impression” – the court had no decisions of its own to rely on, and had to look to other jurisdictions for precedents. Thus over time the decisions throughout the country became more uniform. The primary and universal determining factor became the period of time the employee spouse “earned” the stock option. If the options were earned entirely during the marriage they were entirely marital property. If not, then an analysis was needed to determine what portion of the options was earned during the marriage. This resulted in a “time rule” where the option was granted for purposes of retaining the employee. Under the time rule, the portion of the option that is granted during the marriage and vests during marriage is marital property; the portion that vests after final separation is not. Any portion partially vested is pro-rated.

Where the option is granted, in whole or in part, for purposes other than retention, the vesting period is often ignored. An option granted as a “signing bonus” is held to be given for accepting employment, and thus “acquired” at the inception of employment. If the employee is married at the inception of employment the option is marital property. If the employee is not married at the inception of employment then the option is not marital property. Another less frequent purpose of an option grant is to “reward” the employee for past services to the company. If the services were performed before the marriage, the option is not marital property; if the services were performed during marriage, the option is marital property, and if the services were performed both before and after marriage, the option is part marital and part non-marital property.

Purpose of the Grant

Perhaps the most difficult issue to be resolved is the purpose of the grant. Most stock option plans contain a “plan purpose” statement. Unfortunately, these statements are bound to have been revised from time to time, and list multiple factors as the plan purposes. In most large companies, the recipient's immediate supervisor decides whether a grant is going to be made, and if so, at what number of shares. There is usually a dearth of record keeping on the decision. By the time the issue arises in the context of marriage dissolution, the supervisor has often left the company. Even if the supervisor can be found, he or she will most likely have no recollection of the reasons behind the option decision, which was sometimes made many years before the dissolution proceeding. The courts look to the circumstances surrounding the grant as well as any documentation that exists. For example, if an option was granted coincident with a promotion, the argument can be made that the grant was, at least in part, a reward for the past performance of the employee, the spouse continues to own the portion of the option awarded to the non-employee spouse for his or her benefit. The agreement or decree provides that the employee spouse has to exercise the portion held for the benefit of the other only on the other spouse's direction. The non-employee spouse is liable for the taxes paid by the employee spouse.

How the Tax Is Figured

Most stock options are “non-qualified,” meaning they do not qualify for the special tax treatment of “qualified” options. Non-qualified stock options are not taxed when granted, or even when vested. They are taxed only at the time the option is exercised. The tax is at “ordinary” income tax rates, just like wages. The tax is figured on the difference between the exercise price, the price of the stock at the time the option is exercised, and the strike price, the amount paid for the stock. In addition to income tax, there is also a Social Security and Medicare tax due on the difference. The difference between the strike price and the exercise price is subject to the minimum withholding rules, so a minimum of 20% of the difference must be withheld by the employer, along with the employee's share of the Social Security and Medicare taxes, just the same as on a wage or salary check.

'Paperless' Transactions

Because of the large amounts involved, stock options are frequently exercised in a “paperless” transaction through a brokerage firm. The process starts when the employee gives notice of exercise of an option. The employer provides the number of shares of stock involved, the brokerage firm sells the stock on the open market and gives the employer the amount equal to the strike price; the employer withholds income tax, Social Security and Medicare taxes, and the balance of the stock sale proceeds goes to the employee. If the employee is exercising the option at the direction of the former spouse, then the employee simply forwards the funds.

Sometimes the employee will use available cash to acquire the stock. When this is done, the employee, after giving notice of exercise of the option, simply pays the employer the amount of the strike price, plus the amount of the minimum withholding for income tax and the amount of the Social Security and Medicare taxes. The stock is then issued to the employee. If the employee is exercising for the former spouse, the funds are paid to the employer by the former spouse and the employee transfers the stock to the former spouse when issued.

Non-vested stock Options

Stock options that are not vested are difficult to value, as no one can predict what will happen to the stock price between the valuation date and the date on which the option vests. Stock options can be valued simplistically by obtaining the current price of the stock and computing the after-tax proceeds if the option were to be immediately exercised. Since the vested options can be exercised immediately, one can argue this valuation is valid. However, this simplistic method does not take into consideration the value of holding the stock with absolutely no money paid toward the purchase, with the chance the stock will increase in value before expiration of the option. Of course the simplistic method can be applied to unvested option as well — and frequently is — but is less reliable because the options holder cannot exercise the option. Various models have been developed by economists, most notable the Black-Scholes method (a very complicated process requiring the use of judgment by the valuation expert). However, all such methods require the use of judgment by the valuation expert. Many cases eliminate the valuation issue by awarding the marital stock options fairly equally.

What Happens Now?

The thrilling stock option ride came to an abrupt halt in March of 2000, when the bubble burst on the stock market, sending the tech stocks to levels far below their previous prices. Since the strike price for options is set at the price at the time of the grant, after the market crashed many employees found themselves with options that were “under water,” which means that the market price of the stock was less than the strike price. Many options have since expired, never regaining a price above the strike price. Others issued before March 2000 that have not expired have failed to regain any value. Because the number of new companies declined drastically after March of 2000, fewer employers have been issuing options. As a result, fewer and fewer marriage dissolution cases have significant stock option issues to decide.

Just as Microsoft led the expansion of stock option usage, offering options to many employees, not just senior executives, it may be leading a similar expansion of the use of restricted stock. Microsoft recently announced that it was terminating the grant of stock options, and starting a new plan called Stock Awards. Though not an option plan, it has many similarities, and many of the rules on stock options will carry over to the new restricted stock award plans.

The Stock Awards plan at Microsoft will award shares of Microsoft stock to employees. The employee's manager, the same person who made those option decisions, will make the decision as to which employees will receive awards and if so, how many shares. However, the stock will be “restricted” in that a) the shares will “vest” at the rate of 20% per year over 5 years, with the first portion to vest on the first anniversary of the grant, b) the employee must still be employed when the stock vests, and c) the stock will not be entitled to dividends until vested.

The Stock Awards plan differs from the option plan in the method of taxation. As with options, there is no tax at the time of the grant. The tax on the restricted stock occurs at the time the stock vests. The amount of income recognized by the employee is determined by the market price at the time of vesting. The same withholding rules apply, and the company will keep a sufficient number of shares to cover the minimum withholding for income tax and Social Security and Medicare taxes.

At the time of vesting, the restricted stock is converted to common stock, shares are issued, and may be traded as any other listed stock. After vesting, dividends will be paid on the stock. Once the vesting has occurred and the stock is converted to common shares, the holding period for long-term capital gain tax treatment commences.

Just as there were few cases with options a number of years ago, there are not many cases dealing with the issues presented by restricted stock in marriage dissolution. However, the existing cases indicate that the same analysis will apply to restricted stocks included in the marital estate that was used for stock options, with the emphasis on the purpose or purposes of the award, and the period of labor associated with the award. There are some cases that hold that restricted stock, though still unvested at the time of the final separation of the spouses, is marital property. There is emphasis on the attributes of ownership, such as whether or not the stock is entitled to dividends and whether or not the stock allows the employee to vote the shares. Where these factors are present, it is more likely that the fact the stock is not vested at the time of final separation will be ignored.

Valuation issues are easier, because when vesting occurs the common stock is issued and valued just as other common stock. The same valuation problems exist with unvested restricted stock as with unvested options.

Conclusion

It is anticipated that stock award plans will become more prevalent and thus become a growing issue in marriage dissolution. It is also anticipated that the stock option cases will be further analogized to the restricted stock cases, as has already occurred.