What is the role of stock options in negotiating a divorce settlement? Far from being an academic question, the answer can actually determine the ownership of hundreds of thousands of dollars generated by the sale of appreciated stock acquired through company stock options. By specifying in the divorce settlement exactly how stock options will be treated—even if no such stock options exist at the time of divorce—divorcing spouses can proactively minimize future problems.
When it comes to complex compensation packages, the importance of understanding the mechanics, purpose and nature of stock options should not be overlooked. The ability of divorcing couples and their advisors to properly determine the role a stock option plays is pivotal in both the division of marital assets and as a potential mechanism for calculating future support.
Unfortunately, stock options often go unnoticed during settlement negotiations. One reason is the nature of stock options themselves. Stock options give an employee the right to buy company stock in the future at today’s prices. Typically, an employee will have up to 10 years to exercise this right once the vesting period has expired. The first potential pitfall is identifying if any options exist. The second is determining if they have any value. Thus, stock options can be easily overlooked as either an asset or a potential source of income at the time of divorce.
Once the parties have an understanding of the stock options, the next question is how the options should be treated in the divorce settlement. Indeed, two Massachusetts court opinions make it clear what a difficult question this is—and exactly how much is at stake.
The two cases offer guidance from two different perspectives on how stock options should be handled in divorce. In one case, stock options are considered a marital asset to be divided at the time of divorce. In the other, the exercise and sale of the options after the divorce are viewed as income and are subject to alimony. This seemingly technical difference between one approach and the other can add up to hundreds of thousands of dollars.
In 2001, Massachusetts courts ruled that stock options were a marital asset in the widely cited case Baccanti v. Morton. The principle of this case was that stock options should be divided between divorcing spouses, with any non-vested options apportioned according to a vesting percentage.
In Baccanti, the options to be allocated as part of the division of assets were granted before the divorce. Even though the value of the options was uncertain at the time of the divorce, the right to buy existed and was thus dividable as an asset as part of the divorce settlement. According to the ruling, the husband could exercise his options and provide the wife with half the net gain. If he decided not to exercise his options, he could notify the wife of his decision and allow her to exercise her portion of the options through him.
However, the 2009 Massachusetts case Wooters v. Wooters opened the door to a different interpretation. At the time of the divorce, the husband was a partner in a law firm who reported fluctuating annual income. In determining alimony, the agreement gave the wife one-third of her ex-husband’s future gross income. After the divorce, the husband went to work for a new company that provided him with stock options. When he exercised and sold those options for a substantial profit 12 years after the divorce, the gains created by sale of the options showed up as income on his W-2, boosting his gross pay to nearly $1.2 million. The ex-wife claimed a one-third share under the terms of the original divorce settlement.
The trial court ruled for the ex-wife, and the Appeals Court of Massachusetts agreed, saying that the husband’s exercised stock options fell within the definition of “gross annual employment income” and were therefore subject to the alimony agreement. In issuing this ruling, the appeals court cited cases in other states—including Arizona, Illinois, California, Florida, New Hampshire and Ohio—where exercised stock options were considered income for the purposes of either child support or alimony. The Wooters case is a cautionary tale: Divorcing couples need to address the issue of stock options even if no options actually exist at the time of the divorce.
Faced with these two distinct and seemingly contradictory rulings, advisors and their clients should consider a wide range of “what ifs” in negotiating divorce settlements.
For example, what would the court ruling have been in Wooters v. Wooters if the stock options had been granted during the marriage? Would the options have been considered an asset, precluding their eventual inclusion in future gross employment income?
What if the husband had immediately exercised his options, purchasing them with his own money at their initial strike price? That would have converted any eventual appreciation of the stock into a capital gain instead of employment income reported on his W-2.
Stock options are a unique benefit awarded to employees. A stock option is designed as an award that grants the employee the future right to purchase company stock, with their own money, at their discretion based on the company’s stock price as of the date of the award. But how stock options are characterized is a key issue for any divorce settlement. Was the stock option awarded to compensate an individual for taking a reduction in an annual salary? The ongoing income from these options could more closely resemble forfeited wages and thus figure into the calculation of alimony. In contrast, if the options more closely resemble an additional benefit to purchase company stock in the future, this more closely resembles an asset in the form of an investment and thus could be considered a marital asset to be divided at the time of the divorce. Understanding the difference could help guide divorcing couples and their advisors in determining how to treat stock options.
To help shed additional light on the appropriate way to treat a stock option in divorce settlements, one might take a look at a different type of non-compensatory plan which awards an employee “restricted stock units.”
A restricted stock unit is an award that gives the employee automatic ownership of stock when the stock actually vests. A restricted stock unit vests when the employee has satisfied the vesting requirements, such as length of employment.
The distinction of how an employee takes ownership of stock options compared to restricted stock could play a critical role in determining if the options should be treated as a marital asset or as income. With a stock option, the employee has a right to purchase company stock and will only purchase the stock if the current stock price exceeds the grant price—the price at which the employee can purchase the stock. With restricted stock, however, an employee will take ownership of the stock at the vesting date even if the current price is below the grant price.
Consider the case of an employee who is annually awarded both stock options and restricted stock. Once the restricted stock vests, based on annual grants, it will eventually create a form of additional annual income to the employee and, as a result, may become part of the alimony calculation. With a stock option, the employee will only purchase the stock with his or her own money if the stock price appreciates—an outcome for which there is no guarantee. The stock option in this case is more likely to be considered a marital asset subject to division.
Based on current rulings, stock options seem to be an asset that can morph into income at a later date depending on the way they are exercised, the timing of their exercise and the profitability of the transaction. That means divorcing spouses need to plan for all stock-option eventualities in their settlements.
Failure to understand and properly address key issues—the timing of the stock options, the nature of the stock grant and what the owner actually may do with the option—could leave divorcing parties open to future litigation.
The appeals court in Wooters v. Wooters makes this point clearly, with the judge noting that the parties could have restricted the definition of “gross annual employment income” at the time of divorce if they had wished to do so.
Those who fail to take such steps when negotiating a settlement may come to wish that they had.
Marc D. Bello, CPA/ABV, CVA, MAAF, CFF, MST, is a partner in the accounting firm Edelstein & Company LLP in Boston.
