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Stock Options in Divorce
July 1, 1999
Stock options are a true “win-win” scenario for businesses and their executives. They only cost the business money if the company appreciates in value. For the employee, contrary to the normal rule of investing that the “greater the return, the greater the risk which must be run,” for stock options, there is a possibility of a great return with no risk whatsoever.
In divorce, courts have struggled with certain issues regarding stock options. Where the options can be cashed on the day of trial, they present little problem in valuation. However, future vesting presents other issues. In addition, a recent Ohio case raises the question of whether stock options are available for child support.
What is a Stock Option?
A stock option is the ability to buy stock at a future date at a specific value, usually the value on the date of granting the option. For example, if the stock is trading at $10 per share, the company may grant an option for, say, 1,000 shares, vesting in one year and good for 5 years. In other words, at any time between one year to 5 years later, the employee may buy 1,000 shares of the company stock for $10 per share. Thus, if the company stock has appreciated to, for example, $20 per share, the employee can instantly realize $10 per share in profit. The option, in theory, entails no risk because if the stock falls below $10 per share, the employee simply does not exercise the option.
Of course the “no risk” must be qualified to remain true to the old saw that there is no such thing as a free lunch. By offering the employee a stock option, the employer may not be affording the employee other compensation, such as salary or bonus. To the employer, this is a good deal because the stock option will only be exercised if the company stock appreciates. While the employee does not bear the normal risk to an investment if the stock depreciates in value, the employee may have forgone other forms of compensation when the option was granted. In most cases, the employee probably had no choice, as the employer chose the form of compensation.
Property Division Issues
Two Wisconsin cases address the application of property division issues in divorce to stock options. In Chen v. Chen, the supreme court held that a stock option is an enforceable contract right, an economic resource comparable to other employee benefits, and thus a form of property and properly included in the marital estate. Five years later, however, in Wikel v. Wikel, the court of appeals held that the trial court did not abuse its discretion in ruling that only the options that were exercisable as of the first day of trial would be considered part of the marital estate.
These cases can be read as harmonious if one keeps in mind the general rule that property accumulated after the divorce is not divisible. Further, efforts to earn income are not divisible, either, except if there is a maintenance and child support order. Thus, in Wikel, if the option vests after the divorce, the “value,” which is appreciation of the stock, is “earned” after the divorce and is, thus not divisible. Please remember, however, that the court of appeals affirmed the trial court’s decision as not being a misuse of discretion, rather than holding that as a matter of law the unvested options were not divisible. While not addressed in Wikel, it would make sense if unvested options would be treated the same as unvested pensions in cases like Leighton, Thus, if the trial court found that the option was close to vesting and the employee spouse was likely to continue working at the company until the vesting was complete, it would not be a misuse of discretion to include the option in the marital estate. On the other hand, if, as in Wikel, there was a lengthy time before vesting, it would make more sense to exclude the option as property since it would be primarily “earned” post divorce.
Valuing Stock Options
For a sophisticated discussion of valuating stock options, see Nancy Czaplisnki’s article, “How to Value and Treat Options” in the January, 1998 edition of the WJFL. Many cases do not need such a sophisticated analysis. If the stock is publicly traded and the option is fully vested, the value is the difference between the market value and the exercise value, reduced for taxes and any costs associated with exercising the option. If the exercise price is less than the market value, of course it has no value.
A more difficult issue involves unvested options. Arguably, they are worth nothing, as they cannot be “cashed in” on the date of the divorce. On the other hand, as stated above, Wisconsin courts have held that trial courts have discretion to consider unvested interests in retirement plans in divorce. As discussed above, the determination is based on the discretion of the trial court in an individual case and would likely turn on how soon after the divorce the option will be vested.
Child Support Issues
Based on anecdotal evidence only, stock options do not appear to be playing much of a role, if any, in child support negotiations or litigation in Wisconsin. In fact, there is not a single reported case on the issue in Wisconsin.
This may change. On February 28, 1999, the Ohio Court of Appeals issued a well-publicized decision in Murray v. Murray. The court, following Ohio child support law, held that the appreciation of unexercised stock options are included in a child support payor’s gross income. The court found that the options are given to the payor every year as an integral part of his compensation. Failure to include the options, the court held, would allow an employee to “shield a significant portion of his income from the courts, and deprive his children of the standard of living they would otherwise enjoy.”
The court rejected the payor’s argument that the options are nonrecurring, as they were granted to him annually. Therefore, the court found that the options, once they may be exercised, are to be included in the payor’s gross income for the purpose of calculating child support.
A similar, although less well publicized decision, was reached by the Colorado Court of Appeals in In re Marriage of Campbell. Analyzing stock options under Colorado’s child support law, the court held that proceeds received for the exercise of stock options were income for child support purposes. The appellate rejected the trial court’s consideration of potential income from future options in favor of the actual income received as the difference between the “purchase price” and the price at which the stock was sold.
Are these holdings valid in Wisconsin? Certainly, under HSS 80, stock options must be considered for child support. In Wisconsin, gross income available as child support includes “All income considered federal gross income under 26 CFR 1.61-1. HSS 80.02(13)(a). Stock options fit that definition.
However, it is not that simple. Stock options typically have, following vesting, an exercise period after which the option terminates. No taxes are due until the option is exercised. To take a “snapshot” at any point in time, as would be done for property division purposes, would not be appropriate as it is entirely possible that an option, worth significant money at one point, can be worthless at a different point in time if the value of the stock goes down.
Similarly, to charge child support when exercised, as done by the Ohio and Colorado courts, may not be appropriate, as the exercise periods may be lengthy. So a payor, knowing that the exercise could trigger a significant child support payment would likely wait, if possible, until child support terminated before exercising the option.
In many cases, it might be a non-issue. For one thing, many employees who are awarded options are significantly enough compensated that the trial court might “cap” child support in any event. And, of course, to the extent the option was valued as part of the marital estate, including it again for child support could constitute impermissible “double dipping.”
Still, practitioners need to be aware of the possibility that the exercise of stock options could have child support ramifications. For the payor, the stipulation should be carefully drafted to identify what sources of income are available for child support. Merely stating that “25% of all gross income” will be paid as child support, for example, may include stock options, as well as other unintended consequences.
The payor should also be aware of the possible value of stock options. Especially in smaller companies, executives can negotiate compensation packages. Trading off immediate salary for long range benefits, such as stock options, may be one alternative which could defeat the amount of child support which would otherwise be paid.
As with most other issues, the true answer lies in compromise. As stated above, if the payor is getting stock options, chances are the child support from base salary is adequate for immediate needs. On the other hand, the stock options are clearly a component of compensation. One compromise would be to require the payor to apply a certain percentage of the stock option exercise, after taxes, to the higher education costs of the children. By doing so, there is no “overpayment” of child support, but the payor will keep all of the extra compensation for him/herself. Most important, the children will benefit from the additional compensation, which is the underlying purpose of child support anyway. The obligation of a parent may end legally on graduation from high school, but as well known by most parents, the practical and moral obligation does not. Such a compromise would make a winner out of everyone, most importantly the children.
This article originally appeared in the Wisconsin Journal of Family Law.