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By Jennifer Wehrle, Certified Divorce Financial Analyst*
The grant of stock options to key employees is now commonplace as many companies strive to add extra incentive to the overall compensation plan. Traditionally, stock options are used to reward and retain the top tiers of management and other key employees. Particularly in the last decade, however, many companies have opted to include more employees by offering broad-based stock option plans. It is estimated that nearly a third of large domestic companies now have broad-based stock option plans covering all or a majority of their employees. Obviously, stock options will be seen more and more in future divorce cases as a substantial marital asset.
Given the complicated nature of stock options, attorneys specializing in divorce need to understand the basic function of stock options and the unique tax and distribution issues resulting from valuation and division during divorce. When an attorney has a divorcing client where options are part of the matrimonial assets, a copy of the Stock Option Plan document from the issuing company should be requested immediately. Stock options have very specific exercise provisions and the attorney must be aware of these terms to avoid economic loss to one or both divorcing parties or a potential malpractice claim. Typically, this document will define the parameters of how the stock options may be treated – whether they may be transferred or assigned.
Basically, there are two categories of stock options. ISOs, or Incentive Stock Options, are statutory and are not transferable or exercisable by anyone other than the employee. ISOs require more tax planning because it is a preference item for the alternative minimum tax. The second category is NQOs or Non-Qualified Options. NQOs may be transferable and exercisable by the non-employee spouse. Again, it is imperative to gain a copy of the company’s Stock Option Plan document. Also, it is important to note that if the NQOs are assigned to the non-employee spouse, the employee will be taxed on the income at exercise.
Once you have defined the marital options and taken into consideration the consequential tax treatments and tax effects (income on other areas of the tax return), you can begin stock option valuation. The two most popular methods are the “intrinsic value” and the “Black-Scholes” method. In the intrinsic value method, the value of the stock option is equal to the difference between the option exercise price and the fair market value of the stock. The Black-Scholes method is similar to the intrinsic value method, but is more complex because it incorporates volatility into the calculation. For example, the Black-Scholes method distinguishes between options from a slower growing utility-type company and a faster growing technology-based corporation, whereas intrinsic value will not factor non-numerical data into the equation. Although options analysis software is readily available, it is advisable to consult with a certified divorce financial analyst or a certified public accountant when trying to determine the best options valuation model for your client. Afterwards, when the value is understood and established, the options can be negotiated into the divorce settlement.
Clients should be educated on the factors relating to stock options, such as investment risk of the underlying stock, time value of assets, and tax issues inherent to options. Considering the complexity of design and exercise, attorneys involved in a case concerning stock options should consider drafting agreements with provisions including compulsion to sell vested options at designated times, payment of strike price, and payment of resulting taxes from exercise.
As you can see, division of stock options during divorce will require more attention to financial detail than is normally required from a retirement plan type of division. As more employees accumulate stock options, divorce attorneys will need an increasing awareness of the effective handling and treatment of this unique marital asset.
* Jennifer Wehrle is on the staff of Fifth Third Bank, Lexington, KY. If you have questions about this article, she may be contacted by phone at (859) 455-5464 or on the Internet at Jennifer.Wehrle@53.com.
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