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UPDATE ON EMPLOYEE STOCK OPTIONS
1996 National Legal Research Group, Inc.

Unexercised employee stock options can be a sticking point in settlement negotiations. Are the options a reward for efforts during marriage, or an incentive for future efforts, or both? The right to purchase stock in a successful company may be potentially lucrative, but what if the employee quits or is fired before the options can be exercised? Most courts so far have treated stock options as distributable property, to the extent earned during marriage, with profits to be shared when and if realized.

After some background information on employee stock options (Part I), this article discusses classification issues (Part II), valuation (Part III), and techniques that have been used to distribute these important employee benefits (Part IV).


I. Background

What Is An Employee Stock Option? An employee stock option is essentially an offer by a corporation, continuing for a stated period of time, to sell stock to its employee at a stated price. The employee is not obligated to pay the purchase price until and unless he elects to exercise the "option." 7 Stand. Fed. Tax Coordinator (CCH) <188> 19,611.

Most stock options are so-called statutory stock options, structured to take advantage of the special federal tax treatment that is accorded incentive stock options, I.R.C. 422, and employee stock purchase plans. I.R.C. 423. Stock purchase plans are primarily intended for rank and file employees, while incentive stock options are granted to key employees. Most of the difficult disputes in equitable distribution cases involve options granted to key employees. Hence, this article focuses on these options rather than on employee stock purchase plans.

If the statutory conditions for an incentive stock option are met, the employee is not required to recognize ordinary income for federal tax purposes when an option is granted to him or when he exercises it. (This advantage is generally not applicable to an employee who receives a nonstatutory option; he generally realizes income when the option is granted.) When the employee sells the stock, any gain is taxed as capital gain (assuming that holding-period requirements are met). 7 Stand. Fed. Tax Coordinator (CCH) <188> 19,601.

What Is the Purpose of An Employee Stock Option? As explained in the leading case on the subject of employee stock options, In re Marriage of Hug, 154 Cal. App. 3d 780, 201 Cal. Rptr. 676 (1984), this question can only be answered on a case-by-case basis by evaluating the particular stock option:

One purpose is to provide incentive for the employee to work hard and remain with the company. Options granted for this purpose are compensation for future services.

In other circumstances, such as in a smaller company or in one without substantial cash resources, the purpose may be to attract a strong employee for modest current compensation in return for substantial future rewards. Options granted for this purpose are deferred compensation for present services.

An option may be intended as a bonus for work already performed by the employee. Options granted for this purpose are additional compensation for past services.

What Facts Does a Typical Case Present? In most cases that produce disputes between divorcing spouses, the employee spouse has been granted a stock option during the marriage, meaning that he or she has received a right to purchase stock in the future if still employed with the company on the specified date. However, the date when the employee may purchase the stock has not yet arrived by the time of the dissolution, so the option has not yet become "exercisable," that is, the option is not "vested" or "matured." If the employee is still with the company when the specified date arrives, he or she may "exercise" the option by purchasing stock pursuant to the terms of the option agreement.

What Do the Spouses Disagree About? In the typical case described above, the spouses disagree on both classification and distribution.

The employee contends that the option is his or her separate property, in whole or in part, because it represents compensation for postdissolution services and/or because its value will not be realized during the marriage. The employee may claim that the option is too speculative to characterize as "property" because he or she may lose his job before the option becomes exercisable or because the option cannot be valued with certainty.

In contrast, the employee's spouse argues that the option was earned during the marriage when it was granted to the employee and that it represents deferred compensation for past services.

For additional discussion, see Brett R. Turner, Equitable Distribution of Property 6.15 (1994), and Eric Hollowell, Annotation, Divorce and Separation: Treatment of Stock Options for Purposes of Dividing Marital Property, 46 A.L.R.4th 640 (1986).

II. Classification

How Do Courts Classify Stock Acquired During Marriage Through Options Granted Before Marriage? Stock acquired during the marriage through options granted to a spouse before marriage is classified as marital property in the absence of evidence that separate funds were used to purchase the stock. In re Marriage of Renier, 854 P.2d 1382 (Colo. Ct. App. 1993). The fact that the options were the employee spouse's separate property does not mean that the stock acquired by exercising the options is likewise separate, if marital funds were used to exercise the options. Id.

How Do Courts Classify Options That Are Exercisable but Not Yet Exercised?If a spouse has been granted stock options during the marriage and the options have become exercisable<197>but they have not yet been exercised<197>by the cutoff date for marital property, virtually all courts agree that the options constitute deferred compensation that must be classified as marital property subject to equitable distribution. Richardson v. Richardson, 280 Ark. 498, 659 S.W.2d 510 (1983); Hann v. Hann, 655 N.E.2d 566 (Ind. Ct. App. 1996); Green v. Green, 64 Md. App. 122, 494 A.2d 721 (1985); Smith v. Smith, 682 S.W.2d 834 (Mo. Ct. App. 1984); Callahan v. Callahan, 142 N.J. Super. 325, 361 A.2d 561 (Ch. Div. 1976); Hall v. Hall, 88 N.C. App. 297, 363 S.E.2d 189 (1987).

The minority view refuses to include such options in the marital estate on the ground that the value of the options, as well as the employee spouse's financial ability to exercise them, is speculative. In re Marriage of Moody, 119 Ill. App. 3d 1043, 457 N.E.2d 1023 (1983). (The court in Moody retained jurisdiction, however, to divide whatever profits were realized if and when the employee decided to exercise the options.)

How Do Courts Classify Options That Are Not Yet Exercisable? Some courts have held that options that are not yet exercisable are nonetheless marital property. E.g., In re Marriage of Miller, 915 P.2d 1314 (Colo. 1996) (to the extent that an employee stock option is granted in consideration of past or present services during marriage, the option constitutes marital property when granted, even though the option may not become exercisable until a later date and the spouse must remain employed during that period); Goodwyne v. Goodwyne, 639 So. 2d 1210 (La. Ct. App. 1994) (option granted as a reward for community services was community property even if partly an incentive for future effort); Green v. Green (stock options, like pension rights, constitute "property" within the meaning of the state equitable distribution statute, and options granted to a spouse during marriage are "acquired" during the marriage and thus are marital property); Smith v. Smith (options that would mature after dissolution were already earned through spouses' joint efforts and were marital property); Pascale v. Pascale, 140 N.J. 583, 660 A.2d 485 (1995) (options that came about as a result of the excellent service that the wife provided to her employer during the marriage were marital property); De Jesus v. De Jesus, 163 Misc. 2d 267, 620 N.Y.S.2d 704 (Sup. Ct. 1994) (stock options received by the husband were wholly marital even though he received them less than a year before the commencement of the divorce action); Dietz v. Dietz, 17 Va. App. 203, 436 S.E.2d 463 (1993) (stock options acquired during marriage were deferred compensation to be distributed pursuant to statutory provision on pensions and deferred compensation); Chen v. Chen, 142 Wis. 2d 7, 416 N.W.2d 661 (Ct. App. 1987) (options were an economic resource acquired during marriage and thus were part of marital estate, despite husband's claim that inclusion of options that were not exercisable until after divorce improperly awarded wife an interest in his future labor); see also In re Marriage of Isaacs, 260 Ill. App. 3d 423, 632 N.E.2d 228 (1994) (if and when exercised, stock option granted to the wife near end of parties' marriage would be marital property, because option was meant to compensate her for the diminution of the value of stock that was marital property); Hann v. Hann (Chezem, J., dissenting) (stock options typically are part of present executive compensation in lieu of a higher salary, and thus are earned during marriage); In re Marriage of Short, 125 Wash. 2d 865, 890 P.2d 12 (1995) (options granted for past or present employment services are acquired when granted and thus are community property).

Separate Property - A few courts have held that options which are not exercisable by the state's cutoff date for identifying marital property and which may be lost as a result of events occurring thereafter should be classified as separate property. Hann v. Hann (options which did not become exercisable prior to final hearing were not a divisible marital asset, in view of longstanding principle in Indiana that only property in which a spouse has a vested interest may be divided as a marital asset); Hall v. Hall (options that are not yet vested are in essence an expectation of a future right contingent upon continued service and should be considered separate property).

Part Marital, Part Separate. - Most courts appear to have characterized options that have not yet become exercisable as both marital and separate. Nelson v. Nelson, 177 Cal. App. 3d 150, 222 Cal. Rptr. 790 (1986); In re Marriage of Hug; In re Marriage of Miller (employee stock option granted in consideration of future services is marital property to the extent that the employee has performed those services during marriage); Salstrom v. Salstrom, 404 N.W.2d 848 (Minn. Ct. App. 1987); Garcia v. Mayer, ___ N.M. ___, 920 P.2d 522 (Ct. App. 1996).

As support for this view, the New Mexico Court of Appeals in Garcia v. Mayer cited the American Law Institute's Principles of the Law of Family Dissolution: Analysis and Recommendations 408(1)(b) (Tentative Draft No. 2, 1996), which states that "[c]ontingent returns on labor performed during marriage, including unvested pension rights, choses in action, and compensation contingent on post-marital events, are marital property to the extent they are earned during the marriage."

Reasoning that such options are partly for past employment and partly for future employment, these courts have generally applied a "time-rule" formula to distinguish the portion of the option rights attributable to employment after the particular state's cutoff date from the portion of the rights attributable to employment during the marriage. E.g., Nelson v. Nelson; In re Marriage of Hug; Salstrom v. Salstrom; Garcia v. Mayer; see also In re Marriage of Short (time- rule formula should be applied to first option for future employment services that vests after cutoff date, but not to options for future employment services that vest after that first option); Chen v. Chen (use of formula permissible but not required). But see In re Marriage of Miller (expressly rejecting time-rule formula as improperly assuming that options were granted solely for future services and as failing to acknowledge possibility that some portion of the options may have been granted for past services and thus constituted marital property at the time when they were granted); De Jesus v. De Jesus (inequitable to apply a formula for pension plan, which determines nonemployee's share by comparing the length of employee's plan participation to total length of plan participation, to stock options; such a formula would unfairly diminish nonemployee's share of benefits from options bestowed on employee during marriage).

In In re Marriage of Hug, the California Court of Appeal approved a formula comparing the length of employment prior to the parties' separation (California's cutoff date) to the length of employment after separation up until the options became exercisable. To calculate how many of the shares were community property, the court used the ratio that the length of preseparation employment bore to the total length of employment prior to the options' exercisability. This formula was suited to the facts of the case, the court found, since it was clear that the option rights were an important part of the employment package from the outset of the husband's tenure with the company. The court cautioned that each case is unique, and a formula appropriate in one situation might not be appropriate in another. It is up to the trial judge in each case to fashion an equitable allocation of separate and community interests in stock options exercisable by the employee spouse after the date of separation, the court declared.

In Nelson v. Nelson, the numerator was the number of months from the date of the grant of the options to the date of the couple's separation, while the denominator was the period from the time of the grant to its date of exercisability. While acknowledging that a slightly different formula was used in Hug (which included employment before the options were granted), the court pointed out that Hug itself said that no single rule or formula is applicable to every dissolution case involving stock options. The circumstances in Nelson made it appropriate to emphasize the options' reward for future productivity, the court explained, while the facts in Hug called for a formula emphasizing the employee's entire tenure with the company.

In Garcia v. Mayer, the New Mexico Court of Appeals said the formula to compute the marital share should include employment predating the stock option grant (as in Hug) if that employment was a factor in the decision to grant the options. But if the option rights were granted solely as an incentive for future employment and effort, the community share of the options should reflect only the length of time from the option agreement until the cutoff date (as in In re Marriage of Harrison, 179 Cal. App. 3d 1216, 225 Cal. Rptr. 234 (1986)), the court held. "There is no a priori reason to treat all options the same," the court noted. Garcia v. Mayer, 920 P.2d at 525-26.

In Salstrom v. Salstrom, the Minnesota Court of Appeals held that the time rule set out in Hug should be used as a starting point for determining what portion of the options was nonmarital. However, modifications of the rule might be warranted to reflect Minnesota's different cutoff date, the court said. It echoed the Hug court's caution that the formula appropriate in any given case depends on the particular facts of that case and on the purposes to be served by the stock options in that situation.

In In re Marriage of Short, the Washington Supreme Court addressed the situation where an employee holds a number of stock options which were granted for future services and which will vest at staggered intervals after the cutoff date for acquiring community property. The first such option to vest after the cutoff date is partly marital and partly nonmarital, and the time rule should be applied to this option, the court decided. It also held, however, that additional options which were granted for future services and which will vest subsequent to that first option are entirely nonmarital. "Multiple stock options granted for future services vest consecutively, not concurrently," the court explained. 890 P.2d at 17.

How Do Courts Classify Options That Are Granted After the Cutoff Date? The general rule is that the marital estate does not include option rights that are granted to a spouse after the cutoff date for acquisition of marital property. Ettinger v. Ettinger, 637 P.2d 63 (Okla. 1981) (trial court lacked authority to decree that each spouse was to receive a one-half interest in all stock options that husband might obtain in future from his then-current employer; options that were not yet in existence were not property acquired during the marriage); see also In re Marriage of Hug, 201 Cal. Rptr. at 685 n.4 (dicta; claim of community interest in stock options granted to employee spouse after marriage dissolution would be too speculative).

However, in Pascale v. Pascale, New Jersey's high court held that options granted to a spouse for services performed during the marriage were marital property even though the options were received shortly after the state's cutoff date. The bright-line rule fixing the cutoff date should not insulate assets obtained after the cutoff date from distribution if they were acquired as a reward for efforts expended during the marriage, the court reasoned. Just like pension benefits earned during the marriage but received after the end of the marriage, stock options awarded after the marriage has terminated but obtained as a result of efforts expended during the marriage should be subject to equitable distribution. See also Goodwyne v. Goodwyne (not error to partition stock option as community property when employee received it partly for work performed during the marriage, even though it was granted after dissolution of community).

What if a Court Ignores Stock Options? A trial court distributing property upon marriage dissolution cannot simply ignore stock options granted to a spouse during the marriage. Demler v. Demler, 836 S.W.2d 696 (Tex. Ct. App. 1992); Kapfer v. Kapfer, 187 W. Va. 396, 419 S.E.2d 464 (1992).

In Demler v. Demler, the Texas Court of Appeals held that the trial court erred by failing to divide the husband's stock options, despite his claim that the wife had not introduced evidence that would permit a proper division. The husband conceded that employee stock options may constitute community property subject to division, the court observed. Since the statutory duty to divide property is mandatory, it was error for the trial court not to dispose of the options in its divorce decree.

In Kapfer v. Kapfer, West Virginia's high court held that because the husband's stock options had been acquired during the marriage they should have been considered by the trial court. Noting that the record lacked sufficient information to determine their value or how much of that value should be considered marital property, the court remanded for the trial court to develop the record by expert testimony, if necessary, in order to classify and value the options. While expressing hesitation to dictate any specific method for evaluating and dividing the options, the court did note that the trial court should follow broad guidelines enunciated in an earlier case for distributing pension benefits.

III. Valuation

How Do Courts Value Stock Options? Only a few decisions have tackled the issue of how to value stock options. In Maryland, where valuation is mandatory in all cases, the court's intermediate appeals court acknowledged that an unassignable, unsalable option has no fair market value, but the court insisted that such an option is nonetheless an economic resource, comparable to pension benefits, to which a value can be assigned. That value can be determined by considering the stock's market value on the date of divorce (Maryland's valuation date), less the cost to the employee of exercising the rights, the court said. Green v. Green; see also Richardson v. Richardson (value of options to purchase publicly traded stock was difference between cost of exercising options and worth of the stock).

The Michigan Court of Appeals characterized the calculation of value as a "formidable task given the numerous possible contingencies and restrictions involving stock options." Everett v. Everett, 195 Mich. App. 50, 489 N.W.2d 111, 113 (1992). In this case where the husband asked the trial court to assume that he would exercise all his options the present value of the stock options should be calculated by subtracting the option cost from the market price of the stock on a date to be determined by the trial court in its discretion, the court decided. The tax consequences of exercising the options should be considered when valuing them, the court directed. It added that if the market price of the stock were lower than the options' cost, then the options would be worthless and need not be allocated.

Most courts have sidestepped valuation by using some method of deferred distribution (discussed below). For example, in In re Marriage of Hug, the court rejected the husband's argument that the trial court erred in failing to fix the value of his stock options. Benefits may be divided when eventually realized even if they cannot be valued, the court explained.

IV. Distribution

How Do Courts Distribute Stock Options? Immediate Distribution. The present value of options was distributed at the time of divorce in Richardson v. Richardson where each spouse was awarded one-half of the value of matured but unexercised options.

According to In re Marriage of Hug, an immediate distribution awarding the options to the employee and offsetting property to the other spouse is the most equitable approach if the options are publicly traded or can otherwise be valued, even for options that are not yet exercisable. The risk of loss due to termination or other causes is best borne by the employee spouse, the court said.

Deferred Distribution. Most courts have preferred a deferred distribution in view of the possibility that the options might never be exercised. For example, when an Illinois court held that nontransferable stock options were too speculative to classify as "property," it nonetheless authorized the trial court on remand to retain jurisdiction until such time as the options were exercised or expired. If and when the options were exercised, the trial court would have discretion to allocate "an appropriate share of any profit realized from the transaction to each spouse." In re Marriage of Moody, 457 N.E.2d at 1027; accord In re Marriage of Frederick, 218 Ill. App. 3d 533, 578 N.E.2d 612 (1991).

What Different Approaches Have Been Utilized for Deferred Distribution? The following are some examples of different approaches to the deferred distribution of stock options:

In In re Marriage of Isaacs, the trial court was directed to retain jurisdiction for the purpose of allocating the proceeds from the wife's stock options if and when they were exercised.

In De Jesus v. De Jesus, the wife was awarded the right to exercise one-half of the husband's stock options as they matured. Sixty days before the husband's right to purchase a specified number of shares was to accrue, he was to notify her in writing of the date the option right would mature, the total number of shares that could be purchased, and the amount needed to fund such purchase. If the wife wished to purchase, then within 30 days of receiving the notice she would have to notify him in writing of her election to receive the marital portion (50% of the total shares available for purchase, or such lesser amount as she elected to purchase) of the shares and send with the notice a money order or cashier's check in an amount sufficient to fund her share of the purchase. The husband then would have to purchase and hold the shares as constructive trustee for the wife until the shares could be transferred to her. If she elected not to exercise her right to purchase all or a portion of her shares, or failed to respond to the notice within 30 days, the husband would be entitled to purchase all or any part of those shares for his own benefit. The husband was not required to continue his employment, and if his rights to the options failed to mature or were forfeited the wife's rights would likewise terminate.

In Smith v. Smith, the decree gave the husband the right to decide whether to exercise any of his options. If he did so, he was to give the wife notice, and she would have 30 days to provide him with the cash to buy a one-half interest in the option on her behalf. If she did not provide the cash, she forfeited her right to one-half of the option. Each party was to pay a share of the income taxes on the options. The trial court retained jurisdiction to determine questions concerning the disposal of the options.

In Green v. Green, the court emphasized that no distribution should be made that would effectively compel exercise of the options, since to do so would deprive the employee of the essence of his property interest the right to choose whether or not to purchase the stock. Instead, the trial court should determine, at the time of the divorce, a percentage by which the profits from the options should be divided if, as, and when the options were exercised.

In Chen v. Chen, the decree required the husband to pay one-half of his net profits to the wife as soon as possible following the sale of any stock purchased through his employee stock options. If the stock remained unsold 18 months after exercise of the options, the wife could elect to be paid for her share based on the stock price at that time. The husband also was required to provide accountings to the wife and to share his tax savings with her.

In Callahan v. Callahan, the court established a constructive trust under which the husband was to hold 25% of his stock options in favor of the wife. The court instructed that the husband was to exercise the wife's share of the options only at her direction, but that she was to either supply him with the necessary funds or instruct him to pledge the stock to finance the purchase. Following the exercise of her share, she could have either the stock or its proceeds after sale transferred to her.

In In re Marriage of Miller, the husband was required to retain the right to exercise the options, and the wife would receive her part of the profits or proceeds from the options when they were exercised, after deduction for taxes and costs. In Salstrom v. Salstrom, the court indicated that options may be divided through a deferred distribution similar to that used for pension benefits, but it did not provide details about the exact formula to be used.

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