The story has become quite familiar: A brilliant, hardworking young professional joins an energetic start-up working on an idea with incredible promise. The company — long on potential, but short on cash — compensates its employees in part by offering the chance of a huge payoff when its stock is eventually worth something. In return for the lean years early on, the employee hopes one day to be made wealthy. Indeed, stock options and restricted stock have resulted in some famously huge payoffs.
However, if that brilliant, hardworking young professional gets divorced, the stock options and restricted stock will have to be divided with a soon-to-be-ex-spouse. How does that work?
Well, of all the assets that must be divided when a couple divorces, stock options and restricted stock are some of the most difficult to address. Many people don’t have a clear idea what these assets are, precisely, let alone how to determine what they’re worth or what a fair split of them might be. So, let’s start with definitions:
Stock options give an employee the right to buy company stock at a set price, at a future date. The idea is that the set price will be much lower than the future trading price, so that the employee can then turn around and sell their cheaply-bought stock at great profit.
Restricted stocks are company shares that are granted at no cost to employees, but that are not transferable until certain conditions (such as employment by the company for a specified period of time) have been met.
Stock options and restricted stocks have become increasingly popular components of corporate compensation packages. While most do not result in wealth on the scale of small nations, they can certainly be very valuable.
Here are some key steps to follow if stock options and/or restricted stock will be divided as part of your divorce:
1. Verify that the options/stock actually exist. Oddly, this isn’t something you can take for granted. Stock options and restricted stock do not appear on tax returns, W-2 forms, or other financial documentation you have access to, unless and until the options are exercised and the restricted stock has vested. If your husband is inclined to hide assets, it’s unlikely that he’ll mention that he has unexercised stock options and unvested restricted stock.
To determine whether your husband is holding such assets, and what the timetable is for being able to exercise the options/sell the stock, your attorney may have to subpoena his employer.
2. Assess the value of the options or restricted stock. Determining the current share value for publicly traded companies can be as quick as a Google search. However, it can be quite difficult to determine the current value of stock options and restricted stock for a privately held company. While there is certainly an expectation of increasing value over time, nobody knows how much they will actually turn out to be worth until the options are exercised and the stock is sold. It is especially complicated to assess the value of stock options and restricted stock that have been granted, but haven’t yet vested.
Different states treat this differently. In some states, if the stock options/restricted stock have not vested as of the Date of Separation, they are not considered marital property. In others they are, but their current value depends on several factors including how far in the future they vest. It is easier to compute with restricted stocks, because unless the company goes bankrupt, the stock should have some value; whereas stock options might have an exercise (strike) price that exceeds its market value (this is called “being under water”).
“In my experience, employee spouses with ‘under water’ stock options often claim the value for marital property division to be zero, but even if the exercise price is less than the market price of the stock, options can have tremendous value in the future if (or when) the market price exceeds the exercise price,” Memphis Divorce Lawyer and Family Law Attorney Miles Mason, Esq., told me. “When faced with this situation at the divorce negotiating table, I use an example to make the point that even under water options can have value. I offer $20.00 cash to the employee spouse for the stock options. Of course, the employee spouse turns my offer down. Then, I offer $100.00. Again, my offer is always rejected. Ultimately, the point is made.”
Particularly in volatile market conditions, or in a new business with a promising but uncertain future, it is all but impossible to pin down the precise value of stock options. An option to buy shares at $25 when they are trading at $125, for example, can be worth quite a lot. However, your $25 option is worth nothing, at least temporarily, if the stock is trading at less than that.
“We recommend clients utilize a forensic accountant or economist to discuss the potential value over time,” Attorney Mason said. “At the end of the day, negotiating value for under water stock options is part science and part art. The result of the negotiation may likely depend on the value placed on the options’ ownership by the employee spouse which could be based partly on knowledge of the companies’ performance and partly based on unpredictable emotion.”
Your divorce financial planner will work though estimates of the probable worth of your husband’s stock options/restricted stock. Based on independent evaluations of his company’s potential and performance, it may be possible to predict, at the very least, whether you have a potential winner on your hands, or if the stock will be a flop.
3. Make sure you get a fair share. Once you have a good estimate of the value of the assets, your divorce financial advisor will work through all the angles involved in determining what constitutes a fair division, and your attorney will work to make sure your settlement includes it. If you opt not to receive any of the stock options/restricted stock, be sure your settlement includes assets that are just as likely to appreciate just as much, and with no worse tax consequences. Speaking of which…
4. Always consider taxes. Taxes on profits from exercising stock options or selling restricted stock can be significant, and should factor in to the evaluation of what these assets are worth.
For example, income from exercising “qualified” options, such as ISOs (Incentive Stock Options), which can only be granted to employees, is generally taxed as capital gains, not as ordinary income, provided the options are held for two years after the grant date or one year after the exercise date, whichever is later.
On the other hand, when nonqualified stock options are exercised, the difference between the market price and the strike price will be taxed at the higher rates applicable to ordinary income. If those shares are then sold, any gain or loss will be taxed as short-term, if held for less than one year and long-term if held for more than one year.
Restricted stock is taxed as ordinary income upon vesting.
In many cases, options and restricted stock cannot be transferred to a spouse, so your ex may have to exercise and/or sell them on your behalf. In that event, keep in mind that the proceeds would be taxed at your ex’s income tax rate.
5. Have a plan for exercising the options. Once you know about the stock and/or options, have a sense of at least the scale of their value, know how much will be part of your settlement, and understand your potential tax situation, then you will need a plan for turning this “paper wealth” into cash! Financial professionals often recommend exercising options as soon as possible, to avoid any loss in value.
Fair division of stock options and restricted stock in divorces requires expert professional help. In fact, even your expert professional help might require expert professional help! Be sure that your divorce financial advisor has both the know-how and experience you need and a network of professional colleagues to support all efforts on your behalf.
Jeffrey Landers is a member of the DailyWorth Connect program. Read more about the program here.