Stock options give an employee the option to buy shares in a company at a set “strike” price, once the option has vested. Typically the options will vest over a two to five year period according to a vesting schedule. How to address stock options in a divorce?
California law is not at all precise when it comes to stock options in a divorce. There is no single rule or formula. In fact, courts may decide on a different solution for each different situation.
Stock options can be complicated. Often there is a mixture of vested and unvested options. Options that have vested may not have been exercised, i.e. the shares may not yet have been purchased by the employee spouse at the strike price.
The unvested options have no concrete value until their vesting date. They just represent a future opportunity. If the employee leaves the company prior to the vesting date, the unvested stock options are lost. And there’s no definite rule as to how unvested options are to be valued. Nonetheless, California law presumes that unvested stock options that were acquired during the marriage are community property subject to division.
Stock Options Division Approach
As with other assets in a divorce, it’s a good idea to approach stock options as follows:
- List them out and understand them (including the vesting schedule) fully.
- Characterize them as community or separate property or a mixture of the two. If a mixture, try to work out and agree upon the percentages of the shares that are community and separate property.
- Value them.
- Consider the tax implications.
- Negotiate who will receive them or exactly how they will be divided.
Stock options that were acquired between the date of marriage and the date of separation are presumed to be community property, whether or not the shares have actually been acquired or the options have vested.
However, the company’s intention behind the grant of stock options is relevant. Do they represent compensation for past services or an incentive for future services? If say a stock options grant was made on the date of separation, if it was a form of compensation for services already rendered, the option would be community property. If, however, it was an incentive for future service or performance, it would be the separate property of the employee spouse. And often the company’s intention is not clear.
Stock Options Granted During Marriage and Vesting Afterwards
The most common issue concerning stock options in California divorces arises when they were granted during the marriage but vest after the date of separation. California appellate case law has two “time rule” formulas that can be applied to such options.
The Hug case viewed the options as a form of deferred compensation for past service. The Hug formula says that the fraction of the unvested stock options that are community property is:
(the period of time between when the employee started work for the company and the couple’s date of separation) divided by (the period of time between when the employee started work for the company and the date the options vest).
If, for example, the employee spouse worked for the company during the marriage for 48 months prior to the date of separation and certain options don’t vest until 12 months after separation, 48 / (48+12) = 4/5 of them would be considered community property.
The Nelson case viewed the options as primarily an incentive for future work. The Nelson formula says that the fraction of the unvested options that are community property is:
(the period of time between when they were granted and the couple’s date of separation) divided by (the period of time between when they were granted and the date they vest).
If, for example, the options were granted during the marriage 12 months prior to the date of separation and don’t vest until 24 months after separation, 12 / (12+24) = 1/3 of the stock options would be considered community property.
Which formula to apply? It depends on your situation. If you are negotiating a settlement, perhaps with the help of a divorce mediator, you can choose. Or you may come up with your own formula or approach.
Valuing Stock Options
In a divorce, what price should you apply to the unvested stock option shares? If the court decides the matter, the court will normally use the current market price. There may be some logic in using the market price on the couple’s date of separation. But the law generally indicates that they would be valued with a current market price.
If the market price is less than the strike price, there would no reason to exercise the options and buy the shares at the strike price because this would result in an immediate loss.
Shares are subject to taxation when they are sold. The gain or loss will be the difference between the sales proceeds and the purchase cost. If the shares have been held for a year or more, it will be considered a long-term capital gain or loss. Otherwise, it will be considered a short-term capital gain or loss.
Short-term gains are taxed just like ordinary income. Long-term gains have lower federal tax rates (normally 15% or 20%). California uses ordinary income tax rates for both short-term and long-term capital gains.
Options for Division
When working out your own settlement, you can be creative as regards the stock options. When at least some portion of them are community property, here are some common approaches for giving the non-employee spouse his/her share:
- Give the non-employee spouse other marital assets equal in value to their share of the community property stock options;
- Sell some vested, exercised shares to generate cash for the division. Note that there may be capital gains tax to pay due to the sale;
- As regards the unvested stock options, agree to wait until the they vest and then buy and sell shares to generate cash for the non-employee spouse. Again there may be capital gains tax to pay;
- The company might agree to have a number of options transferred into the name of the non-employee spouse.