How Stock Options can Deepen the Pockets as More Courts Treat Them as Income

By Charles F. Vuotto Jr. and Paul Gazaleh

Most state courts have held that stock options are assets subject to distribution along with all other assets acquired during the marriage. However, some courts have begun to characterize the option as “income,” as well. This interpretation arises from an increased incidence of stock option plans replacing typical cash-based compensation.

The last decade of the preceding century found an ever-growing list of companies issuing stock option plans more often and to a greater diversity of employees than ever before. Even though there has been a recent economic slowdown and downturn in the market, stock options are found in the asset portfolios of many divorcung parties and, under an increased number of circumstances, they are being looked at as income when spousal and child support awards are calculated.

Options as Income

          A stock options is “[t]he right to buy a designated stock, if holder of option chooses, at any time within specified period, at a  determinable price, or to sell designated stock within an agreed period at a determinable price.” Blacks Law Dictionary 1418 (6^th ed. 1990). Stock options “are often granted to management and key employees as a form of incentive compensation.”

When deciding if stock options should be viewed as income in a divorce settlement, courts have looked at how often a party received options, whether the options have been exercised and the likelihood that the party will receive more options in the future.

• Historical receipt of stock option. An increasing number of courts have relied on the recurring pattern of an obligor spouse’s past stock option awards in order to justify a projection of income to be received from the receipt of stock option awards in the future. Courts then impute the projected future income for purposes of establishing spousal and child support.

For example, in Kerr v. Kerr, 91 Cal. Rptr. 2d. 374 (Cal.Ct. App.     1999), the California Court of Appeal concluded that in a situation where a former husband had a past history of receiving stock options from his employment throughout the marriage, the trial court was justified in finding that his spousal support included a percentage of his receipt of stock options in the future. Despite the fact that all stock options existing at the time of the partie’s separation were already included as assets in the property division, the Kerr court found that any stock options that the former husband received in the future were part of the  former husband’s overall compensation package and, therefore, must be considered income for purposes of both spousal and child support.

However, it is important to note that the Kerr court held that the stock options received in the future were valued as income only after they had been exercised and, consequently, found that the wife and the children were entitled to receive 40 percent of all the former husband’s future stock options aftr they had been exercised.

Charles F. Vuotto Jr. is a shareholder with Wilentz, Goldman & Spitzer in Woodbridge, N.J. Paul Gazaleh is a certified public accountant and vice president of The Chalfin Group, Inc. in Metuchen, N.J.

Courts in other states have applied reasoning similar to the Kerr court. For instance, in Moore v. Moore, 2000 WL 564165 (Lowa  Ct. App., May 10, 2000), the court upheld a decree modification, formed in lieu of child support payments,  that granted a former wife half of all income from any stock options that her former husband would exercise in the future. The court expressed that  although the former husband had never received stock options in the past and had no current stock options at the time of divorce, both parties were of the likelihood that the former husband would receive stock options in the future due to the nature of his employment. Congruous with the decision in Kerr, the Moore court valued the future stock options as income only after they had been exercised.

Additionally, in Burns v. Burns, 677 A.2d 971 (Conn. App. Ct. 1996), the court upheld the trial court’s award of periodic alimony payment to the former wife, including 20 percent of earned income from any future bonuses from stock options. In Burns, the former husband had received bonuses during the two years preceding the dissolution of the marriage. The Burns court concluded that an alimony award “could be contingent on some future event,” and that courts had the authority to “ fashion an award of alimony that tracks the [former husband’s] future salary.” However, the Burns court did not specify whether the future ctock options will be valued as income at the time they are grabted or at the  time they are exercised.

Moreover, in Nolan v. Nolan, 1999 WL 639409 (Wash. Ct. App., Aug. 23, 1999), the court upheld a child support award in excess of the statutory guidelines based, in part, on a finding that the obligor spouse could afford the high payment because he had received money from stock options in the past and, at the time of trial, the court had no reason to believe that the former husband would not continue to receive the benefits of these stock options in the future.

• Unexercised stock options. The seminal case holding  that existing stock options that were unexercised can be characterized as income for purposes of support is Murray v. Murray, 716 N.E.2d 288 (Ohio Ct. App. 1999). In Murray, the parties’ orginal divorce  decree divided all unexercised stock options existing at the time of the divorce as marital property. Accordingly, these stock options were not viewed as income or included in the orginal child support calculation.

The Murray court asserted that the former husband’s vested but unexercised stock options that he had received after the divorce were income for purposes of determining a child support modification application. In reaching its conclusion, the court reasoned that the former husband had consistently received stock options as a form of yearly compensation and this compensation,

Whether exercised or not, represented gross income that must be factored into the former husband’s child support obligations.

The Murray court examined the applicable Ohio statute that exempts “nonrecurring or unsustainable income” from gross income (citing Ohio Rev. Code $3113.215 (A)(2)(e), repealed, identical language currently found at Ohio Rev. Code Ann. $3119.01 (C)(7)(e)). The statute defines nonrecurring or unsustainable income as income received “any year or for any number of years not to exceed three years that the parent does not expect to continue to receive on a regular basis.” The court concluded that the former husband’s pattern of receiving stock options, combined with the likelihood that he would continue to receive the stock options, demonstrated that the stock options were recurring and, therefore, constituted income to be included in child support calculations.

The court emphasized that the former husband must not be allowed to usurp child support payments by declaring that his unexercised options are not income until realized, while simultaneously declaring that once he does exercise the options, the money received is still not income because it constitutes nonrecurring income. The court stated that “[s]uch an individual would be shielded from bearing the child support obligation for which he should be responsible.”

The Murray court asserted its own method of valuation of the unexercised stock options that it felt was “a simple, common-sense based method which courts may reliably utilize for purposes of determining child support obligations.” The court reasoned that the options should be valued on the date the options should be valued on the date the option could be first exercised because this was the date that was most important to the option holder. The court stated that “[t]he best way to value such (unexercised) stock options is to account for the options’ appreciation in value as determined on the options’ grant and exercise  dates in the income year at issue.”

Unlike the Kerr court, the Murray court valued existing unexercised stock options as income at the point that the existing unexercised stock option vested, while the Kerr court valued  nonexisting,  future stock options as income only after they had been exercised.

Courts in Texas and Florida have relied on an obligor spouse’s future gain from existing, unexercised stock options is income for support purpose. In Haselbarth v. Haselbarth, 1998 Texas App. Lexis 320 (Tex. Ct. App., Jan. 15, 1998), the court ruled that a former husband’s contribution to his stock option plan should be considered in his child support obligation because “[t]hough [the obligor spouse] did not receive the money with each pay check, he would see the money eventually.” Consequently, the court concluded that the existing, unexercised stock options were included in the net resource calculations.

Similarly, the court in Seither v. Seither, 779 So.2d 331 (Fla. Dist. Ct. App. 1999), upheld the trial court’s determination that a former husband’s existing, unexercised stock options were income to be factored into his alimony payments and valued based on the future monetary gain he would receive once he exercised the options.

• Exercised stock options. Exercised stock options have been found to be income for purposes of support modification. In Kenton v. Kenton, 571 A.2d 778 (Del.1990), the Supreme Court of Delaware concluded that although stock options are not expressly mentioned in the Delaware Code’s definition of income, exercised options are analogous to a “bonus” and are included  as “any form of payment made by the employer.”

(Quoting Del. Code Ann. $ 513(b)(5)). Consequently, the court decided that the trial court did not err in including exercised stock options as income in its determination of child support.

Moreover, in Stacey v. Stacey, 1999 Tenn. App. Lexis 668 (Tenn. Ct. App., Oct. 6, 1999), the court averaged an obligor spouse’s exercised option income into his base salary. The Stacey court noted that “[t]he guidelines do not allow the trial court to ignore income from the exercise of stock options in setting child support.” See also Smith v. Smith, 1999 WL 548568 (Tenn. Ct. App., July 29, 1999) (prorating exercised stock options in a child support modification application); and In re Interest of C.J., Child, 2001 WL 493701 (Tex. Ct. App., May 10, 2001) (noting that income from exercise of stock options should be included in computing income for child support).

Post-Distribution

    If stock options have already been distributed equitably between the parties, court may refuse to view any future gain received from these same options as income. (However, as noted above, this would not bar the projection of  future income relative to future awards based on the historical receipts of stock options.)

For example, in Denley v. Denley, 661 A.2d 628 (Conn. App. Ct. 1995), the court held that stock options that had already been distributed at dissolution cannot be considered income for purposes of accessing income for support modification. The court in Kapfer v. Kapfer, 419 S.E.2d 464  (W.Va. 1992), provided another example of this line of thought when it stated that “[t]o the extent that the stock from the employee stock option  plan is part of the assets for distribution, the value of the stock shares should not be considered as income to avoid duplication.”

Nonrecurring Income

          Additionally, if the stock option is not considered to be recurring, courts may refuse to view the stock option as income for purposes of alimony and child support. In Yost v. Unanue, 671 N.E.2d 1374 (Ohio Ct. App.  1996), the court held that the capital gain an obligor spouse received was not income for child support determinations because the income was non recurring. The court relied on the same statute addressed in Murray, which exempts non recurring income from the definition of gross income.

The court concluded that since the obligor spouse had exercised stock options on only two occasions, the stock options constituted nonrecurring income and were, consequently, exempt from gross income. See also Miller v. Miller, 1999 Ohio App. Lexis 4313 (Ohio Ct. App., Sept. 17, 1999)(income an obligor spouse received from shares of stock in book value incentive plan did not constitute income for support purpose because it was nonrecurring).

Two Connecticut cases have held that stock options are not income for purposes of spousal support. In DeAnda v. DeAnda, 2000 WL 1765450 (Conn. Super. Ct., 25, 2000), the court asserted that income includes only that which is shown on a W-2 and/or 1099 tax form. However, DeAnda involved stock options that were distributed over a two-year period only. If the stock options had been distributed on more occasions, the court may have found the stock options to be recurring and, as a result, concluded that the stock options were income.

Similarly, in Kress v. Kress, 1990 WL 277456 (Conn. Super. Ct., Oct. 2, 1990), the stock options at issue, which were held not to constitute income, were exercised on only one occasion. Furthermore, there was no opportunity for future stock options because the obligor spouse had received the stock option as part of his forced termination.

Therefore, it appears that courts will decline to include income incident to stock options where (1) the income is derived from a previously distributed option and (2) there is an insufficient history of the exercise of options to conclude that it would reoccur in the future.

    Quantification

          Courts have held that stock options are just another form of compensation that cannot be ignored when assessing an obligor’s available pool of income; but how do you quantify that income?

Specifically, we propose the future projection of income using past awards as a guide. The courts that have used this approach based their decisions on the theory that the existence of a regular stream of grants in the past will likely lead to awards in the future. This is no different than bonuses paid by an employer regularly.

Because there are several measurement points along the stock option time line-(1) date of grant, (2) date of vesting, (3) date of exercise and (4) date of sale_ the proponent of this concept must determine the appropriate date that should be used to determine the value of the options for income purposes.

Since the dates of exercise and sale are driven by investment decisions of the employee, they are clearly not the best measurement dates. The date of vesting is set by the employer and is the point in time when the exercise restrictions lapse. An argument can be made for this to be the measurement date. At this point- usually three to four years after the grant date-the employee can realize, in tangible form, the financial benefits of the stock options. However, the employer frequently uses the vesting period as a retention tool rather than a compensation tool. The compensation tool is the grant of the options themselves.

Therefore, for purposes of calculating the income component of stock options, we propose that the date of grant is the appropriate measurement date. On this date, the company grants what is effectively a bonus to the employee in the form of a right to buy company stock at a point in the future at a fixed price. However, this bonus has a risk component associated with it because over time, the options could increase in value or decrease in value and in the worst case scenario, they could be rendered worthless.

To value the options on the date of grant is no different than valuing them at any other point in time-with one exception. Because accounting rules require that stock options be granted at or near the fair market value of the stock, there is little, if any, intrinsic value to the options. The intrinsic value is calculated by subtracting the exercise price of the option from the fair market value of the stock. As a result, this method cannot be used. The Black-Scholes  model, on the other hand, takes into account the future movement of the stock (in the form of appreciation and depreciation) and calculates the present value of the projected future benefit from the exercise of the stock option. See the sidebar on page 4 for a discussion of this method of valuation.

One school of thought holds that if the recent past reflects a pattern of awards with a quantifiable value and three is an expectation that the awards will continue in the future, a reasonable amount (based on past awards) should be added to the income of the employee spouse for purposes of calculating support. How much is reasonable?

An approach that has been used is based on a weighted average of the annual value of the stock option awards. Similar to the approach used in the valuation of a business, this method relies more heavily on the recent past with the premise that it is a better indicator of the future. The weighted average should then be added to the base salary, traditional bonus and any other form of compensation earned by the employee. Using this approach, the employee’s total compensation, including the value of the stock option awards, is considered when calculating the obligor’s total income.

Proposed Rules

       Stock options are, in essence, a salary substitute. Consequently, under appropriate circumstances, courts should view stock options as income for the purpose of assessing child and spousal support incident to divorce. In light of this, consider the following proposed rules.

• Previously distributed options: If options have already been included in the scheme of property distribution in a divorce, income from those same options should not be included in an obligor’s available income.
• Existing but undistributed options: Income from the exercise of options existing at the time of the divorce, when those same options have not been distributed, should be included in an obligor’s pool of income based upon the quantification method described above.
• Projection of future income from past awards: Future income from stock options should be included in an obligor’s pool of income. In this case, however, we propose that safeguards must be put in place. Specifically, prior to the inclusion of future income, there should be:

. a sufficient history of past recurring awards (or other evidence) to justify projecting future awards and income therefrom;

. reasonable restrictions placed on the employee’s ability to exercise the future options; and

. no other circumstances that would make inclusion of income from future projected stock options unfair or inequitable to the obligor spouse.