(973) 403-9200
Charles F. Vuotto, jr. Esq. and Paul Gazaleh, CPA
Special Thanks to lisa steirman
2001
I. Introduction
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 commonly found in the asset portfolios of most divorcing parties where one or both of them are or were employed in corporate America. Most state courts have held that options are assets subject to distribution along with all other assets acquired during the marriage. However, some courts have taken the next step and have begun to characterize the option as “income” as well. This article will discuss the cases in the nation that have done so and the approaches they have used.
A stock option is “[t]he right to buy a designated stock, if holder of option chooses, at any time within specified period, at determinable price, or to sell designated stock within an agreed period at a determinable price.” Blacks Law Dictionary 1418 (6th ed. 1990). Stock options “are often granted to management and key employees as a form of incentive compensation.” Id. In effect, stock options are replacing typical cash based compensation packages. Such broad-based implementation of this compensation scheme has obvious implications for asset distribution and support awards incident to divorce proceedings. The dual nature of the stock option as both an asset and income has been a topic debated in the courts with varying outcomes.
II. Stock Options As Income For Purposes of Spousal and Child Support
A. Projection of Future Income Based on an Obligor Spouse’s History of Receiving Stock Option Awards.
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, the California Court of Appeals 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. Kerr v. Kerr, 91 Cal. Rptr.2d. 374, 379 (Cal. Ct. App. 1999). Despite the fact that all stock options existing at the time of the parties’ 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. Id. at 377. 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 forty percent of all of the former husband’s future stock options after they had been exercised. Id. at 379.
Courts in other states have applied reasoning similar to the Kerr court. For instance, the Court of Appeals in Iowa 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. Moore v. Moore, No. 99-0280, 2000 WL 564165, at *2 (Iowa Ct. App. May 10, 2000). 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 aware of the likelihood that the former husband would receive stock options in the future due to the nature of his employment. Id. at *1. Congruous with the decision in Kerr, the Moore court valued the future stock options as income only after they had been exercised. Id. Additionally, in Burns v. Burns, the Connecticut Appellate Court upheld the trial court’s award of periodic alimony payments to the former wife, including twenty percent of earned income from any future bonuses from stock options. Burns v. Burns, 677 A.2d 971, 977 (Conn. App. Ct. 1996). In Burns, the former husband had received bonuses during the two years preceding the dissolution of the marriage. Id. at 973. 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.” Id. However, the Burns court did not specify whether the future stock options will be valued as income at the time they are granted or at the time they are exercised. Id. Moreover, inNolan v. Nolan, the Washington Court of Appeals 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. Nolan v. Nolan 1999 WL 639409, *6 (Wash. Ct. App. Aug. 23, 1999).
B. Projection of Obligor Spouse’s Future Income Due to Existing Unexercised Stock Options
The seminal case holding that existing stock options that were unexercised can be characterized as income for purposes of support isMurray v. Murray, 716 N.E.2d 288 (Ohio Ct. App. 1999). The parties’ original divorce decree in Murray 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 original child support calculation. Id. at 290. 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. Id. at 290. 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. Id. at 295.
The Murray court examined the applicable Ohio statute that exempts “nonrecurring or unsustainable income” from gross income. See Id. at 291-295 (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 Ohio 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.” Ohio Rev. Code § 3113.215(A)(11), repealed, identical language currently found at Ohio Rev. Code § 3119.01(C)(8). 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. Id. at 294-950. 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. Id. at 670. The court stated that “[s]uch an individual would be shielded from bearing the child support obligation for which he should be responsible.” Id.
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.” Id. at 298. The court reasoned that 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. Id. 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. Id. 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 non-existing, future stock options as income only after they had been exercised. (See section IV below which suggests the appropriate quantification method to be valuation of the options by the Black Scholes method on the date of grant, with an averaging of the calculated additional income to determine a historical record with which to project future income.)
Courts in Texas and Florida have relied on an obligor spouse’s future gain from existing, unexercised stock options when concluding that the value of unexercised stock options is income for support purposes. The Texas Court of Appeals 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 paycheck, he would see the money eventually.” Haselbarth v. Haselbarth, No. 01-96-00108-CV, 1998 Texas App. Lexis 320, at *10 (Tex. App. Jan. 15, 1998). Consequently, the court concluded that the existing, unexercised stock options were included in the net resource calculations. Haselbarth, 1998 Tex. App. Lexis 320, at *10. Similarly, the Florida District Court of Appeals 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. Seither v. Seither, 779 So.2d 331, 332 (Fla. Dist. Ct. App. 1999).
C. Exercised stock options as Income
Exercised stock options have been found to be income for purposes of support modification. 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.” Kenton v. Kenton, 571 A.2d 778, 782-83 (Del. 1990) (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. Id. at 783. The Court of Appeals of Tennessee averaged an obligor spouse’s exercised option income into his base salary. See Stacey v. Stacey, No. 02A01-9802-CV-00050, 1999 Tenn. App. Lexis 668, at *11 (Tenn. Ct. App. Oct. 6, 1999). 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.” Id.; see also Smith v. Smith, No. 01-A-01-9809-CH00515, 1999 WL 548568, at *1 (Tenn. Ct. App. July 29, 1999) (prorating exercised stock options in a child support modification application); In re Campbell, 905 P.2d 19, 20-21 (Colo. Ct. App. 1995) (asserting that “…for purposes of child support, father’s income, as derived from the exercise of the stock options, is limited to the difference between his purchase price of the optioned stock and the price at which he then sold it”); Forsythe v. Forsythe, No. 133882, 1996 WL 1065613, at *2 (Va. Cir. Ct. Sept. 27, 1996) (“stock options exercised or paid out are clearly gross income…”); In re Interest of C.J., Child, No. 05-98-01973-CV, 2001 WL 493701, at *2 (Tex. App. May 10, 2001) (noting that income from exercise of stock options should be included in computing income for child support).
III. Stock Options Not Considered Income for Child Spousal and Child Support
If stock options have already been equitably distributed between the parties, courts 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. See the quantification of this amount under section IV below.) The Appellate Court of Connecticut held that stock options that had already been distributed at dissolution cannot be considered income for purposes of accessing income for support modification. See Denley v. Denley, 661 A.2d 628, 631 (Conn. App. Ct. 1995); see also Kapfer v. Kapfer, 419 S.E.2d 464, 467 (W. Va. 1992) (stating 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”); See also Hamlin v. Hamlin, No. CO-93-676, 1993 WL 469139, at *1 (Minn. Ct. App. Nov. 16, 1993).
Some courts have distinguished between vested and unvested options at the time of the divorce, asserting that under normal circumstances vested options are assets subject to equitable distribution, while unvested options are income for purposes of support. See Zettersten v. Zettersten, No. M1999-0186-COA-R3-CV, 2000 WL 1231372, at *6 (Tenn. Ct. App. Aug. 31, 2000); see also Wofford v. Wofford, 991 S.W.2d 194, 198-90 (Mo. Ct. App. 1999) (holding that only those options which an obligor spouse can currently withdraw constitute income for purposes of child support); Tarifi v. Tarifi, No. 233425, 1996 Conn. Super. Lexis 3265, at *7 (Conn. Super. Ct. Mar. 29, 1996) (stating that unvested stock options are “not a source of present disposable income and, therefore, although a part of [obligor spouse’s] benefit package, are not a part of the [alimony] calculation here”).
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. The Ohio Court of Appeals held that the capital gain that an obligator spouse received was not income for child support determinations because the income was nonrecurring. Yost v. Unanue, 671 N.E.2d 1374, 1376-77 (Ohio Ct. App. 1996). The Court relied on the same statute addressed in Murray, which exempts nonrecurring income from the definition of gross income. Id. at 1376 (citingOhio Rev. Code Ann. § 3113.215 (A)(11)). 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 id. at 1376; see also Miller v. Miller, No. C-980892, 1999 Ohio App. Lexis 4313, at *11 (Ohio Ct. App. Sept. 17, 1999) (holding that the income which an obligor spouse received from shares of stock in book value incentive plan did not constitute income for support purposes because it was nonrecurring).
Two Connecticut cases have held that stock options are not income for purposes of spousal support. In DeAnda v. DeAnda, the court asserted that income includes only that which is shown on a W-2 and/or 1099 tax form. DeAnda v. DeAnda, No. FA9903351865, 2000 WL 1765450, at *5 (Conn. Super. Ct. Oct. 25, 2000). However, DeAnda involved stock options which were distributed over a two year period only. Id. at 2. 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, the stock options at issue, which were held not to constitute income, were exercised on only one occasion. Kress v. Kress, No. FA900109671 S, 1990 WL 277456, at *2 (Conn. Super. Ct. Oct. 2, 1990). Furthermore, there was no opportunity for future stock options because the obligor spouse had received the stock option as part of his forced termination. Id.
Therefore, it appears that courts will decline to include income incident to stock options under two circumstances, (1) where the income is derived from a previously distributed option and (2) where there is an insufficient history of the exercise of options to conclude that it would reoccur in the future.
IV. QUANTIFICATION
As explained above, courts have held that stock options are just another form of compensation (akin to a bonus) which cannot be ignored when assessing an obligor’s available pool of income. This section will address the quantification of that income. Specifically, we propose the future projection of income using past awards as a guide. The courts which have used this approach base 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 regularly paid by an employer. The issue becomes one of the method to quantify this past income for projection purposes.
Since there are several measurement points along the stock option time line, the proponent of this concept must determine the appropriate date 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 as when the exercise restrictions lapse, therefore, 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. This “bonus” has a risk component associated with it that could increase or decrease the future value of the option or render it worthless.
To value the options on the date of grant is no different than valuing them at any other point in time. But, there is one exception. Since 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. This formula is an algorithm which considers several variables to calculate the value of each option. The formula is as follows:
The formula is divided into two parts. The first part, SN(d1), calculates the expected benefit from acquiring a stock outright. The second part of the model, Ke(-rt)N(d2), calculates the present value of paying the exercise price on the expiration day. The difference between these two parts is the fair market value of the call option.
After reviewing the two methods of valuation, the Black Scholes Method is the appropriate method for purposes of calculating the compensation value of the stock options because it calculates the present value of the expected benefit to the employee at the time of grant. In other words, if one is attempting to determine an obligor’s historical income for the last three years of a marriage, a determination must be made of the value of that compensation in each of those three years (e.g., salary, bonuses and options). Therefore, the value of the option must be valued at the time of grant.
It is imperative that the components included in the Black-Scholes calculation reference the relevant time period. For example, use 2001 information for 2001 calculations. Do not use data from different points in time. This will require some research to determine the variables for prior years that can sometimes be obtained from the annual report and 10-K forms filed by publicly traded companies.
The following example is presented to further illustrate this point.
EXAMPLE: An employee of a large publicly held company received an annual grant of nonqualified stock options that vest equally over a three-year period. What value did the employer intend to award to the employee as a result of granting of the stock options? To determine this, the Black-Scholes Method is used based on information available at the time of grant. A summary of the assumptions used in the calculations is as follows:
After plugging the above variables in to the Black Scholes formula, the value of the options ranged from $4.80 to $19.99 as explained in the following chart:
As a result of the grants of stock options, the employee received a “bonus” of an additional $7,200 to $64,968 per year which is calculated by multiply the value of each option by the number of options granted. This value is based on all of the relevant data available at the time of grant. Although the ultimate amount actually received by the employee will vary depending on the performance of the company’s common stock, this method accurately quantifies the “value” of the additional compensation when paid by the employer.
One school of thought holds that if the recent past reflects a pattern of awards with a quantifiable value and there 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.
V. Conclusion
Stock options are, in essence, a salary substitute. Consequently, under appropriate circumstances, courts should view stock options as income incident to divorce. Consider the following proposed rules:
1) 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;
2) 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;
3) PROJECTION OF FUTURE INCOME FROM PAST AWARDS: If a court is to add to an obligor’s pool of income due to the projection of future stock options based on past awards, certain safeguards must be put in place.. We propose the following safeguards:
a) There must be a sufficient history of past recurring awards (or other evidence) to justify projecting future awards and income therefrom;
b) There must be reasonable restrictions placed on the employee’s ability to exercise the future options;
c) There must be no other circumstances which would make inclusion of income from future projected stock options unfair or inequitable to the obligor spouse.
It is herein suggested that once these safeguards are satisfied, income from future projected stock options should be included in an obligor’s resources for the purpose of assessing child and spousal support incident to divorce.
· Charles F. Vuotto, Jr. Esq. is a shareholder with the Woodbridge based law firm of Wilentz, Goldman & Spitzer. He is a member of the New Jersey State, Union and Middlesex County Bar Associations and a member of each Association’s Family Law Section. Mr. Vuotto has lectured on Family Law on behalf of the New Jersey Bar Foundation and continues to lecture to the public, bench, bar and paralegals on various family law related issues. He has published articles on the topic of Family Law including: “Employee Stock Options and Divorce,” The Lifestyle Analysis,” “What to Consider in Divorce Actions When Valuing the Private Equity and Other Investments of High Net-worth Individuals,” and has co-authored an article for the New Jersey Institute for Continuing Legal Education entitled “Enhanced Earning Capacity: Is It An Asset Subject To Equitable Distribution Under New Jersey Law?”
· Paul M. Gazaleh is Certified Public Accountant and vice president of The Chalfin Group, Inc., a consulting firm providing strategic planning and valuation services to entrepreneurial businesses and individuals.
· Lisa Steirman is currently a Summer Associate at Wilentz,Goldman & Spitzer and will be entering her third year at Rutgers-Newark School of Law .