Jacqueline Gold Roessler
Originally prepared for the Institute for Continuing Legal Education (ICLE)'s 2006 Marital Property Update Seminar
I. Introduction:
A. Sample Case
George and Jane have been married for 10 years. George is a highly paid and well-respected executive at an automotive firm and Jane has been a stay-at-home parent to the parties' three children. George has been employed by his corporation for 15 years. George has recently filed for divorce.
Jane knows that in addition to George's regular benefit package, he has received (and will continue to receive) various perks and incentives his employer put in place to ensure George doesn't seek employment elsewhere. However, she's not exactly sure what these "career-assets" are, nor whether or not she'll be entitled to a share of them as a result of the divorce proceeding.
Jane's attorney sends a subpoena to George's employer and the response comes back with an alarming amount of strange words and complicated looking spreadsheets and numbers. Vested stock options, non-vested stock options, stock appreciation rights, non-qualified deferred compensation plans; what are these assets and how should they be valued? Jane also reminds her attorney that George has been promised lifetime health insurance coverage throughout retirement and she, of course will have no access to it. Shouldn't that be valued as well?
B. Overview of Issues: What do these types of Benefits have in Common?
There are several considerations when determining what portion of a non-standard benefit is includable in the marital estate and how it should be valued. It's helpful for the attorney to remember that among the benefits being discussed in this presentation, they share several common elements.
The first of those is that they are generally not divisible via a Qualified Domestic Relations Order (QDRO). Keep in mind that a QDRO is used is to assign a portion of an ERISA (Employee Retirement Income Security Act of 1974, as amended) sponsored qualified defined benefit or defined contribution retirement plan from one spouse to the other with no tax consequences. It cannot be used to transfer anything other than a qualified pension plan from the employee to the non-employee spouse. Therefore, all the QDRO "rules" and guarantees do not apply to these non-standard benefits.
Another significant shared point in common is that they have an inherent risk of forfeiture should the company experience financial difficulty or should the employee leave employment. Again, this is quite different than a qualified pension plan or retirement account and needs to be considered during valuation.
The third point that they share in common is a general unease and lack of education amongst many family law attorneys about the nature of these benefits and what the key arguments are as to whether or not they should be included in the marital estate.
This presentation will clarify and define the most commonly encountered "non-standard" employee benefits as well as present information on what the arguments are in favor of (as well as against) including all or a portion of them in the marital estate.
II. Stock Options
A. General Definition
Simply put, a stock option is the right granted to an employee to purchase the company's stock if certain requirements are met in the future.
For example, in our case study, over the last 10 years of his employment, George has been granted options to purchase company stock at various share prices, given that he stays at the company for "x" number of years at the time he exercises the options to buy.
The most lucrative of these options gives him the right to purchase 1,000 shares at $10.00 per share. The current share price of the company stock is $22.50 per share. If George were to exercise these options today (i.e. acquire the stock), he would own stock valued at $22,500, however, it would only cost him $10,000 (not including any taxes or transaction costs, which may apply). Therefore, in very simple terms, George would increase the value of his assets by $12,500 if he exercised the options today.
Companies award stock options to their employees with the hope that they will work hard to increase the value of the company's stock. The rationale is that if the employee has a personal monetary incentive to make the stock price (and thus the value of the company) increase, it becomes a "win-win" for the corporation and the employee. It follows then that these are generally granted only to highly paid individuals who are believed to have an impact on the corporation's bottom line.
A stock option exercise can either be a "cash-less" or a "cash" transaction. In a cashless transaction, the option is exercised and the stock sold on the same day. In a cash transaction, the employee must provide the funds to acquire the stock.
When determining how and if they should be valued in a divorce case, the family law practitioner should review:
- Should taxes be deducted from the value? (Are they Incentive Stock Options (ISO's) or Non-Qualified Options (NQ's))?
- Are they fully vested?
- If not, why does that matter?
- Is there a strong likelihood that the employee will leave employment prior to vesting?
- How volatile is the company stock?
B. Taxation of Stock Options: ISO's and NQ's
There are two basic types of stock options, Incentive Stock Options (ISO's) and Non-Qualified (NQ's) Options. The main difference between ISO's and NQ's is the way in which they may become taxable to the employee. It's important to keep in mind that no taxes are due upon the granting of a stock option (whether and ISO or an NQ) to an employee.
If an option is deemed an ISO and is exercised (acquired) pursuant to what is termed by the IRS, a "qualifying transfer" no income will be realized for the employee. In plain English, this means that as long as certain rules are met, when exercising an ISO, no income tax will be due.
A qualifying transfer as per IRC Sec. 421(a); Treas. Reg. Sec. 1.422-1(a)(1) occurs as long as:
- the stock is held for at least two years after the date of grant and at least one year from the date of exercise and
- ii. the employee remains employed by the corporation at all times from the date the option is granted until 3 months before exercise.
Even if it's not a taxable event upon exercise, the spread between the exercise price and the sale price can affect a person's tax liability through the Alernative Minimum Tax (AMT) calculation.
Keep in mind that exercising the stock option is different than selling (or disposing of) the stock. Upon sale of a stock, if there is an increase in value (i.e. a "capital gain), there will be taxes due upon that transaction at the long term capital gains tax rate. The tax basis will be the amount paid by the employee to acquire the stock (vs. the fair market value of the stock on the date of exercise). Therefore, in our example above, if George exercised his options to buy the company stock at $10 per share (even though it's valued at $22.50) and sold it at $25 per share, he will owe capital gains tax on $15 per share multiplied by how many shares he acquired (1,000), multiplied by capital gains tax rate.
If the stock option exercise doesn't meet the above requirements and is therefore a "Non-Qualifying Transfer", the basis will be increased by amounts includable as compensation income (taxed as ordinary income).
In the case of non-qualified stock options, taxes are due upon the exercise of the option (as opposed to on the sale of the stock in the case of ISO's), at ordinary income tax rates.
C. Marital vs. Non-Marital Stock Options:
In our case study, Jane's attorney has stated his opinion that all of the options listed on Attachment A are marital assets and thus should be divided between the parties. Before we examine how the options can be divided, let's take a look at his claim that they are 100% marital.
The first set of options, granted in 1995, were awarded prior to the marriage, therefore, George's attorney claims that those are pre-marital and thus George's separate property. However, as Jane's attorney correctly points out, the options didn't fully vest until the year 2000, therefore, a portion of them could be considered marital. He suggests that a coverture fraction be applied in order to determine how many options are part of the marital estate. If the parties agree on this theory, the coverture fraction would have a numerator equal to the number of years from the grant date to the date of divorce and the denominator would be the total number of years from the grant date to the fully vested date. Therefore, 4/5 of the 1,000 options granted would be marital (800 options).
Next, George's attorney argues that the non-vested options are not part of the marital estate at all. They're worth nothing today (i.e. "under-water") he says, therefore 50% of nothing, is nothing. Plus, he states, anything that is acquired after the marriage is not a marital asset.
Jane's attorney argues back that the same coverture fraction theory should be applied to all the non-vested options. For example, the 2002 options won't vest until 2007. If the parties are divorced at the end of 2006, the coverture fraction would again be 4/5 multiplied by the total number of options granted (800 out of 1,000), since a portion of them vested during the marriage.
D. Valuation and Offset
Once the parties agree to exactly what is includable in the marital estate, the next concern is how to divide them.
One option is to place a present value on them and add them to George's side of the ledger in the marital asset division.
There are two main methods of valuing options. The simplest is to assume that the options are exercised today, at the stock's current fair market value. The fair market value is thus subtracted from the exercise price (and appropriate taxes applied).
The other method (Black-Scholes Method) takes into consideration the volatility of the underlying stock , potential future dividend rates and lost interest.
If you represent the employee-spouse and there's a strong likelihood he (or she) will leave employment prior to vesting, valuation and offset should be avoided. Similarly, if the stock is extremely volatile, the risks of valuation and offset should be thoroughly discussed with the client to avoid any post-judgment issues.
E. Dividing Stock Options
Another option is for George to hold Jane's shares as a beneficial interest for her . The stock option can then be exercised at Jane's trigger in the future. Upon the sale, the proceeds (net of taxes) would be remitted to her by George.
Similarly, rather than transferring the proceeds to Jane, net of the taxes, George could pay the proceeds to Jane on a pre-tax basis in the form IRS Code Section 71 payments. Thus, the payments would be deductible by George as spousal support and treated as taxable income to Jane. Of course, one of the requirements of IRS Code Section 71 is that all payments must be made in cash (not stock). Therefore, only cash transactions (versus transfers of stock) would qualify under Section 71.
The inherent risk for the family law practitioner is making sure that the language in the settlement agreement clearly protects both parties. For example, what happens if Jane's shares expire before she lets George know she wants to exercise them? Is George responsible for letting her know they're expiring? What happens if Jane needs to bring cash to the transaction? Within how many days will she give it to George? If it's a cashless transaction, how many days does George have to submit the after-tax proceeds to Jane? Lastly, how can each of them know that the taxes are being addressed correctly if Section 71 payments are not being made?
II. Other Stock-Based Incentive Plans
A. Stock Appreciation Rights (SARS)
A Stock Appreciation Right (SAR) gives an employee the right to acquire the increase in value of the company stock from the strike price to a fair market price in the future. The theory behind it is the same as the theory behind granting stock options; give the employees an incentive for the stock to increase.
Upon exercise of an SAR, ordinary income is realized for the employee.
B. Phantom Stock
Phantom stock is similar to SAR's, however, the employee must wait for a specified time period to end before they can acquire the "appreciation". Again, similar to SAR's, upon exercise of phantom stock, ordinary income is realized for the employee.
III. Non-Qualified Deferred Compensation Plans
A. Overview
Non-qualified deferred compensation plans allow highly paid employees a vehicle in which to defer receipt of a portion of their compensation until retirement. Again, keep in mind that these types of plans are not subject to division via a QDRO.
If Deferred Compensation is funded by the employer, it's treated as taxable income to the employee in the first year in which his/her rights are not subject to "substantial risk of forfeiture". Many companies avoid this from happening by placing the money in what is referred to as a "Rabbi Trust".
B. Rabbi Trusts
A+-* Rabbi Trust is an unsecured promise by an employer that the employee will receive certain benefits upon retirement or death. Payments are made to an irrevocable trust on the employee's behalf. They are not currently taxable, because they are subject to a "substantial risk of forfeiture" since the assets are subject to creditors' claims. Any money that goes into a Rabbi Trust isn't treated as taxable income to the employee until it's actually distributed. If the employer were to go bankrupt, the employee would be viewed as an unsecured creditor. Some important issues for the family law attorney to address are: 1. How solvent is the company? 2. Should the funds set aside for the employee be added to his compensation for purposes of child and spousal support? 3. How can these funds be divided or assigned to the non-employee spouse? B. Case Study: Problems with Division In our case study, George has a Non-Qualified Deferred Compensation plan. The total account balance, as evidenced by an account statement is $300,000, 100% of which is marital. Mary's attorney recognizes that a QDRO cannot be used to divide the account so she suggests that George keep the entire account and Mary could receive her $150,000 share from George's remaining half of his 401(k). But George has a problem with that. The Non-Qualified Deferred Compensation account is not guaranteed money. What if he buys out Mary's interest and then the entire $300,000 is forfeited? He's not willing to take that risk. Therefore, he offers to hold Mary's interest for her in a beneficial trust and will distribute her share to her at his retirement date. There a few problems with this approach. The first is that Mary will not have any investment control or real ownership over her share of the assets. What if George decides to put his money (and hers) into penny stocks or other risky ventures and loses her investment? The second issue is what will happen if George pre-decease's her receipt of her share of the account balance? Some plans allow for a beneficiary to be named, but there's no guarantee that George will comply with the divorce decree and continue to name Mary as beneficiary to her interest in the plan. The third, and most problematic concern is determining what portion of the future growth (and loss) belongs to Mary since it's presumed that George will continue to contribute to the account balance. The first issue can be solved by allowing Mary access to the investment options and giving her the right to direct George (perhaps on an annual basis) how to allocate her funds. This gives Mary some control and relieves George of the liability of having to invest Mary's assets. The second issue as to survivor rights for Mary can be addressed by providing her with a lien against George's estate should he remove her as beneficiary on her portion of the account balance. The last issue as to differentiating between growth on current assets owned by Mary from George's earnings on current assets and future contributions. The easiest way to accomplish this is if Mary's assets are invested in holdings that George doesn't have any money invested in. In this way, Mary's money would be kept separate. However, this is not always possible if there are limited investment choices. Another option is to hire a neutral accountant to track the investments and their earnings (both for Mary and George) on an annual basis and provide this to the parties. Distribution to Mary can also occur (as with stock options) as Section 71 payments. This would be allow George to shift income from his high tax bracket to Mary's low one. It would also avoid a potential fourth problem of how to account for the taxes owed on any distributions if George gives Mary after-tax dollars. The most important issue with these types of plans (as with any other) is to conduct appropriate discovery early on in the case and to consider all possible outcomes and contingencies when drafting the final agreement. IV. Lifetime Health Insurance Benefits A. An Overview As Mary indicated to her attorney, she believes that George will be receiving lifetime healthcare insurance in his retirement and she wants to be compensated for lack of access to similar benefits. Mary's attorney suggests hiring a pension valuation specialist to perform a present value of the future benefit. However, George's attorney absolutely disagrees with this approach. First, he points out that it's nearly impossible to determine what the monthly benefit (premium payment) is for George. If no one can ascertain the monthly benefit to George, how can a present value be calculated? Second, and most importantly, George believes he is really not guaranteed any health care coverage in retirement. Further, if he does receive any, it will only last until Medicare kicks in as primary coverage, of which Mary will have access to. Therefore, George's attorney is emphatic that this is a completely unsubstantiated and frivolous claim. B. The Facts For many employees of large corporations, they used to count on what is often called "cradle-to-grave" health care coverage. However, in today's economy and health care environment, it seems unlikely that those hoping to retire in the next 5 years and any time thereafter will actually receive such benefits. In December of 2005, the S&P 500 issued a report that they conducted on the S&P 500 corporations and their health care plans for retirees. The report indicated the following alarming information. Only 22% of all S&P 500 companies have set aside enough money today to fund 100% of retiree health care obligations. This seems like a staggeringly small number. In fact, it's much larger than the deficit most . companies have with regard to their pension funds. In fact the two companies listed with the largest deficit are Ford Motor with 32.4 billion dollars in unfunded retiree medical costs and General Motors with 61.5 billion dollars in unfunded retiree medical costs. Beginning in January, 2007, the retirement health care picture even for current Ford Retirees will be changing. Any insurance premium costs above the 2006 premium level will be 100% paid by the employee. C. Conclusion Therefore, in a divorce scenario today, such as George and Mary's, Mary's attorney will have a difficult time proving that Mary is entitled to some compensation for George's "lifetime healthcare benefits". It is possible, however, especially for some State of Michigan employees where a valid case could be made. As always, each case needs to be reviewed in context of the overall facts of the case as well as the company particulars. V. Summary In summary, the most important thing to keep in mind is that non-standard benefits must be treated in a non-standard way during a divorce. That means that the discovery process is particularly important to determine what types of plans or benefits are being dealt with and what it will take to value or divide them. As always, it's especially important to involve experts early so that they may be of the most assistance to the attorney. What's also extremely important is that careful thought should be given to the exact wording put in the divorce decree to avoid confusion post-judgment.