introduction to stock options in a divorce process
If you or your spouse have stock options that need to be allocated as part of your divorce process then beware. Things can get complicated very quickly. You or your spouse can easily find yourself in a tax trap paying more than you expect after it is all said and done. You might also find yourself not properly allocating the stock options between you when you arrive at the asset-debt allocation process in your divorce. An improper allocation of the stock options can leave you with an expectation that you will experience a certain level of financial flexibility in the future which may not come true due to a number of factors. For your information, the asset-debt allocation process is beyond the scope of this article. Yet, we have mentioned it here as it is an important component to a divorce which can fundamentally impact your outcomes, especially when it comes to the stock options allocation process.
When you think about the stock options in your marital estate you will want to not only think about how to best design a diligent tax strategy to mitigate your tax exposure from exercising the stock options and when you decide to sell them, but also how to develop effective divorcing strategies as you enter your divorce negotiations. As noted above, the stock options analysis and framing process can be complicated. That’s why it is critically important to keep as much time on your side as possible to determine what is the best scenario (i.e. financial strategy) you need to employ for your situation. Once the diligent planning is completed, you can then pre-experience plausible financial outcomes to make you stronger for your negotiations and especially before you sign on the dotted line.
As implied above, once you figure out the right strategy, then you have to make sure you handle the stock options properly in your marital estate and understand how they will play a role in your financial future.
overview of stock options
An employee stock option (ESO) is a form of deferred compensation issued to an employee from an employer often from a privately held company. ESOs:
are often used as a method to motivate an employee to work hard for the company
contain performance metrics that are aligned to the growth in the value of the business
When the business gets bought out, goes public, or otherwise, the employee who exercises and later sells an ESO can gain a significant financial reward.
You can also think of an ESO as a derivative of a stock. It is similar to a “call option” where an employee has the right to buy an equity position in the company at a discount for a finite period of time. When the employee buys the stock at a discount equity holders who have the same class of stock often experience a dilution in their ownership interests.
ESOs come in different shapes and sizes. An ESO could be issued in the form of a:
statutory stock option (often referred to as a qualified stock option or an incentive stock option)
non-statutory stock option (a.k.a. a non-qualified stock option or NSO)
restricted stock grant, providing an employee the right to acquire or receive shares once certain performance criteria is met
stock appreciation right, the right to benefit from the increase in the value of a designated number of shares
phantom stock which can pay a future cash bonus equal to the value of a defined number of shares; phantom stock usually does not transfer legal ownership to the employee although it might be convertible to actual shares if a defined trigger event occurs
Stock options do not come with voting rights or dividend attributes. Stock options are known to have a vesting schedule which accumulate each year if not exercised. Stock options can expire over time if the employee does not exercise the ESO within a certain period of time. It is common for ESOs to have a lifespan of ~10 years from the date of the stock grant. Once the 10 years have elapsed, an ESO expires. There are strict rules around expiration dates which have to be diligently managed. Some ESOs offer what is referred to as a re-load option where the employer can grant more stock options to the employee after the employee exercises an ESO.
For privately held companies, once a qualified stock option is exercised, the options change form from a stock option to shares of stock in the company. Once the stock option is in the form of a stock, the shares are then considered part of an employee stock purchase plan (ESPP) which is managed by a fiduciary either inside or outside of the company. By exercising the stock option the employee has in essence purchased the shares of the stock through the ESPP. Incentive stock options are not purchased through an ESPP, rather through an ISO plan.
tax implications of stock options
If the employer grants a statutory (vs. a non-statutory) stock option to an employee, the employee generally does not include the value of the statutory stock option into her or his gross income when she or he received or exercised the statutory stock option. However, if the statutory stock option is an ISO, the employee may be subject to alternative minimum tax in the year the employee exercises the ISO. For your information, NSOs work differently from statutory stock options in context to their tax implications.
An employee who exercises a statutory stock option and triggers an alternative minimum tax (AMT) will need to report the transaction(s) on IRS Form 6251 and attach the form to her or his personal tax return. An AMT calculation can be complicated. You will want to diligently strategize and analyze how to best manage your financial outcome from a potential AMT exposure. The AMT may allow for various tax deductions, tax adjustments and/or certain tax exemptions that need to be evaluated and managed to figure out how to lower your overall tax burden that could arise from the exercise of a stock option.
The spread between the exercise price and the grant price of the stock option is included in ordinary income for tax purposes. When the stock option is sold, the difference between the sale price and the exercise price is deemed a capital gain (or capital loss) subject to capital gains taxes (or passive activity loss rules) depending on the timing of the sale and related holding period. ISOs must be held for at least 2 years from the date of grant and 1 year from the date of exercise to qualify for long term capital gains tax treatment. NSOs only require a 1 year holding period from the date of exercise even if the employee exercises the NSOs immediately after the date of grant. Managing these variables can be tricky and impact the financial outcomes you experience from your divorce process. There are other special rules that need to be managed in a divorce process in context to stock options, some of which are highlighted below.
When you are strategizing how much to sell and when to sell an ESO, you want to be aware of the price volatility of the stock option, how much time remains until the ESO expires (time to expiration), the holding period of the stock option and overall market timing of the sale of the ESO. Market timing is difficult to manage. Yet, an acquisition of a privately held business into a public company may be a factor that could impact the market timing.
To avoid having an incentive stock option (ISO) from being classified as an NSO, which would require immediate tax withholdings upon exercise, there is a tax rule that exists that limits an employee from receiving more than $100,000 worth of incentive stock options in a single tax year. Employers or employees may seek to issue stock options that exceed the $100,000 limit in an effort to shelter the tax. Yet, this $100,000 tax rule prevents such tax sheltering. The $100,000 limit is subject to vesting rules. In other words, for example, if the vesting schedule associated to the stock option is over a 5 year schedule, the total amount of the stock grant is then divided by 5 to determine whether the $100,000 threshold has been triggered.
These matters are important to understand in context to a divorce process. For example, taxes may have already been withheld on the stock options that were granted or exercised and need to be included in the marital estate as an asset subject to allocation. As a result, you may have what we call a tradable component for your divorce negotiations where stock options were exercised and withheld at a higher rate than what you would have experienced after your divorced was finalized, It all depends on the quantity and value of the stock option exercised and later sold.
For instance, different tax strategies that your spouse may or may not have consulted with you about before your spouse made a decision around the stock options might have resulted in a different outcome for you. Your spouse may be in a different tax bracket than you. If the taxes have already been withheld, you may limit other strategies you could employ which can impact your negotiating position in your divorce process.
It is worth noting you might want to consider exercising and/or selling the stock while you are still married. Why? Your tax bracket often shifts after the divorce which can create higher or lower taxes for you or your spouse. This matter needs to be diligently managed in a divorce process. Furthermore It might be wise to transfer the stock options to the other party in exchange for other assets to maximize the amount of total wealth that can be retained. It all depends on your specific situation.
It is also important to understand the 83(b) election in context to how stock options intersect with a divorce process. The 83(b) election allows startup founders or employees the option to pay taxes on the total fair market value (FMV) of the restricted stock at the time of the stock grant instead of the time of vesting. The election needs to be attached to your personal tax return in the year of the stock grant. The election informs the IRS to tax the taxpayer (you and/or your spouse) at the time of the stock grant not at the time the ISO vests which can have a material difference in the after tax benefits. By definition, the rationale to elect to be taxed at the time the stock was granted can be highly speculative. Your risk tolerance may not align with your spouse’s risk tolerance which may create another tradable component for your negotiations. The employee who executed the transaction must have performed sufficient due diligence to respectably understand whether the value of the stock options as of the date of the stock grant will be lower than the value of the stock grant at of one or more future vesting dates. After exercising the stock option, if the stock later declines then the taxpayer would have paid a tax based on a higher valuation which could prove costly.
As implied above, if you were involved in the decision process to exercise and/or sell the ESO then you would not necessarily have a tradable component available for your negotiations. You may be unclear whether you or your spouse have already withheld taxes on previous ISO grants. If monies were withheld they might be deemed an asset in your marital estate. Furthermore, if the ISO was taxed at the time of the stock grant, not at the time of exercise, you may limit your flexibility to minimize your future tax exposure on the stock options. If you do exercise your stock options, you will want to evaluate whether to file the 83(b) election which will need to be filed within 30 days of the exercise date to qualify for special tax treatment.
It is worthy to note, if you are required to pay an AMT tax you should include those payments in your tax basis. Why? Paying an AMT tax increases your tax basis. It is in essence a cost of the stock that will reduce any future capital gains or increase potential losses you might experience. By including the AMT payments in your tax basis helps to mitigate your risk of accidentally paying double taxes for what you already paid for through an AMT calculation. Furthermore, if possible, you will want to recoup the AMT paid in a future year through what is known as an AMT tax credit. If you are successful to recoup the prior AMT you paid via an AMT tax credit and have already included the previous AMT paid in your tax basis, you will then need to reduce your tax basis for the amount of the AMT returned to you. This is important as it will require you to maintain what is often referred to as a basis schedule on a going forward basis until at least all of the stock options are sold and the AMT is fully recouped.
The AMT tax credit is calculated based on the difference between your regular income tax that you would normally pay compared to the AMT calculated for your then-current taxable income. For every taxpayer, the AMT is calculated “behind the scenes” and is compared to the tax you generate from your “regular income”. Many people do not hit the AMT threshold. Yet, it is calculated anyway. In context to the AMT tax credit, this is a good thing. You want the AMT to be calculated so you can demonstrate the regular tax is higher than the AMT calculation which will then allow you to facilitate an AMT tax credit.
Where your future year AMT calculation is less than your regular income tax you can apply for an AMT tax credit via IRS Form 8801. The amount of the AMT tax credit will only be up to the amount of the difference between your regular income tax and the calculated AMT. In other words, it could take years to recover a previously paid AMT. So, it is important to be aware as you navigate how to best manage the timing, allocation, etc of the stock options in your marital estate as you migrate through your divorce process.
Another important component to understand is how the IRS is informed about the exercise of a stock option. When the employee exercises a stock option, the employer is required to fill out IRS Form 3921. Form 3921 informs the IRS that the taxpayer exercised the stock option. If the employer does not prepare and submit Form 3921 the employer, not the employee, is subject to penalties.
It would be beneficial to obtain a copy of each Form 3921 submitted to the IRS from the employer to avoid a mismatch in tax reporting if possible. Deadlines to file Form 3921 are based on the year after the tax year closes where the ESO has been exercised.
Reporting an ESO to an employee – the deadline is January 31st of the following year
Filing Copy A with the IRS via paper – February 28th is the deadline of the following year
Filing copy A with the IRS electronically – March 31st is the deadline of the following year
If your mediation or trial is scheduled before these dates you may need to wait to obtain these records to verify the figures used in your divorce proceeding align to the figures reported to the IRS. When the stock option is purchased at a discount Form 3922 is filled out and submitted to inform the IRS the stock option was purchased through an employee stock purchase plan from the employer or the corporation’s transfer agent.
Another component of stock options to be aware of is whether the market value of a NSO is readily attainable via the public markets or otherwise. If so, the NSO becomes taxed at the date of grant not the date of exercise. The timing of these matters could impact the outcomes you experience from your divorce process. Where the employer is considering a sale of the business (or in the middle of a sale process) to a public company and the transaction is completed before the divorce is finalized, the value of the NSO would be deemed known and therefore subject to tax as of the date of grant not the date of exercise. The spread between the market value of the NSO and the exercise price is treated as compensation income to the employee and included in the employee’s W-2, subject to federal and state taxes along with social security tax and medicare tax (i.e. the FICA tax). The amount of the spread will be reflected in the employee’s W-2 within Box 12, Code V. Independent contractors will have the amount included in self employment income and may be subject to the full self employment tax (both the employer and employee FICA tax) which could pose additional tax burdens on a divorce process.
It is important to note, if your stock option triggers an AMT, you may not have had enough taxes withheld from the paycheck leaving you and/or your spouse with an unexpected tax obligation. If this matter is not handled properly, the tax obligation can be deemed a marital obligation or a separate obligation. The decision to exercise during marriage or after marriage is important in this context.
You may find the need to exercise the stock options early to provide for your future standard of living without clarity of the longer term implications. These decisions are ultimately yours to make, not ours. Depending on your situation, you may want to negotiate for more or less assets to have the flexibility to hold onto the options within the expiration term to see if you can benefit from a longer term value strategy.
The Net Investment Income Tax (NIIT) is also another matter that needs some consideration in a divorce process in context to how to best maximize your financial outcomes around stock options in a divorce process. Head of household considerations make a difference in terms of the threshold that will be triggered around the NIIT. Therefore, in context to a divorce, if you have young children and can meet the tests to qualify for head of household you may have saved yourself some taxes around the NIIT.
In summary there are a lot of issues to take into consideration around the technical matters how to best handle stock options let alone how they need to be managed in a divorce process. If you need help, feel free to reach out. My name is Larry Smith, CPA MBA. I am one of the founding partners of Divorce Outcomes. We provide a free 30-60 minute call to review your situation with you. You have no obligation to move forward with us at all. The 30-60 minute call exists to see if we can give you some peace of mind and help you in your life. My direct line is 617-680-5222. My email is [email protected].