In Part I of this topic, I discussed the characterization of stock options as marital or separate property. After determining the marital and separate property component of each stock option, the next step is to value and divide the option. The following Part II of this topic addresses the valuation and distribution of stock options in divorce actions.
The primary method of dividing stock options in divorce is to defer distribution until the employee exercises the option. The proceeds, net of taxes to the employee, are divided according to a set percentage established in the decree. The stock price on the date of exercise sets the value of the option. This is called the deferred distribution, or “as, if and when” approach to valuation and division.
A second approach is to establish a present value for the options and award them all to the employee spouse. The other spouse receives different assets of comparable value. This is called the “immediate offset” approach. The problem with this approach is the number of assumptions one must make to assign a present value to a contingent asset.
One present value option simply compares the strike price and the market value of the stock on the date of valuation. The difference between strike price and market value is called the “intrinsic value.” Using intrinsic value deprives the non-employee spouse of the right to benefit from the anticipated rise in stock price before the employee exercises the option. The employee spouse receives no discount for lack of transferability of the option, the risk that the option will never be exercised, or that the price of the stock might go down.
The Statement of Financial Accounting Standards adopts the Black-Sholes Option Pricing Model to value stock options. This is a complicated formula requiring expert analysis and testimony. Accountants use this method to estimate stock option values on company financial statements. The SEC and IRS also make limited use of the Black-Sholes method for disclosure statements, and gift and estate tax valuations. The formula requires use of assumptions and hypotheticals, however, and has been rejected by some courts as too speculative.
In an ideal world, employees would be allowed to divide stock options in divorce like retirement accounts. A spouse could receive options on a certain number of shares as an alternate participant in the plan. If the conditions for vesting and exercise are met by the employee, the alternate participant could directly exercise the option. In the real world, stock option plans rarely, if ever, allow direct assignment of a stock option to a spouse. I have never seen it. Employers naturally want discounted stock to remain with the employee, even if the assignment remains in the family unit. Stock options carry tax consequences that could be manipulated in divorce situations. This detracts from the original purpose the employer intends in granting the option.
Part III of this topic will discuss the information the parties should exchange in a divorce to develop a plan to characterize, value and divide stock options.
by David A. Tracy