Definition: A stock option is the right given to an employee by a corporation to purchase a set number of shares of the corporation’s stock during a specific period of time at a fixed purchase price.

General Discussion: If an employee is given a stock option he/she is not required to purchase the stock, but can or may elect to exercise the option at his/her choice. Stock options are either statutory or nonstatutory.

Statutory options give the employee the ability to take advantage of special federal tax treatment that is accorded to incentive stock options. If the federal statutory regulations are met, the employee will not have to pay ordinary income tax on the options when they are granted or exercised. After they are exercised and sold they are taxed at the appropriate capital gains rate, provided they are held for the required amount of time. On the other hand, nonstatutory options usually are taxed as regular income when the option is granted (when the stock is purchased).

Why do corporations offer employees stock options? In order to determine the answer, each stock option should be analyzed on a case by case basis. The more common reasons are as follows:

1. The corporation wants to provide an incentive for the employee to remain with the company. This would represent compensation for services to be rendered in the future.

2. Options are offered to attract new employees who are usually then paid below the going rate in return for part of the future growth of the corporation. This would represent deferred compensation for services rendered in the present.

3. The corporation wants to give the employee a bonus for having done a good job. This would represent compensation for services rendered in the past.

Classification: In order to determine if stock options should be considered a marital asset subject to distribution, the critical issue revolves around the reason the corporation granted the stock options. Were they granted for past, present or future service? The courts generally follow a four step process to determine the marital portion.

Step 1: The court must determine the number of shares granted for past and future service.
Step 2: The number of shares granted for past service is deemed to be marital to the extent that the marriage coincides with the period of employment until the granting of the options.
  Most states apply a coverture fraction (time rule) to determine the marital portion. The numerator of the fraction would represent the later of the beginning of employment or the beginning of the marriage to the date the options were granted, and the denominator the date of employment to the date the options were granted.
Step 3: A second coverture fraction (time rule) would be applied to the number of shares granted for future service to determine the marital portion. This would represent the growth from the date the options were granted to the date the marriage ended (cut off date) and any additional growth due to contributions of the non-employee spouse.
Step 4: All options found to be marital could be divided between the parties. Any options not deemed marital property would remain the sole property of the employee spouse.

Most equitable distribution states have adopted the following positions relative to the classification of stock options:

Stock options which are exercisable upon the date the marriage ended or which may not be cancelled, and which may, therefore, be said to be vested as of the date the marriage ended, are viewed as marital property. Any stock options which are not exercisable as of the date the marriage ended and which may be lost as a result of events occurring thereafter (not vested), would be treated as the separate property of the employee spouse, even though they may vest at some time in the future.

Stock options that are designed to vest and become exercisable over a period of time should be considered both compensation for the employee’s past services and incentive for the employee to continue employment in the future. The options which have already vested would be a reward for past service rendered during the marriage, and, therefore would be marital property. Those options which have not vested represent a future right contingent upon continued service, and therefore would be considered non-marital property.

Most community property states take the opposite position. They have determined that unvested stock options constitute a contingent interest in property, and therefore are a community asset.

Valuation: The valuation of stock options is not difficult. The option is valued at the market value of the stock on the date of valuation less all costs associated with exercising the option. However, this simple calculation can be complicated by other factors such as:

  1. Tax liability to the optionee;
  2. The optionee may have to continue employment in order to exercise the option;
  3. After exercising the option the optionee may be prevented from selling the shares;
  4. The options may not be vested on the date the marriage ended;
  5. The optionee may have to borrow money to exercise the option; and
  6. There could be other contingencies.

Distribution:

Immediate Offset: Some courts take the position that this is the most equitable approach to use if the options can be valued. This is true even for options that have not been exercised. The optionee bears all risk relative to loss due to any cause. The optionee is awarded all the options and the non-employee spouse receives property of equal value.

Deferred Distribution: Because the possibility exists that the options might not be exercised most courts retain jurisdiction until they expire or are exercised to make a distribution between the parties.

SOURCE: Pension Appraisers