Understanding Equity Compensation During Divorce: A Comprehensive Guide

Equity compensation is a complex topic.  Equity can be an amazing benefit for employees, but the programs are complicated and those who receive it rarely understand exactly what they get and how.  In the context of divorce, it becomes even more complicated as the equity must be valued and divided.  But whether you receive equity compensation or your soon to be ex-spouse does, it can be a major source of wealth.  You will want to make sure you understand what it is and that you have the right professionals involved to help you divide it.

Understanding Equity Compensation

As a first step in understanding how equity compensation might be treated in a divorce, you need to understand the various types of equity compensation and what considerations might apply to you.  In order to understand what you are working with you will want to gather plan documents, award letters with vesting schedules, and account statements.  From these documents you will be able to see what kind of equity compensation has been granted, how it vests, and what has been exercised or cancelled to date.

Stock Options

A stock option represents the right to buy stock at a certain price at a future date.  They can come in the form of Non-qualified Stock Options (NQSO) or Incentive Stock Options (ISO).  These differ in how they are taxed at exercise (or sale).  Stock options typically have a vesting schedule, a strike price, and an expiration date.  Depending on the stock price when the options were granted and the current stock price, the option may be worth nothing (if stock price has fallen) or may represent significant value (if stock price has climbed).  Since the value of the options varies with the stock price, they can be difficult to value prior to exercise.  Tools like Black-Scholes models can be used to determine the value of the options during a divorce proceeding.

Restricted Stock Units (RSUs)

A restricted stock unit (RSU) is the right to a share of stock in the future.  These shares are transferred to the employee on the vesting date and are taxed at that time.  The employee is typically able to sell the shares after vesting with no additional holding period.  Employees that receive this type of award often receive different grants with different vesting schedules over time.  As such, there can be different values and restrictions on various shares.  When the RSUs are being divided, the total number of shares can be divided (along with their specific terms) or shares can be sold and then the proceeds divided.

Stock Appreciation Rights (SARs)

A stock appreciation right (SAR) gives the employee stock or cash in future.  There is generally no specific date, but the value will be tied to the company’s stock performance.  The goal here is to incentivize the employee to stay with the company and help drive up the stock price over time.  Given the undefined benefit of this kind of compensation, it may be something that requires division to be deferred into the future to the actual delivery date, even if that is years after the divorce.  In this case you will want to ensure that your divorce agreement addresses this and requires delivery of year-end paystubs in the future so that the appropriate calculations can be completed, and the assets divided.

Deferred Compensation and Supplemental Executive Retirement Plans

Another commonly used type of incentive compensation is called deferred compensation (or sometimes a Supplemental Executive Retirement Plan or SERP).  While this is not truly equity compensation, as it is paid in cash rather than shares, it carries many of the same characteristics as equity compensation.  This type of program is funded by the employer and may be distributed and taxed in full at termination.  This type of compensation is generally not transferable and lacks transparency.  The employer can restructure it at any time.  Given the difficulty in valuing and transferring deferred compensation, it can be easiest to offset the value with other marital property if available.

Vesting and Tax Implications

One of the reasons employers offer equity compensation is that it helps tie employees to the company.  The way they do this is through a vesting schedule.  Vesting is just another way to say ownership.  The company grants the employee the stock or compensation, but the employee doesn’t get the benefit immediately.  While a paycheck is received every few weeks, equity compensation can be structured to vest over years (typically anywhere from one to five).  If an employee leaves prior to vesting, then they forfeit the compensation, so they are incentivized to stay with the company until vesting.  This becomes important in divorce because you can’t just sell off unvested assets and split the proceeds.

Another key consideration is the tax treatment of the compensation. Some equity compensation is taxed when granted, while other types are taxed when exercised or sold.  Additionally, some types of equity compensation are taxed as ordinary income while others are taxed at the more favorable capital gains rates.  Those types taxed as ordinary income can also be subject to FICA taxes.  You will want to understand all of these nuances before dividing assets as the post-tax value can be very different than the face value.

Equitable Division of Equity Compensation

In addition to understanding the vesting schedule and tax treatment of the equity compensation, you also need to know whether you live in a community property or an equitable distribution state.  In community property states, the stated intent is to split property obtained during the marriage equally. In equitable distribution states, a court will divide marital property in a manner which it considers fair, but not necessarily equal, to each party.  These state specific rules will have a significant impact on how any equity compensation is divided.

The next step is valuing the equity compensation.  Again, the state you live in will have an impact here as there are different valuation dates defined by each state.  Some states will consider the value as of the date of separation while others look at the date the divorce is finalized (or projected to be finalized).  This step can also be complicated if the company granting the equity is not yet a public company and pricing is not readily available.  The valuation of the compensation is important so that you can divide it or so that you can determine what other marital assets you can offset it with if dividing it is not possible or practical.

Identifying and Characterizing Marital vs. Separate Property

Finally, you need to understand what portion of the equity compensation is marital property vs. separate property.  Only marital property is subject to division during a divorce.  Equity granted and vested prior to the marriage is likely separate property, but if it was granted and vested during the marriage it is marital property.  However, given the long vesting timeframes of many types of equity compensation, it is often the case that only a portion of the compensation is considered marital property.  In this case, something called the coverture fraction will be used to determine how much of the asset is considered marital property to be divided.

As you can see, there are a number of complexities with understanding, valuing and dividing equity compensation.  This is where a Certified Divorce Financial Analyst (CDFA) can help.  They understand the various types of equity compensation that can be at play, the related tax treatment, and the calculations to determine the marital portion.  If equity compensation represents a significant portion of your net worth, you would be well served to hire an expert in this area to help you avoid potential pitfalls.

Given the nature of equity compensation, including long vesting periods and uncertain or fluctuating values, you may want to consider creative solutions to divide property at the time of divorce rather than deferring division until vesting or delivery dates.  One way to do this is by offsetting the value of the equity compensation with other marital assets such as investments or real estate.  While you will be making decisions based only on the information you know now, and might give up future appreciation on the equity, you also avoid headaches and uncertainty down the road.

Equity compensation can be a great wealth builder for employees.  But it can complicate divorce.  If you are contemplating divorce, please research and understand any equity compensation you or your spouse may have.  Gather as much information about it as you can and ensure that you share it with your divorce team so they can appropriately advise you as you move forward.

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