Back in the day, stock options as a form of compensation was all the rage.  Many executives were compensated through the stock option. One could go to work for a small “start up” company with a relatively low salary but enjoy the possible fruits of the stock option package.  In fact,  many of Microsoft executives were compensated in this manner.  Unfortunately,  with the stock market crashes of 2000 and again in 2008, stock options are no longer the golden brick they used to be.  One client said, “tell them to keep the stock options, give me the cash.”  Be that as that may, stock options continue to be a form of executive and managerial compensation.

Stock options are granted to an employee as a form of compensation and as an incentive to continue working for the company.  The option has a strike price which is the value of the option at the time it was granted.  The strike price may well be under the market price.  If the employee exercises his options the employee’s profits are the difference between the market price and the strike price.  Hopefully, this is a positive number.  Stock options are taxed at the capital gains rate as opposed to the ordinary income rate. Stock options also usually come with a “vesting period.”  That is, the employee must continue to work for the company for a period of time before the stock option vests.  That is, the employee has the right to exercise the option only after a period of time – one, two or three years.

Stock options as part and parcel of a property division should usually be divided by “like kind.”  Take for example, wife has stock options which are worth $50,000.00.  Instead of drafting a “stock option trust” to manage the stocks after the divorce, more about that below, the Husband should take $50,000.00 from some other asset for his side of the column.  In that manner, neither Husband or Wife have to continue to rely on each other in the post divorce context at least as applied to the stock options.

Basically, there are two types of stock options:

  1. statutory (or qualified); and
  2. non-statutory (or non-qualified).

Statutory stock options qualify for tax treatment under IRC §422 or §423, which address stock options acquired through employee incentive or stock purchase plans. Non-statutory stock options are acquired in any other way.

Generally speaking, when statutory stock options are exercised, the profits are taxed as capital gains, which is currently at a rate of only 15%. When a non-statutory stock option is exercised, the profits are taxed as ordinary income, which is often at much higher rates.

If a statutory stock option is transferred from one spouse to the other in a divorce (note: many companies will not allow this in the first place), it will lose its statutory classification.  When the transferee or receiving spouse exercises the option, the gains are taxed as ordinary income which is taxed at a much higher rate than current capital gains taxes.  The solution to this problem, is to create a “stock option trust” wherein the options are placed in a trust which is managed by the employee spouse for the benefit of the other spouse.  The managing spouse, or trustee, technically still owns the option which maintains their statutory qualification. The managing spouse as a result of their position as a “trustee” of the stock option trust owes fiduciary duties to the nonemployee spouse.  Thus, if the stock option trustee breaches their fiduciary duty to the beneficiary a cause of action will lie for that breach.  This is the only redeeming factor associated with the stock option trust.

Under the stock option trust, when the stocks are sold the profits from the sale are taxed as capital gains as opposed to regular income. The profits are then distributed by the trustee to the beneficiary – the nonemployee spouse.

The laws and rules governing stock options are in flux and continue to change. WE DO NOT OFFER TAX ADVICE.  The above summary is just that. Thus, any party to a divorce contemplating the transfer of stock options would be well advised to seek the advice of a knowledgeable accountant or tax professional.