Learn how to determine the value of a stock before you decide whether or not to purchase it or take advantage of your employers stock option incentive. Expert accountant explains how the stock system works and formulas used to predict its future.

Employee Stock Options and Divorce

As the stock market continues to rise, divorce attorneys are involved in more and more cases involving stock options. The grant of stock options to key employees is now common in high technology companies and is becoming popular in many other industries as part of an overall equity compensation strategy. Larger, publicly traded companies such as Pepsico, Starbucks, Travelers Group, Bank of America, Merck and the Gap now give stock options to almost all of their employees. Many non-high tech closely held companies are joining the ranks as well.

Traditionally, stock option plans have been used as a way for companies to reward top management and key employees and link (golden handcuff) their interests with those of the company and other shareholders. More and more companies, however, now consider all of their employees as key. As a result, there has been an increase in the popularity of broad-based stock option plans, particularly since the late 1980s. More than a third of large United States companies now have broad-based stock option plans covering all or a majority of their employees—more than double the rate that existed in 1993. In a 1997 survey of 1,100 public companies conducted by Share Data, Inc. and the American Electronics Association, it was found that 53% of respondents provide options to all employees. In companies having 500 to 999 employees, the study found that 51% offer options to all employees, as compared to 30% in Share Data’s 1994 survey and 31% in Share Datas 1991 survey. Forty-three percent of companies with 2,000 to 4,999 employees offer options to all, as compared to 10% in 1994. Forty-five percent of companies with 5,000 or more employees offer options to all, compared to 10% in 1994.

Since this trend shows no apparent sign of slowing down, matrimonial attorneys must be ready to address the unique issues that arise therefrom. This article will explain the basic nature of employee stock options, how they are valued, taxed and ultimately distributed incident to divorce.

What is an Employee Stock Option?

There is no question that stock options are assets subject to equitable distribution. However, simply to say that they are assets is not enough to guide the matrimonial litigator. We must first understand the basic nature and definition of a stock option. Basically, a stock option is the right to purchase a specified number of shares of stock for a specified price at specified times, usually granted to management and key employees. The price at which the option is provided is called the grant price and is usually the market price at the time the options are granted.

Generally, stock options are an incentive to stimulate the efforts of key employees and to strengthen the desire of employees to remain in the employment of the corporation. Such incentives do not apply to retired employees. Stock option plans can be a flexible way for companies to share ownership with employees, reward them for performance, and attract and retain a motivated staff. For growth-oriented smaller companies, options are a great way to preserve cash while allowing employees a piece of future growth. They also make sense for public firms whose benefit plans are well established, but who want to include employees in ownership. (Note: By issuing stock options, a company potentially dilutes the value of existing shares.)

Whether a stock option is granted for money, for past services, as an incentive for future services, or for no consideration at all, an option holder must exercise the option within its terms or he is subject to the loss of his/her right to do so. In an option contract time is of the essence. Generally, expiration provisions and stock option agreements are strictly enforced. The courts reject the inevitable breach of contract and forfeiture claims that employees, former employees and other stock option holders press when they fail to timely exercise their options. Although this rarely becomes an issue in divorce litigation, it is something to keep in mind in order to avoid severe economic loss to either party or a potential malpractice claim.

Are there different kinds of stock options, and how are they taxed?

Generally, stock options come in two basic categories: (1) incentive stock options (commonly referred to as ISOs) which are qualified or statutory options and (2) non-qualified stock options (which are commonly referred to as NQSOs). Simply put, the difference between an ISO and a NQSO turns on its compliance with specific Internal Revenue Code requirements at the time of grant which ultimately effects how the option is taxed.

Incentive stock options are granted to individuals for reasons connected to their employment. As a result they may only be granted to employees. They must also be approved by the shareholders of the corporation and granted at fair market value.

NQSOs, on the other hand, may be granted to both employees and independent contractors, and their beneficiaries.

An employee will not realize any taxable income upon the grant or exercise of an ISO. Concomitantly the corporation is not entitled to a deduction upon the exercise of the option. If the employee sells the stock within two years after the option is granted and within one year after the option is exercised, ordinary income will be realized in an amount equal to the lesser of 1) the excess of the fair market value of the shares at the date of exercise over the option price, or 2) the excess of the amount realized on the disposition over the option price. If the individual holds the shares for two years after the grant of the ISO and one year after exercise of the ISO, the difference between the sale price and the option price will be taxed as a capital gain or a loss. If the stock is sold after the two-year/one-year period, that gain will also be an alternative minimum tax preference item subject to the26/28 percent tax rate.

Regarding a NQSO, the holder employee of a non-statutory option must recognize income at the time the option is granted if the option has a readily ascertainable fair market value at the time of grant. If the option is not transferable and does not have a readily ascertainable fair market value, no income will result to the individual upon the granting of the option. When the non-qualified stock option is exercised, the individual is taxed at ordinary income rates on the difference between the fair market value of the stock and the exercise price of the option. When the individual sells the stock, a capital gain or loss will be incurred on the difference between the amount received for the stock and its tax basis. Typically the tax basis is equal to the fair market value at the time of the exercise of the option. The capital gain would be either long term or short term depending on the length of the time the shares were held after exercise.

If the option is actively traded on an established market the code considers the option to have a readily ascertainable fair market value. If there is no readily ascertainable fair market value at the time of the grant, the optionee recognizes income at the time of the option either: (1) becoming substantially vested or (2) is no longer subject to a substantial risk of forfeiture. Any profit is a short term capital gain, taxable at ordinary income rates. The code establishes four conditions necessary for an option that is not actively traded on an established market to meet the readily ascertainable fair market value standard: (1) the option is transferable by the optionee (2) the option is exercisable immediately in full when granted (3) there can be no condition or restriction on the option that would have a significant effect on its fair market value, and (4) the market value of the option privilege is readily ascertainable. All four conditions must be met. Since these conditions are seldom satisfied, most non-qualified, non-statutory stock options not traded on an established market, do not have a readily ascertainable value.

There is another factor to consider that can apply to both incentive and non-qualified stock options. Some companies are offering options with a reload feature. A reload option provides for automatic grants of additional options whenever an employee exercises previously granted options.

If the stock that is received upon the exercise of the option is restricted property, the taxation is deferred until the restrictions lapse. Frequently employees receive restricted stock for services. The stock is not freely transferable and is subject to a risk of forfeiture based on the individuals performance or continued employment for a period of time. Pursuant to Internal Revenue Code Section 83(b), an individual can elect to recognize the fair market value of the shares, ignoring the restrictions, as income at the time of the award; if a Section 83(b) election is made, the holding period for capital gains purposes commences at the time of the election, otherwise the holding period begins to run at the conclusion of the restriction.

Based upon the foregoing, it may be appropriate to tax effect executive stock options for purposes of equitable distribution. This is because executive stock options have a fixed expiration date and therefore must be exercised and sold. The resulting tax is inevitable and therefore should be considered.

How are Stock Options Valued?

There are various methods to arrive at a present value for stock options. The two most popular are the intrinsic value and the Black-Scholes method. In 1995 the accounting profession formally recognized that executive stock options have value beyond their intrinsic value. In addition, the Black-Scholes Option Pricing Model was recognized as an appropriate method to calculate the value of executive stock options by the accounting profession. Interestingly, the Financial Accounting Standards Board (FASB) specifically stated that, an employee’s stock option has value when it is granted regardless of whether, ultimately (a) the employee exercises the option and purchases stock worth more than the employee pays for it or (b) if the option expires worthless at the end of the option period.

In the intrinsic value method, the value of the stock option is equal to the difference between the option exercise price and the fair market value of the stock. For example, if you had an option to purchase stock x for $5, and the stock was currently trading for $27 per share, the intrinsic value of the option would be $22 ($27 — $5 = $22). However, the intrinsic value method does not consider the value to the holder of having the right to buy the stock at some point into the future at a predetermined price. It also does not consider the volatility of the underlying stock as well as the incumbent advantages and disadvantages of same. Moreover, it does not consider the advantages and disadvantages of the option holder not receiving the stock’s dividends as well as the opportunity cost of purchasing the stock and forgoing the lost interest on the acquisition funds.

Black-Scholes

One method that considers the above-referenced items is the Black-Scholes Method. You can see the Black-Scholes formula by clicking here.

The explanations of the letter designations for the other variables in the Black-Scholes formula are:

• C = SN (ln(S/K)
• C = theoretical call premium
• N = cumulative standard normal distribution
• e = exponential function
• log = natural logarithm

The first part of the calculation determines the expected benefit of purchasing the stock outright. The second part of the calculation determines the present value benefit of paying the exercise price in the future. The difference is the fair market value of the option.

However, an underlying problem with the Black-Scholes Method is that it makes assumptions concerning the volatility of the stock, future dividend rates, and lost interest. A change in these underlying assumptions can affect the value of the option calculated pursuant to this method.

The following table provides a summary of how a change in one of these assumptions will affect the value of the stock options calculated under the Black-Scholes Method.