§ 7.11 Employee Stock Options

• Jurisdiction: United States
• Publication year: 2021

§ 7.11 Employee Stock Options⁷⁹¹

[1]—The Nature of Employee Stock Options

Employee stock options sometimes are given by an employer to an employee as part of the employee's compensation. A stock option is a right to purchase the employer's stock from the employer for a specified price. For qualified stock options, the specified price is the market price of the stock at the time the option is granted. An option can be exercised during a specified term (normally beginning years after the date of grant). If the market price of the employer's stock increases after the date of issuance of the option, the option to purchase shares at the lower specified price becomes valuable. If the stock price goes down after the grant, the employee would not exercise the option and would therefore not lose any money as a result of the decreased stock price. If the employee desires to exercise the option to purchase the employer's shares, the employee notifies the employer and pays the price specified in the option.

Employee stock options usually are not transferable and are not immediately exercisable. There normally is a specified waiting period of significant duration before the options can be exercised. After this waiting period expires, the options become exercisable for the remainder of the option term, but only if the employee is still working for the employer at the time the options are exercised. The waiting period and continued employment requirements are incorporated to encourage the employee to continue working for the employer. The option is a contingent right that only becomes valuable if the employee renders services for a certain period after the option is granted.

Nonqualified options can have different characteristics. For example, they can be made immediately exercisable. However, the stock purchased could still be subject to divestment for a certain period if the employee quit or was fired.⁷⁹²

If the option is a nonqualified option, the employee will incur income tax liability when the option is exercised. The amount taxable is the difference between the option purchase price and the market price of the stock on the date the option is exercised. No tax is due upon exercise of a qualified stock option. The employee's basis in the stock is the option price, and capital gains tax is payable when the stock is sold.

[2]—Employee Stock Options as Property

A few courts have held that options that are unexercisable at divorce are not divisible property; these courts perceived these rights as an expectation contingent on continued service.⁷⁹³ (This view would be more persuasive in states where property rights need to be "vested" at divorce to be divisible.) Most courts have determined that unexercisable stock options are property.⁷⁹⁴ Even though the options are subject to various contingencies, they could become valuable rights, and the courts usually cite cases involving pension rights to support this view.⁷⁹⁵

Stock purchased with stock options normally should not be difficult to characterize if the spouse was married when she received the options, and all options had been exercised with marital funds before divorce. The stock should be 100% marital property (if the stock when purchased is not subject to divestment), as long as the options were not intended to reward services rendered before marriage.⁷⁹⁶ (If separate funds were used to buy the stock, presumably the stock would be part separate and part marital, based on the ratio between the stock price and the market price on the date of purchase.⁷⁹⁷ The marital estate's contribution would be the discount provided by the option, and the separate estate's contribution would be the cash advanced toward the purchase price.) Similarly, if the spouse received the options and exercised them before marriage, and purchased the stock with separate funds, in a marital property state the stock should be 100% separate.⁷⁹⁸ Options received after divorce should be nonmarital, unless they were intended to reward efforts during marriage.⁷⁹⁹ However, life rarely is so convenient. Many divorce cases involve situations where the employee has received the options during marriage but has not yet exercised them. This presents a more complex characterization problem.

[3]—When Employee Stock Options Are Considered Acquired or Earned⁸⁰⁰

[a]—Options That Are Unexercisable at Divorce

In marital property states,⁸⁰¹ a divorce court can only divide property "acquired" by either spouse during marriage. Indeed, even in "kitchen sink" states (sometimes referred to as "hotchpot" states), where all of the spouses' property may be divided at divorce, post-divorce acquisitions may not be divided.⁸⁰² Divorce cases involving stock options present an interesting question of determining what is "earned" after divorce. An employee is granted the option at a particular time. Some courts treat the option as fully acquired on the date of grant.⁸⁰³ In these cases, the options granted during marriage were treated totally as marital property, even though the divorce occurred before the options became exercisable.⁸⁰⁴ This assumes that the options are "earned" solely from services rendered at the time of grant. However, the structure of employee stock options strongly suggests that options are earned not at any one moment, but over time. The options are exercisable only if the employee is still employed at the end of the waiting period, and are therefore intended to induce the employee to work for the employer during the waiting period. In divorces involving a spouse holding unexercisable options, most courts have recognized that the options are partly separate and partly marital property.

While evaluating an option granted during marriage that is not exercisable at the time of divorce, many courts will inquire whether the option was intended to reward only efforts rendered by the employee before the option grant. If the court concludes some or all of the options were solely intended to compensate efforts before the grant, those options will be considered 100% marital property.⁸⁰⁵ In making this determination, the Vermont Supreme Court has suggested that courts should consider a number of factors, such as: (i) whether these options were intended to induce the spouse to accept employment, (ii) to induce the spouse to keep working for the employer, or (iii) to reward the spouse for completing a project.⁸⁰⁶

To the extent that options are perceived to compensate an employee for services from the date of grant until the date of exercise, options not yet exercisable at divorce are in many states considered partly divisible and partly non-divisible post-divorce compensation.

In a New Jersey case, the husband received stock options three days before the divorce petition was filed. The court considered these options 100% the separate property of the husband. The court emphasized that the options were given to the husband to induce him to accept a new job.⁸⁰⁷

However, in many instances, if a spouse receives an option during marriage that is not exercisable at divorce, the option will be considered compensation for the period between the grant date and the exercise date.

For example, in an Oregon case the trial court commented that the purpose of stock options generally is "to retain an employee and encourage outstanding performance in the future."⁸⁰⁸ Similarly, a New Jersey court found that the structure of the options was "a means to insure the husband's continued employment with the company."⁸⁰⁹ However, the Colorado Supreme Court stated that "there is a distinction between conditioning the receipt of benefits on the employee remaining in the employ of the employer and providing benefits in consideration of the performance of future services."⁸¹⁰

In a Maryland case, the husband was granted 5,000 options during the marriage.⁸¹¹ At divorce, 2,500 were currently exercisable. The appellate court endorsed an "if, as and when" deferred distribution of the option "profit" if the husband exercised the options. The exact procedure suggested, however, is not clear. Does the "profit" at exercise mean the difference between the market price of the stock on the exercise date and the option price, or should future tax liability and any borrowing costs be considered?

The court also made this statement: "[T]he court must attach a value to options as of the date of divorce. That value may be determined by taking into consideration the market value of shares of the stock as of the time of the decree, and the cost to the [husband] of exercising options."⁸¹² Under this view, presumably the non-employee spouse cannot share in any stock appreciation after the divorce. The court referred to computing a "value" of the options as of the date of divorce. It is unclear whether a present value computation⁸¹³ is contemplated here. If this is true, should the value be discounted for all contingencies⁸¹⁴ affecting the ability to exercise the options, such as the possibility that the employee will quit or be fired before the waiting period ends? In addition, because the option "profit" will be realized in the future, it is unclear whether the option value should be discounted for this reason.

When computing this value of a stock option of a company that has publicly traded options, one could consult the market price. However, employee stock options are not transferable, so the value of transferable options may not be the same as employee stock options.

One court has pointed out that an option can have value even if the strike price is higher than the current market price.⁸¹⁵

When valuing options, most courts look to the difference between the market price of the underlying stock and the option price.⁸¹⁶ Some other courts have approved the use of the Black/Sholes method of valuing unexercised options.⁸¹⁷ A Connecticut case discusses another way to determine the value of an option that is not yet exercisable. This approach starts with the...