Should Unexercised Stock Options Be Considered Gross Income Under State Law for Purposes of Calculating Monthly Child Support Payments?

• Publication year: 1998

33 Creighton L. Rev. 235. SHOULD UNEXERCISED STOCK OPTIONS BE CONSIDERED GROSS INCOME UNDER STATE LAW FOR PURPOSES OF CALCULATING MONTHLY CHILD SUPPORT PAYMENTS?

Creighton Law Review

Vol. 33

JACK E. KARNS(fn*) JERRY G. HUNT(fn**)

I. INTRODUCTION

With about half of all marriages ending in divorce, one issue of paramount concern is that of stock options and how they should be handled with regard to their valuation relative to calculation of monthly child support obligations under state law. This Article is based on a particular case emanating from the State of Ohio, Murray v. Murray,(fn1) in which the husband and wife were divorced in 1994, and entered into a separation agreement which was incorporated into the final decree in the same year.(fn2) During this process, Mrs. Murray was awarded custody of the couple's only child and the marital property was divided according to state law.(fn3) Most importantly, this included unexercised stock options that Mr. Murray had received up to that time as an executive of his employer, Proctor and Gamble Company.(fn4) The trial court calculated Mr. Murray's child support obligation relative to a salary of approximately $212,000, which was based on true salary and average bonuses, but did not consider unexercised stock options that existed at that time and which had been divided as marital property assets in the property settlement.(fn5)

This Article briefly reviews the factual background of the Murray case, the issue of stock options as gross income relative to realized income, and then will look at the unexercised stock option as a gross income expectancy, thereby rendering it a property asset versus an income asset. The latter point would subject the property item to capital gains tax and not gross income tax. Finally, in Part Four the rationale of the Murray court will be dissected one assignment of error at a time, and the authors will set forth arguments premised with appropriate legal, financial, and economic theory supporting the argument that the result in Murray is not only wrong, it violates principles that linchpin the aforementioned theories and calls into question the equities of state income tax policy. A final concern is that this case will serve to bolster other state appellate courts to reach similar conclusions based on comparable facts with rationales similarly grounded in unsubstantiated fact and theory.

II. THE MURRAY CASE - FACTUAL BACKGROUND

The Murray's were divorced in 1994 and entered into a separation agreement that became a final decree on May 16, 1994.(fn6) Mrs. Murray received custody of the couple's son, and Mr. Murray was required to pay child support in the amount of $1,810.00 per month.(fn7) At that time, marital property was divided between the parties and, because Mr. Murray was an executive employee of Proctor and Gamble Company, this included unexercised stock options which he held. His child support obligation in 1994 was calculated using a salary of $212,702.00, and the unexercised stock options were not part of this computation. The court ruled that the options were part of the property asset division.(fn8)

Mr. Murray's income at Proctor and Gamble increased substantially, causing his former wife to file a motion for modification of child support in 1997.(fn9) In the request for modification of support, Mrs. Murray asserted that there had been a significant increase in Mr. Murray's income, and although he stipulated as to the components which constituted his increased salary, he did not include the unexercised stock options he had received since the divorce.(fn10) A counteroffer by Mr. Murray was rejected and a hearing was held before a magistrate judge as to whether the unexercised stock options should be included as "gross income" as the term is defined by Ohio domestic law.(fn11)

On May 18, 1998, the magistrate ruled that the unexercised options were imputed to Mr. Murray as income and, therefore, should be included within the term "gross income" based the appropriate Ohio statute.(fn12) As a result, Mr. Murray's child support payments were increased to $7,494.10 per month. Mr. Murray's appeal of the magistrate's decision which overruled, but his motion to reconsider the calculation of the value of the options was granted.(fn13) The trial court held that the options had been incorrectly valued and changed Mr. Murray's monthly child support obligation to approximately $6,800.00 per month.(fn14) On July 23, 1998, Mr. Murray filed a petition alleging three assignments of error, and the court below held that the unexercised options at the time of divorce had to be considered as "gross income from any source." Therefore, Mr. Murray's monthly child support payment increased substantially.(fn15) Mr. Murray filed an appeal which contained three assignments of error.(fn16)

The first assignment of error addressed the issue of whether the unexercised Procter and Gamble stock options constituted "potential cash flow," and whether they should be included in the gross income definition as defined in Ohio Revised Code section 3113.215(A)(2).(fn17) Mrs. Murray countered this argument, claiming that the stock options were deferred compensation, representing a source of "potential cash flow" and could not be marital property assets.(fn18) The key here regards the handling of the tax consequences of the issue involved. Mrs. Murray's position was premised on the notion that she should receive all of the tax benefit that accrued with an unexercised stock option, while the recipient of the stock option was to be stripped of the opportunity to exercise that option when he or she sees fit, or when it is most advantageous, financially and economically, to do so.

Simply stated, following Mrs. Murray's line of argument, the exercising of the options would be a taxable event to Mr. Murray, and the payment of child support would be a nontaxable event to Mrs. Murray because she would not have to claim the child support payment as gross income under either federal law or Ohio state law, and Mr. Murray would not be permitted to claim the child support payment as a deduction on his federal and state tax returns. The text of this Article will argue that Mrs. Murray's position is fundamentally incorrect and inequitable, and goes against public policy of income tax law and policy as set forth in both case law and in the Internal Revenue Code ("I.R.C.") Finally, this note will contend that just because the Ohio state legislature uses the term "gross income from any source" does not automatically mean that state courts are required to include unexercised stock options within that meaning. On something of a lesser, but very important, level the American taxpayer complies with our voluntary system of paying federal and state income taxes simply because he or she believes that the policy is fair and equitable. The Murray case is not in accord with this national policy and serves as a dangerous precedent undermining our voluntary tax compliance system.

In assignment of error number two, Mr. Murray argued that the trial court erred as to the application of the Ohio Revised Code section 3113.215(B)(2)(b) relative to calculating his child support obligation because the needs and the standard of living of the child and the par-ents' were not properly taken into consideration.(fn19) The most interesting issue to be noted at this point is that the court took a very "strict constructionist" approach as opposed to a "plain meaning" view of the child support guidelines and stated that "because the terms of the child support statute are specific and mandatory, the trial court must follow the statute precisely, and failure to do so will constitute reversible error."(fn20) What makes this particular conclusion interesting - relative to the options issue at conflict in the Murray case - is that the court did not see fit to exercise more than a plain meaning view of "gross income from any source" when evaluating assignment of error number one.

In other words, why were the unexercised options that accrued subsequent to the divorce, and apparently not handled in a court petition, or in the original marital property asset agreement agreed to by Mrs. Murray at the time that property and income issues were resolved, being resolved now? This is not a simple question that can be brushed off lightly and will be discussed below. That is to say, when the latter unexercised options became available, why were they not "marital property" versus "gross income from any source?" The current judicial stand gives Mrs. Murray all the tax advantages: Mr. Murray is taxed on the capital gain of the option on the exercise date; he receives no deduction for the payment of child support; and Mrs. Murray is not required to include that payment in her income. If she were to receive the unexercised option as additional marital property, then she would face the tax consequence of having to pay the capital gains tax on the date of exercise. The question of whether Mr. Murray should be liable for additional child support payments in years that he decides to exercise the stock options is a separate question from the one that is presented by Mrs. Murray in the petition at hand, and certainly a different issue from the one that the court decided in this particular case.(fn21) One final hypothetical question is whether legal counsel thoroughly reviewed the options...