Before you negotiate a strategy for dividing executive compensation, you should have a solid understanding of it and the process involved.
In our recent webinar, Thomas T. Field of the Illinois law firm Beermann LLP and AACFL Advisory Faculty Member Jim Godbout, Principal at CliftonLarsonAllen discussed executive compensation. They went over the following forms of payment and how to divide them in divorce proceedings using innovative strategies:
- Deferred Compensation (Section 409A)
- Stock Options (Incentive and Non-Qualified)
- Restricted Stock Awards (RSAs)
- Restricted Stock Units (RSUs)
- Stock Appreciation Rights (SARs)
- Phantom Stock
- Stock Warrants
Besides defining each type, Mr. Godbout and Mr. Field went into the legal rights each employee has regarding them and the tax implications involved, together with formulas for division. They also included examples to illustrate their points.
The hosts have extensive experience with complex financial matters. Thomas T. Field heads Beermann’s Family Law Practice Group. His experience includes resolution of post-dissolution conflicts and analyzing complex financial matters such as executive compensation, closely-held businesses, and real estate holdings. Jim Godbout specializes in business valuation, dispute advisory, and financial consulting. He offers financial consulting and forensic accounting services for divorce, shareholder disputes, Employee Stock Ownership Plans, and other tax, corporate, and law-related matters. He has testified in federal and state courts and at American Arbitration Association proceedings.
Getting Started With Executive Compensation
Among the first things you should look at when you determine how to separate any form of executive compensation are the documents for the plan; you may also talk to the plan administrator. You should find out:
- the type of compensation
- the reason for it
- the vesting period and schedule
- transferability (upon the employee’s departure, retirement, or a company buy-out)
- any unique provisions
An understanding of the compensation requirements under the plan will help you determine how to handle the asset division.
The Different Types of Executive Compensation
Deferred compensation hasn’t been taxed before and is payable per the compensation plan in a later year at a specified time or under a fixed schedule.
The employee has the legally binding right to earn and vest it during a taxable year. Outside of the plan requirements for vesting, the payout of the deferred compensation will occur upon:
- separation from service
- an unforeseen emergency
- a change in the ownership or control of the company or the ownership of a major part of the company’s assets
Deferred compensation may or may not meet IRS Section 409A requirements. Employers must comply with IRS standards when they report deferred compensation on employee W2 or 1099-MISC forms. If it shows up on a W-2 or 1099-MISC form in the year it’s granted (not received), it’s not actual income. The tax year the employee elects to defer the income affects the taxation.
If it’s classified as non-qualified, the compensation is currently taxed if it’s not subject to a “substantial risk of forfeiture.” If an employee’s deferred compensation is tied to future work performance, the company’s existence, or the employee’s tenure, it’s subject to a substantial risk of forfeiture.
Stock options and restricted stock awards (RSAs) are among the more common types of executive compensation.
With employee stock options, the employer gives the employee the right to buy a limited amount of shares of employer stock at a certain price for a specified time. The vesting schedule is often three to five years. Options are a favorable form of executive compensation for employers because there’s no cash outlay on their part and the company receives a deduction equal to the income the employee recognizes upon exercise.
A stock option is valuable if it rises above the grant or strike price. The employee can exercise and hold the stock or exercise and sell the stock – all in the same transaction.
In terms of taxation, incentive stock options and non-qualified stock options are taxed differently, whether as ordinary income or as a capital gain.
Unlike stock options, with restricted stock awards (RSAs), employees receive the actual shares rather than the option to buy them.
They vest or become available only after a certain amount of time has passed; taxation occurs on the vesting date. They let employees experience the benefits of stock ownership, including voting and dividend rights, and connect employers’ interests with the employee’s. Restricted stock with and without an 83(b) election requires a different treatment for taxation. It’s taxed as ordinary income when “stock ownership is no longer subject to a substantial risk of forfeiture” under IRS Section 83.
Restricted stock units (RSUs) are similar to restricted stock awards. One major difference is in the timing of their exercise. With RSUs, employees may choose to defer payment until they make an election that doesn’t follow a vesting schedule. This is often when they leave their jobs. Unlike RSAs, if that happens, the employee doesn’t get any actual shares. “Anything that’s unvested is simply forfeited,” said Mr. Godbout.
RSUs aren’t taxed upon vesting, but as ordinary income when the employee actually receives them. Most employers sell enough shares to cover withholding taxes and release the net shares. They include the gross amount in the W-2 income.
Mr. Field and Mr. Godbout described the different ways to handle vested and unvested RSAs and RSUs. They also went on to discuss some of the lesser known types of executive compensation, stock appreciation rights, phantom stock, and stock warrants.
Determining the Marital or Community Property Shares
Most states follow equitable distribution or community property laws. For executive compensation, you should use the usual tax treatment in your state and your state’s case law.
In mediation or collaboration, the parties can agree to custom division. As Mr. Field pointed out, “Creating a custom agreement in the ADR [Alternative Dispute Resolution] world gives you certainty of result.” He said he prefers this method because when judges have latitude to make decisions on the division and allocation of these types of assets, you don’t necessarily know what each party will get.
The issue of dividing compensation at the date of marriage or the date of grant is another factor. It depends on whether the company granted the compensation before or after the marriage. Most states count any options granted and vested during marriage as marital property.
Unvested shares or those granted before marriage are usually divided by a time rule. Popular time rule coverture fraction formulas include HUG and Nelson.
Mr. Godbout and Mr. Field also detailed how to use the HUG formula and determine the coverture fraction for open valuation and allocation, how to divide and distribute options, and what to consider when dividing them.
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