Executive Compensation and Divorce

When one or both spouses are highly-compensated business professionals, dealing with executive compensation in divorce proceedings presents a significant challenge for lawyers. The landscape of how top executives are paid is constantly evolving. Often, a substantial portion of earnings is delivered through packages that include both qualified and non-qualified plans. These compensation structures raise critical issues in identifying, valuing, and dividing the marital estate, and raises the contentious “double-dipping” debate, where certain benefits may be treated as both property to be divided and as income for support purposes.

Qualified vs. Non-Qualified Executive Compensation

Executive compensation plans are broadly categorized as either qualified or non-qualified, with the distinction primarily revolving around their treatment under the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA).

Qualified Plans, such as 401(k)s, must adhere to strict federal regulations, including non-discrimination rules that prevent them from favoring highly compensated employees. These plans offer tax advantages to the corporation.

Non-Qualified Plans, often referred to as “Top-Hat plans,” are not bound by the same IRC and ERISA constraints. This allows companies to provide substantial, discriminatory benefits to a select group of key executives. These plans are utilized to attract and retain senior management, supplement pension benefits, enhance early retirement packages, and serve as an incentive in closely held corporations. Common forms of non-qualified compensation include:

• Deferred Compensation: An agreement to delay an employee’s compensation to a future date, with the goal of deferring taxation.
• Stock Appreciation Rights (SARs): A contractual right to receive the appreciation in the value of the company’s stock over a set period, payable in cash or stock.
• Phantom Stock: A contractual agreement granting “units” equivalent to company stock, which provides a cash payment tied to the stock’s market value at a future time without the actual issuance of shares.
• Restricted Stock: Shares of stock awarded to an employee that are subject to vesting conditions, typically based on continued service or performance objectives.
• Incentive Stock Options (ISOs): IRS-qualified options to purchase stock at a specified price. They are not taxed at grant or exercise, with appreciation taxed at capital gains rates upon the sale of the acquired stock.
• Non-Qualified Stock Options (NQSOs): Options that do not meet ISO requirements. While not taxed at the grant, the appreciation is taxed as ordinary income upon exercise.

In recent decades, the composition of executive pay has shifted dramatically. In 1985, base salary constituted about 60% of an executive’s total compensation, but by 2000, it had fallen to just 20%, with incentive-based payments, particularly stock awards, making up the vast majority of compensation.

Issues in Assessment and Division During Divorce

The division of executive compensation in a divorce is a three-step process: identifying assets acquired during the marriage, valuing those assets, and then equitably distributing them. The central challenge is determining which of these compensation elements constitute marital property and how to value and divide them equitably.

Identification and Discovery

For publicly traded companies, information about executive pay can be found in public SEC filings such as the annual proxy statement, Form 10-K, and registration statements. Proxy statements are useful, as they must disclose the compensation for the CEO, CFO, and the next three most highly compensated executives. For privately held companies, which are not subject to the same disclosure requirements, a well-drafted subpoena to the corporation can be an effective method for obtaining detailed compensation information. Relying solely on the executive spouse’s disclosure can be risky, making verification through a subpoena a crucial act of due diligence in the discovery process.

A primary issue is determining whether compensation, especially unvested stock options, constitutes marital property. While assets that are fully vested (meaning the executive has an unconditional right to them) are generally considered marital property, the treatment of unvested assets is a major point of contention and varies across jurisdictions. Courts grapple with whether these options were granted for past services performed during the marriage or as an incentive for future services to be rendered post-divorce. Some jurisdictions, like Indiana and North Carolina, have historically ruled that unvested options contingent on future employment are not marital property. However, other states consider unvested stock options granted during the marriage to be marital assets subject to division.

Valuation

Valuing stock options is a complex and often contentious task. The “intrinsic value” method, which simply subtracts the exercise price from the market price, is considered too simplistic as it fails to account for factors like time to expiration, volatility, and tax implications.

A more sophisticated approach is the Black-Scholes Option Pricing Model, for which its creators won a Nobel Prize. This model incorporates multiple variables, including the exercise price, market price, expiration date, stock volatility, interest rates, and dividends. Some argue that the Black-Scholes model to be inappropriate for valuing unvested, non-transferable employee stock options in a marital context due to its complexity and potential inaccuracies.

Another approach is to look at the marketplace itself, as publicly traded options have established values that often exceed their intrinsic value, reflecting their opportunity value. Discounts may be applied for insider trading restrictions or non-transferability.

Division and Tax Implications

Once valued, the assets must be divided. Given the transfer restrictions on most executive compensation plans, an “in-kind” division is often not possible. One solution is a constructive trust, where the employee spouse retains legal title to the unvested assets for the benefit of the non-employee spouse, exercising the options at their direction and distributing the after-tax proceeds.

The tax implications of these transfers are critical. Under IRC § 1041 and Revenue Ruling 2002-22, the transfer of vested options in a divorce is generally a non-taxable event, with the transferee spouse being responsible for taxes upon exercise. However, the treatment of unvested rights is less clear. There is conflicting guidance on whether the transferor or transferee spouse is liable for the tax when unvested benefits later become taxable. To mitigate risk, settlement agreements should include indemnification clauses and may stipulate an assumed tax rate for calculating post-tax proceeds.

The “Double-Dipping” Dilemma

A significant point of contention is whether certain forms of compensation, particularly stock options, can be treated as both a divisible marital asset and as income for calculating alimony and child support. This practice is often referred to as “double-dipping.”

Stock options and other incentive-based pay are increasingly viewed not just as assets to be accumulated, but as a core component of an executive’s regular income. Given that base salaries now make up a smaller portion of total pay, many families rely on the proceeds from stock options to maintain their standard of living.

This reality challenges the traditional view of these benefits as solely property. Courts have held that unexercised stock options could be included in a payor’s income for child support calculations, especially when they are a recurring and significant part of the compensation package. Stock options have been distinguished from pension benefits, noting they could be considered part of current or future compensation.

The determination of whether to treat these benefits as an asset, income, or both often depends on the specific facts of the case, particularly the family’s historical financial practices. If the family regularly used the proceeds from stock options for ordinary living expenses, a strong argument can be made to consider them as income for support purposes. Conversely, if the proceeds were consistently saved and invested, they are more akin to a divisible asset.

Courts avoid rigid “bright line” rules and instead employ a flexible, equitable approach tailored to the unique circumstances of each case. The ever-evolving nature of executive compensation demands that legal practitioners remain educated on developments in the field of compensation, thorough in discovery, and creative in strategies regarding the dual nature of these valuable and complex benefits.

The Value of Experienced, Educated Legal Counsel

When executive compensation is an issue in a divorce, specialized knowledge is required. It is essential to engage an experienced divorce trial lawyer. Aaron Bundy is educated on the topics and has taught other lawyers and non-lawyer financial professionals about these issues. He is board-certified for family law trials by the National Board of Trial Advocacy and a fellow of the American Academy of Matrimonial Lawyers. Aaron completed advanced training including the Advanced Business Valuation program at the National Family Law Trial Institute and a year-long Certified Financial Planner certificate program at Southern Methodist University. He has extensive experience dealing with complicated executive compensation issues in negotiations, at trial, and on appeal. Few attorneys bring this depth of expertise. Aaron Bundy can effectively protect your interests and ensure that valuable compensation assets are fairly divided.