By: Sheryl J. Seiden, Esq.[1]
In determining how to equitably distribute executive compensation, first, the type of executive compensation must be identified. Then, it must be determined whether the executive compensation was awarded for the party's past efforts or in anticipation of the party's future efforts. Executive compensation awarded prior to the termination of the marriage will be subject to equitable distribution whereas executive compensation awarded after the termination of the marriage will not be subject to equitable distribution. As executive compensation is often awarded for both past efforts and in anticipation of future services, a portion, but not all, of executive compensation is often part of the marital estate for purposes of equitable distribution.
What Are Stock Options?
Stock options ("SOs") are rights to purchase shares of stock for a certain price in the future. The rights are granted to an employee in conjunction with his or her employment. If the stock is trading at a higher price than the grant price of the stock options than the stock options have value but if the stock is trading at a lower price than the grant price, then the stock options have no value at that time and are referred to as "underwater." It is important to note that just because stock options have no value at the time of the division of the assets, they may have value at a later date if the value of the stock increases in the future.
Pursuant to 22 U.S. Code §422, an Incentive Stock Option is
an option granted to an individual for any reason connected with his [or her] employment by a corporation, but only if:
the option is granted pursuant to a plan which includes the aggregate number of shares which may be issued under options and the employees (or class of employees) eligible to receive options, and which is approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted;
such option is granted within 10 years from the date such plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier;
such option by its terms is not exercisable after the expiration of 10 years from the date such option is granted;
the option price is not less than the fair market value of the stock at the time such option is granted;
such option by its terms is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him; and
such individual, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporation.
What Are Restricted Stock Units ("RSUs?")
Restricted Stock Units, commonly known as RSUs, are compensation offered by employer to an employee in the form of company stock which vests overtime pursuant to a vesting schedule. The RSUs are considered income to the employee upon vesting and the employee can either sell the stock or hold the shares upon vesting.
How Are SOs and RSUs Divided?
Although Incentive Stock Options and Restricted Stock Units are not transferable and are rights granted to employees, they are distributable in a divorce. The titled spouse can either buyout the non-titled spouse from his/her share by valuing the asset using the current market value and deducting the applicable taxes or the titled spouse can "hold" the non-titled spouse's share of these assets pursuant to a "Callahan Trust" established in the case of Callahan v Callahan, 142 N.J. Super 325 (Sup. Ct. of N.J. Chan. Div. 1976).
The issues that practitioners face is determining what portion of the stock options are marital and what portion should be awarded to the non-titled spouse. The answer to this question focuses on whether the stock options were awarded for past efforts which occurred during the marriage or future efforts which will occur after the termination of the marital partnership.
In Pascale v Pascale, 140 N.J. 583, 609 (1995), the Supreme Court of New Jersey held that Plaintiff's stock options awarded ten (10) days after the Complaint was filed, which were the result of efforts expended during the marriage, were subject to equitable distribution. Although the stock options were part of the marital estate, the Court must next decide how to allocate this asset between the parties.
In Robertson v Robertson, 381 N.J. Super. 199 (App. Div. 2005), the Appellate Division held that stock options awarded immediately prior to the date of complaint which had a four year vesting schedule were not part of the marital estate subject to equitable distribution. The Wife argued that it was her marital efforts and support that enabled the Husband to qualify for the position that awarded him these stock options. The Appellate Division held that the stock options were offered as an inducement to accept employment, and not for recognition for past performance. In rejecting the argument set forth herein by the wife in Robertson, the Appellate Division stated:
Although that argument may be to an extent factually correct, we do not find it useful in the context of an equitable distribution determination, since its acceptance would permit a supportive spouse to claim assets accruing throughout the work life of the divorced partner, regardless of when the divorce occurred. Such a result would be clearly inequitable, and thus contrary to the principles of equitable distribution.
The Appellate Division held that the four year vesting period was designed to ensure the Husband's continued employment with the company. Therefore, the Court held that the stock options were not awarded for the couples joint marital endeavors, and held them entirely immune from equitable distribution.
The Coverture Formula:
In a situation where stock options are granted during the marriage but vested after the marriage termination, a coverture fraction can be applied to determine the marital portion. This coverture fraction is recognized in Skoloff & Cutler, III, New Jersey Family Law Practice, (12th Ed. 2006). The coverture fraction was developed by the highest court in the State of New York case of DeJesus v DeJesus, 90 N.Y.2d 643 (1997). DeJesus references the case of In Re Marriage of Hug, 154 CalApp. 3d 780 – the case referenced in Skoloff & Cutler. DeJesusaddresses precisely this issue – to what extent an interest in restricted stock and stock option benefits provided during the marriage but which vested after the marriage are subject to equitable distribution. By using the DeJesus formula, the marital portion of the stock options will be distributed to a party while the non-marital portion remains the separate property of the titled spouse.
The coverture portion was also implemented by the formula established in Marx v. Marx, 265 N.J.Super. 418 (Ch.Div.1993), whereby the non-titled spouse receives fifty (50%) percent of the benefit payable to the participant multiplied by the coverture fraction. The numerator of the coverture fraction is the number of during the marital period from the date of grant of SOs or RSUs to date of complaint and the denominator is the number of months from the date that SOs or RSUs were granted to date that they vest. For example, if SOs were granted on January 1, 2012, and the divorce complaint was filed January 1, 2014 and the SOs vest January 1, 2016, the coverture fraction would be as follows: 24 months (from date of grant to date of complaint)/48 months (from date of grant to date of vesting). In this example, 24/48, or 50% of the SOs would be marital, which presumably would entitle the non-titled spouse to 25% of the value. Such a formula takes into consideration that a portion of the SOs vests during the marital period as well as after the marital period.
What is a Forgivable Loan?
A Forgivable Loan is a form of executive compensation used much like a sign-on bonus or performance bonus to give key employees a motivation to "sign-on" with a new employer and deepen their commitment to remain in their new position. The terms of the loan agreement can establish that the loan will be forgiven over the life of the agreement as long as the employee remains employed by the company. The loan amount is taxable as income to the employee, but the tax is spread out over the life of the loan. If the employee leaves before the loan is fully forgiven, then it is repayable in full, with interest. So for the employee, the forgivable loan is a tax-deferred up-front payment for future service with a fairly big club if the employee leaves the company before fulfilling the terms.
The Internal Revenue Service and case law have established that the forgivable loan will not be treated as compensation for tax purposes as long as the loan represents a bona fide debt agreement. If it were compensation, it would be taxable the day it is paid. But as a loan, it is taxable only as it is repaid or forgiven over time, making it the hook that helps retain people in key positions.
Are Forgivable Loans Subject To Equitable Distribution:
Generally, property qualifies for equitable distribution "when it is 'attributable to the expenditure of effort by either spouse' during marriage." Pascale v. Pascale, supra, 140 N.J. at 609, 660 A.2d at 498 (quotingPainter v. Painter, 65 N.J. 196, 214, 320 A.2d 484, 493 (1974). For the purpose of equitable distribution of marital assets, a marriage is deemed to end on the day a valid Complaint for Divorce is filed that commences a proceeding culminating in a Final Judgment of Divorce. Portner v. Portner, 93 N.J. 215, 225, 460 A.2d 115, 120 (1983). When a forgivable loan is issued to an employee, the purpose of the loan is critical in the determination of whether it should be deemed an asset for equitable distribution or income for alimony purposes. If the forgivable loan is to reward an employee or potential employee for his or her goodwill or past accomplishments, the forgivable loan should be classified as an asset. However, if the purpose of the forgivable loan is used as an incentive to entice a potential employee for future contributions not attributable to efforts of either spouse during the marriage or to compensate future work effort, it should be deemed not available to equitable distribution since marital contribution is lacking. In fairness it can only be used as part of the support calculation.
In New Jersey, case law determining whether a forgivable loan should be categorized as income for alimony purposes or an asset for equitable distribution is scarce. However, other jurisdictions provide guidance to determine the classification of such a loan in the divorce context. In O'neal v. O'neal, 55 Ark. App. 57, 58 (1996), the appellant appealed a final divorce decree, which provided that a $35,000 forgivable loan that appellee received from his employer be characterized as deferred compensation and not marital in character. The court affirmed the trial court's decision to categorize it as non-marital property because although appellee acquired the right to earn the $35,000 during the marriage, he did not earn it during the marriage. Id. at 59. The court concluded that the forgivable loan was compensation for future performance; therefore, it was not earned during the marriage and is not marital property. Id. In Mosteller v. Brooks, 2008 WL 5330525 (Va.App), at *3, the court found that the unvested portion of the husband's forgivable loan was not marital property because he alone remained liable for the balance of the loan post-divorce.
In O'Keefe v. O'Keefe, 1998 WL 170117 (Minnesota, April 14, 1998), the husband received two bonuses from his employer, one of which was acknowledged as a signing bonus. Both bonuses were structured as forgivable loans. During the two years following the commencement of the husband's employment, preceding trial of the divorce action, his employer cancelled portions of his debt and reported those amounts as taxable income to the husband. Under Minnesota law, a bonus is included in the calculation of future income for support purposes only if it constitutes a "dependable source of income." The Minnesota Court of Appeals held that the husband "earned" the cancellation of the debt, and the resulting income, with every year of continued service for his employer. Accordingly, the forgivable loans constituted income from which husband was required to pay support and was not designated as an asset subject to equitable distribution.
If Not An Asset, Then Maybe Income?
If the executive compensation is not subject to equitable distribution, then it may be subject to inclusion in a party's income for purposes of determining support. Actual income of the paying spouse is the lodestar for determining the extent of that party's alimony obligation. Steneken v. Steneken, 183 N.J. 290, 293 (N.J. 2005). In Bonanno v. Bonanno, the New Jersey Supreme Court determined that it looks to a person's income to determine support. 4 N.J. 268 (1950). This is consistent with the alimony statute, N.J.S.A. 2A:34-23, et. seq.Income is traditionally defined as "the return in money from one's business, labor, or capital invested." Black's Law Dictionary, 763 (6th ed. 1998). The Internal Revenue Code includes in its definition of "gross income" any "income from discharge of indebtedness." 26 I.R.C. §61(a). It also specifically defines items which are excluded from gross income. 26 U.S.C.A. §108(a). In the taxation context, the United States Supreme Court has defined income as "the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets." Eisner v. Macomber, 252 U.S. 189, 207, (1920) (quotingDoyle v. Mitchell Bros. Co., 247 U.S. 179, 185 (1918). Under that definition, only gains that are actually realized are considered income for taxation purposes. Miller v. Miller, 160 N.J. 408, 421 (N.J. 1999). Accordingly, a forgivable loan or signing bonus may not be an asset but may be deemed income.
Conclusion
The decision of whether to include executive compensation as part of the marital estate subject to equitable distribution will be based on whether it was granted for past services during the marriage or for future services after the termination of the marital partnership.If it is not part of the marital estate subject to equitable distribution, then consider whether it should be part of the title spouse's income for purposes of support.
[1]Sheryl J. Seiden is an attorney admitted to practice law in the States of New Jersey and New York. She is the founding partner of Seiden Family Law, LLC in Cranford, NJ. She is an officer of the Family Law Section of the New Jersey State Bar Association and a fellow of the American Academy of Matrimonial Lawyers – New Jersey Chapter. She is a frequent lecturer on topics affecting the practice of family law.