Employers Face Complications if Stock Options are Transferred in a Divorce

January 25, 2019

Employers may get dragged into an employee’s divorce when stock options are involved. Determining whether stock options may be transferred to a nonemployee spouse and, if so, how to divide them differs in each case. There are important tax ramifications for transferring these benefits that affect how an employer must withhold and report taxes. This article briefly addresses some issues that an employer in this situation should discuss with the divorcing employee and a tax professional.

What are Stock Options?

An employee stock option is a benefit given by an employer that allows the employee to purchase shares of the employer’s stock at a specified price for a specified period of time. The employee is not obligated to pay for the stock until he elects to exercise his option to purchase. The earliest date the employee is eligible to purchase the stock is known as the exercise date or vesting date. It’s common to offer employees a vesting schedule, which details the percentage or number of shares of stock that become vested as of each vesting date and if, or when, the stock option expires.

There are two types of employee stock options—nonqualified stock options (NQSOs) and incentive stock options (ISOs). The employer determines which type of stock option to offer when making the option grant. The difference lies in the income tax treatment when the employee exercises the option.

When an employee exercises an option to purchase an NQSO, he must report the gain as ordinary income. The gain is the difference between the employee’s exercise price and the fair market value of the stock. Ordinary income is subject to income and employment taxes, including Social Security, or FICA, taxes and Medicare taxes. Any subsequent gain or loss on the shares when the employee ultimately sells the stock is taxed as a capital gain or loss.

ISOs are given preferential tax treatment. The employee can select to defer taxation until the date he sells the stock. At that point, the employee is taxed at capital gains tax rates, rather than ordinary income tax rates, on the difference between the stock price when the employer granted the option and the stock price when the employee sold the stock. Certain conditions must be met to qualify for ISO treatment. For example, the employee must hold the stock for at least one year after the exercise date and for two years after the employer granted the option.

Why offer stock options? They can incentivize employees to remain with the company and to improve their performance. Moreover, they may enable smaller companies and companies without substantial cash resources to attract key employees at more modest compensation structures in return for substantial future rewards. Stock options may also be used as a bonus to reward employees for past services.

Divisibility of Stock Options in a Divorce

Stock options, both vested and unvested, are considered assets in a divorce that can be divided between the spouses. The most common way to divide stock options is for the divorcing employee to retain the stock options and award the nonemployee spouse other marital assets of equivalent value as an offset. To do that, the employee and his spouse must agree on the current value of the stock options. Valuing stock options is complex and requires some assumptions about the level of risk and future tax consequences.

Another way to divide stock options in a divorce is to defer distribution in light of the possibility that the stock option may never be exercised. Under this option, the employee may be required to make a one-time cash payment to his former spouse if he ever exercises his stock options in the future. This option prevents the need to calculate the current value of the stock options.

Transferring Stock Options to Nonemployee Spouse

A third, and less common, method of dividing stock options in a divorce is to transfer them directly to the nonemployee spouse. This option is only available for NQSOs; ISOs are not eligible for transfer in a divorce.

The IRS has determined that when stock options are transferred in a divorce, the nonemployee spouse should report the income resulting from the exercise of the stock options and get the credit for the income tax withheld by the employer. As a result, an employer may need to issue a 1099-MISC to a nonemployee spouse and exclude that amount from the employee’s W-2 so the income isn’t taxed twice.

Furthermore, because the amounts received by the nonemployee spouse relate to the employee’s service and remuneration, the unemployment, or FUTA, tax and FICA withholdings would be calculated by reference to the employee’s income. You should consult with a tax professional for specific instructions on how to do that.

Most stock option plans do not permit options to be transferred to a nonemployee under any circumstances. In that case, the divorce decree may indicate that the stock options will remain in the employee’s name but are subject to written exercise instructions given by the nonemployee spouse. In essence, the nonemployee spouse is given a beneficial interest over the stock options and has a power of attorney over the account. The IRS has determined that under this scenario, the nonemployee spouse should bear the income tax consequences, while the employee should receive credit for the taxes withheld by the employer under his name. Again, you should consult with a tax professional for specific instructions.

Bottom Line

Pay close attention to an employee’s divorce when stock options are involved. Inform the employee of any transfer restrictions early in the divorce process. Ask to review the language in the divorce settlement agreement before the employee finalizes his divorce to ensure that his actions are consistent with the stock option plan.

You may need to adjust the tax withholdings and reporting, and cooperate in other respects if stock options are to be transferred to a nonemployee spouse. It would be wise to contact a tax professional for assistance.

This article, slightly modified to note recent updates, was featured in the September 2015 issue of the Wisconsin Employment Law Letter, which is edited by Axley Brynelson Attorney Saul Glazer and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.

For more information about "Employers Face Complications if Stock Options are Transferred in a Divorce," contact Kathryn M. Grigg at kgrigg@axley.com or 608.283.6703.