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More on Stock Options and Drafting

This Practice Aid is limited to Incentive Stock Options (ISO). In this second Practice Aid on Stock Options we discuss the mechanics of transferring the stock (from an ISO) to the Former Spouse. Note: the format for assigning other forms of Executive Deferred Compensation will differ from the following discussion. The operative methodology will not be a Qualified Domestic Relations Order, since, the majority of firms will not honor a Qualified Domestic Relations Order against their Stock Option Plans. However, the fact that a majority of firms will not accept a Qualified Domestic Relations Order does not suggest that equivalent writings are beyond implementation; to the extent that many firms will administer distributions in compliance with an appropriately crafted Order.

Troyan, Inc. has crafted a variety of “writings” that that enable a Plan Administrator to “administer distributions” to a Former Spouse pursuant to a Final Judgment of Divorce. While firms will not “qualify” these instruments, they do acquiesce to the extent that they will comply with making distributions consistent with such instruments. The nature of the “compliance” varies with the firm, but, central to this exercise is the fact that the employer acknowledges that the Executive has become personally bound to honor the terms and provisions of a Property Settlement Agreement or other instrument incident to a divorce.

The function of the attorney representing the non-titled spouse is to craft the Property Settlement Agreement in a form that facilitates the Executive’s compliance with the provisions delineated therein. The key is to bind the Executive and to build into the Agreement reporting and disclosure language that enables the Former Spouse to monitor the ISO’s activity and performance. This language is necessary to alert the Former Spouse to any breach of trust by the Executive that will lead to prompt punitive action.

An initial task is to define the number of options deemed marital/community property. From this number, Incentive Stock Option options that are deemed the property of the Former Spouse is derived. The Property Settlement Agreement then delineates the rights of the Former Spouse regarding the timing of “mandatory” exercises by the Executive. Because breach is possible the well crafted Agreement will include a provision requiring the Executive, his heirs, assigns, estate and all advantaged third parties to immediately pay all legal fees and expenses arising from such breach of trust. Another provision of the Property Settlement Agreement requires that upon exercise of the specified options (at the discretion of the Former Spouse), the Executive will receive in a non-taxable transfer an equivalent number of shares.

When your Property Settlement Agreement is properly crafted and you apply the process found at Internal Revenue Service Regulation 1.425-1(c)(2), the shares will be distributed to the Executive and the Former Spouse jointly. This achieves two objectives: a non-taxable exercise of the options into shares of stock and a distribution not to the Executive, but jointly to the Executive and the Former Spouse (these mechanics must be found in the Property Settlement Agreement) . The attorney representing the Executive will be mindful of the fact that although this exercise is not a taxable event in terms of an ordinary income or capital gain tax, this exercise is likely to cause an “Alternative Minimum Tax”, attributable to the Executive [Internal Revenue Code §56(b)(3) and 422(c)(7)]. An equitable Property Settlement Agreement will reflect this potential and provide appropriate relief to the titled spouse.

The next provision (generally based on your view of market conditions) is that the realized stock is to be held for more than one year. This one year “holding period” causes any subsequent tax on the sale of the stock to be imposed at capital gain rates. Although the holding is joint this capital gain tax will be attributed to the Executive.

Should your Property Settlement Agreement provide for the transfer of the jointly held stock to the Former Spouse after the one year period? If there is a bearish perception of the stock, such sale is appropriate. In a rising market such transfer to the joint owner (Former Spouse) is questionable. In either circumstance be clear that this transfer from Joint Ownership to the sole and exclusive ownership of the Former Spouse constitutes a “disqualifying disposition” and triggers a tax attributable to the Executive at capital gain rates.

A word of caution on the concept of “Repricing Executive Options.” The recent decline in the stock market has sharply reduced the worth of many incentive stock option plans. The result is the corresponding decline in executive motivation. To motivate key executives whose options have declined firms can “reprice” the option. When options are repriced the existing options are replaced by new lower priced options. The employer does not deem this “repriced” option a successor to the cancelled option. It deems this a new issue. Such action by the firm can effectively extinguish the Former Spouse’s award. The marital/community property options are gone and with it the award to the Former Spouse.

“Repricing”, and the resulting loss to the Former Spouse, is a circumstance that can cause the Former Spouse to question his/her attorney. To avoid a bad experience it is urged that you recognize these schemes in your Property Settlement Agreement. Absent language in the Property Settlement Agreement dealing with “repricing” and “reloading” of options it is likely that the employer and a court will deem the repriced options as not covered by the Property Settlement Agreement.

When dealing with Executives at the highest levels it must be recognized that incentive option programs are crafted that are unique to this executive. Although unlikely, be aware of this executive’s capacity to cause options to be repriced, reloaded or by other action eradicate the interest of the Former Spouse.