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Stock Options and Divorce: Qualified Domestic Relations Orders

This Practice Aid covers issues relating to the transfer of Stock Options to an Alternate Payee.

In many cases the determination that all or a portion of a Stock Option Plan is marital/community property is the least difficult aspect of a broader, more complex task of securing and actually distributing these Options to an Alternate Payee. A Qualified Domestic Relations Order is not the appropriate instrument to assign to an Alternate Payee his or her interest in the Stock Option Program. Troyan, Inc. has developed instruments unique to this form of assignment.

This Practice Aid is limited to Internal Revenue Code §422 Options, generally termed “Incentive Stock Options” (ISO). Not covered herein are §423 Options (Non-Statutory Stock Options).

The practitioner’s fundamental concern is:

will a Plan Administrator accept a Domestic Relations Order that assigns to an Alternate Payee all or a portion of the Options (ISO) held by the Plan Participant?

Recall, our focus is not whether the Options are marital/community property, rather it is the ability of an attorney representing an Alternate Payee to craft a settlement that effectively “secures” for an Alternate Payee his/her equitable/community interest in these Options. Assume the court has held that all or a portion of such Options are marital/community property subject to division. Deciding that Stock Options are marital/community property is not the real issue. The issue is the practitioner’s ability to secure the rights of the Alternate Payee to his/her court assigned portion of these Options. Stock Option Plans are Non-Qualified Plans. A majority of Firms will not accept a Domestic Relations Order against a Non-Qualified Plan.

Nevertheless, some Firms will accept such Orders, especially Firms smaller in size than the Fortune 2,000. When a Firm agrees to accept an Order assigning all or a portion of the Participant’s Stock Options to an Alternate Payee the issue of greatest concern to the attorney representing the Participant Spouse is: Does such transfer result in a taxable event, and if so when? If this transfer does result in a taxable event who is liable for the federal taxes on the transfer?

Internal Revenue Code §1041: Transfers of property between spouses or incident to divorce, does not control! A transfer of Stock Options from the Participant to the Alternate Payee incident to a divorce is a taxable event. The controlling law is Internal Revenue Code §83: Property Transferred In Connection With The Performance of Services. The Participant is taxed under §83 at the time of the transfer of the Options to an Alternate Payee. The Alternate Payee then receives the Participant’s carryover basis in the Options under §1041(b).

Since the majority of Firms will not permit a direct transfer of Stock Options from a Participant to an Alternate Payee pursuant to a Qualified Domestic Relations Order, we suggest an alternative strategy; the “Constructive Trust” Methodology. Moreover, this alternate strategy avoids an automatic and immediate tax. It further permits discretion as to the time of exercise in order to maximize gain.

This alternative strategy relies on Internal Revenue Service Regulation 1.425-1: Definitions and Special Rules Applicable to Statutory Options. Troyan, Inc.’s experience in this area indicates that the majority of Firms do not permit a direct transfer of Options, however, many Firms (even those among the Fortune 2,000) will implement a carefully crafted Order that calls for direct payment (in Stock) to an Alternate Payee of Options held by the Participant and exercised by the Participant at the direction of the Alternate Payee. This scheme facilitates discretion as to the time of exercise of the options. This timing enables the exercise to take place at an optimal price point. An added advantage is the deferral of any tax consequence until the Alternate Payee deems the price of the realized stock (he or she now holds) merits he/she sell such stock (generally at capital gains rates). If you are unclear on the significant difference between “exercise” and “sale” contact Troyan, Inc..

The informed practitioner is mindful of the possible death of the Participant prior to an Alternate Payee’s exercise of his/her Option Award. If your Agreement is well crafted the death of a Participant should not adversely affect an Alternate Payee’s interest. On point is Internal Revenue Service Regulation 1.421-7(b)(2) and 1.421-8(c). The practitioner will rely on these sections to bar loss of entitlement by an Alternate Payee as a result of the death of the Participant prior to an election to exercise by an Alternate Payee.

The first section binds the Participant while the second binds the Participant’s estate. Under 7(b), the practitioner inserts language into the “Order” binding the Participant to insert language into the Stock Option Plan’s beneficiary section that designates the Alternate Payee as the person who may exercise the option after the Participant’s death. The post-death exercise of the Option by an Alternate Payee is not a taxable event, however, the subsequent payment to the Alternate Payee is a taxable event attributable to the estate of the Participant. Thus, under 7(b) the Participant is obligated to designate the Alternate Payee as beneficiary, while under 8(c) the Participant is required to bind his estate to treat the Alternate Payee as a beneficiary of the estate. It provides:

If a statutory option is exercised by the estate of the individual to whom the option was granted, or by any person who acquired such option by bequest or inheritance or by reason of the death of such individual, section 421(a) applies to such exercise in the same manner as if such option had been exercised by such deceased individual.

Effective application of this section calls for enhanced reporting and disclosure obligations on the Participant so as to confirm that any of the Participant’s post-divorce directions to the estate have not been altered to the detriment of an Alternate Payee. This circumstance is treated in Troyan, Inc.’s language in the underlying “Order” making the estate of the Participant an additional constructive trustee and inserting language to bind the estate as well as any benefited third party. In sum, attorneys are not without recourse regarding disposition of this asset.