June 24, 2019
Company incentive benefits come in all sorts of forms. Typical rewards are stocks options (qualified and non-qualified), Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPP). They may also include Performance Shares. It’s important to know the structure and workings of each type of plan, as their economic benefits differ.
Stock Options are a right given to the employee to buy the company’s stock in the future at a particular price. The incentive is for the employee to work hard and help the company grow, so that the price of the stock goes up above the grant price. These options come in two flavors: qualified and non-qualified. Qualified options are usually called Incentive Stock Options.
The important difference between the two is the way they are taxed. ISOs are not taxed when the employee exercises his right to buy the stock, tax occurs only when the stock is eventually sold. Non-qualified options are taxed in two segments: when the employee exercises and buys the stock, and later when the shares are sold. Depending on the timing, either stock award may be taxed at ordinary income tax rates or at capital gains rates.
RSUs are shares of stock pledged to the employee, at a particular grant price. The shares will vest at some date in the future, at which point they will automatically be sold. The difference in value between the market price and the grant price of the shares is the reward that the employee receives, and it is taxed just like their wages.
Performance Shares are similar to RSUs, but are tied to company performance. If the company meets the specified performance target on a specific date in the future, the employee earns the reward. These are also taxed like wages.
Employee Stock Purchase Plans allow the employee to put aside some of their wages to buy company stock at a discount. There is no tax when the shares are purchased. At the time the shares are sold part of the gain is taxed as ordinary income, and part at more favorable capital gains rates.
In a divorce it is important to consider the economic treatment of rewards, as their net value can vary greatly. Let’s look at an example:
Jim has 900 non-qualified options granted at $108. The current price of the stock is $250. He also has 900 RSUs granted at $0 cost basis. Both the options and RSUs vest on the same day next year.
Jim wants to exercise and sell the options and give Sally the proceeds, while keeping the proceeds from the RSUs for himself. If he does that, Jim will realize $225,000 ($250 x 900). Sally will realize $127,800 (($250-$108) x 900). This is about half of what Jim gets. Both of these figures are before tax, but it should be noted that most of these awards cannot be divided (with the exception of ESPP shares), so the employee will have to pay taxes on the shares and then distribute the proceeds to the ex-spouse. So in this case both types of rewards have equal tax treatment.
Work carefully when dealing with incentive awards, so that your client understands the net value of the asset and the ultimate division is fair and equitable.