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..
Alert:
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.
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