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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.
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