How Divorce Affects Equity Awards

In the blog, I cover why companies should consider transfer policies for divorce and examine considerations around allowing legal transfers of awards versus requiring that employees retain legal ownership of their plan awards/options/shares and transfer only the economic interest in their stock plan holdings.

Should Companies Have a Transfer Policy for Divorce?

Before you skip ahead, thinking that you may already have policy language within your plan, the policy we are talking about is more than just the blanket “transfers are prohibited” paragraph found in some stock plans. I’ll get into that nuance, but let’s first understand why a transfer policy for stock plans is recommended.

First, other voluntary company benefit plans that hold assets, such as a 401(k) retirement plan, are likely covered under the Employee Retirement Income Security Act of 1974 (ERISA). ERISA is a federal law that sets minimum standards to protect employee participants in voluntary retirement and health plans. As such, when a divorce occurs and assets under a plan subject to ERISA are affected, a divorcing party may obtain a Qualified Domestic Relations Order (QDRO), which is a specific type of court order that recognizes the right of an “alternate payee” to receive all or part of a retirement or pension plan that belongs to another person. So if a non-employee spouse presents a QDRO to the company’s 401k sponsor, then the 401k sponsor would typically be obligated to comply with the order to divide and distribute the assets in the 401k plan.

In the case of equity plans, they are not subject to ERISA, and the same plan sponsor obligation to comply with a QDRO would not apply. Essentially, the company is not obligated to transfer shares underlying or issued in connection with equity awards. This absence of a clear path to settling/distributing domestic claims related to stock plan awards/shares drives the recommendation that divorce oriented plan language is needed for stock plans.

We’ve established that a policy to define how a company will handle divorce scenarios is recommended. Let’s go back to the fact that some stock plans do already contain general language that prohibits transfers – which sounds like a good approach towards nudging employees to solve distribution of their assets in another means besides transfer (for example, by the transfer of economic value of the shares instead of the actual transfer of shares).  Is this the same as having a transfer policy?

Prohibitive language around transfers in the plan sounds ideal at surface evaluation, but our panel points out that there are concerns with reliance on such general language to address divorce transfers. For one thing, courts may tend to narrowly interpret language that prohibits transfers. A plausible scenario is that a court interprets divorce related transfers to be involuntary, and in turn regards general language prohibiting transfers as non-enforceable by the company. Having a clearly defined policy, including who is covered and what types of transfers are permitted, will prevent such a scenario.

What Should be Covered in a Transfer Policy?

As noted above, the plan document should specify whether equity awards can be transferred pursuant to divorce. In addition to this, here are some things you might want your policy to cover:

• How will requests to transfer award be handled? For example, if the plan prohibits transfer and a court orders that the awards be transferred anyway, how will the company address this situation? Will you require the divorce settlement to be redrawn or find a way to comply with the request?
• If the economic interests only are transferred, will the company enforce this or is compliance entirely at the discretion of the employee?
• What paperwork is required for the company to process the transfer? This is clearly an important policy if the company allows legal transfers, but can also be relevant if economic interests are transferred and the company will be involved in facilitating transfer of the shares or proceeds to the ex-spouse.
• Who reviews the paperwork to ensure that the company's understanding of the division of assets is accurate? How will the company handle a situation where the division of assets isn't clear?
• Who is responsible for communicating with the ex-spouse? Will all communications have to go through the employee? What if the employee terminates, reducing the period in which options can be exercise and resulting in forfeiture of any unvested awards--who is responsible for communicating this to the ex-spouse?

Employee Education

It can be helpful to prepare a plain-English explanation of what the company allows with respect to the division of equity awards in divorce settlements. Employees can give this document to their attorney and to their ex-spouse, which can go a long way toward ensuring that courts divide the awards in a manner that is acceptable to your company. 

Economic Interest vs. Actual Transfer: What’s the Difference?

When it comes to dividing stock plan holdings in a divorce, there are two primary approaches: transfer the actual awards (if permitted), or, transfer the economic interest in the awards. A transfer is how it sounds – the paper ownership and control of the awards/shares transfers to another party. In the transfer of economic interest, the shares don’t change ownership on the books – but the non-employee ex spouse gains the right in the divorce settlement to direct the exercise of stock options and receive shares upon vesting of awards. So which is the best choice for companies in considering a transfer policy? There are pros and considerations to each approach. Let's examine each one in more detail: 

Transfer of Economic Interest

• Grantee ex-spouse continues to hold awards in his/her name
• Transferee ex-spouse can direct exercise of options he/she is awarded an economic interest in and will receive a portion of the shares or proceeds upon exercise/vesting of awards

Pros: 

• Easy administration for plan sponsors, since they are dealing with the employee spouse only.
• May be a good choice for incentive stock options, since an outright transfer automatically disqualifies ISOs from preferential tax treatment.

Considerations: 

• Requires communication between ex-spouses, since the employee spouse will have to execute transactions on behalf of the non-employee ex-spouse.
• Employee spouse retains the award for tax purposes and will pay taxes on the award, creating a need for employee to potentially have to pursue reimbursement of withheld taxes from ex-spouse.
• Potential liability issues for employee upon termination of employment and forfeiture of unvested awards. 
• Nonemployee spouse subject to employee spouse’s limitations on trading – e.g. blackout periods.

Legal Transfer of Awards

• Grantee ex-spouse ceases to hold portion of awards transferred to ex-spouse
• Ex-spouse becomes legal holder of all or a portion of awards

Pros:

• Each spouse controls their own stake in the awards/shares/options.
• Employee does not have any income reportable event at transfer.
• Employee does not have to report income for for FIT purposes for ex-spouse's transactions (employee will still recognize income for FICA purposes) and all tax withholding (FIT and FICA) is paid by the ex-spouse
• Divorce transfers are not considered a disposition of shares acquired under ISOs or ESPPs.

Considerations: 

• Companies with significant global populations have requirements of multiple jurisdictions to consider.
• Company required to report income for the non-employee ex-spouse (process and resource considerations).

One of the most significant factors in determining whether to prohibit transfers is consideration for the processes and resources that would be needed to support actual transfers. Since a transfer introduces the nonemployee spouse into the picture, the company now needs to figure out how to handle things like income reporting and withholding, which can be done through payroll for the FICA wages but payroll may not be equipped to manage this for the FIT wages. Moreover, if your company has multiple payrolls, different processes may be needed. These are not light considerations and should be evaluated carefully in determining how the company will approach implementing (or enhancing) a transfer policy around divorce. 

Accounting and Insider Considerations

Regardless of which approach is used, the good news is that both should be a non-event for accounting, insider trading, and Section 16 purposes:

• Neither type of transfer is a modification, so there should not be any change in the award fair value or expense for accounting purposes. Don't forget that the company still needs to recognize expense for unvested awards transferred to the ex-spouse and needs to account the tax effects of any transactions by the ex-spouse.
• Generally no issue for insider trading purposes, since no sale or purchase takes place.
• Generally exempt from Section 16 reporting; consider footnote disclosure of ownership changes at next filing (cash exercises may be exception, if employee deemed to have retained pecuniary interest in the shares; if not then applies to cash exercises also.)  

More Info

For more information on the tax consequences of transfers of equity awards pursuant to divorce, see the article "Taxation of Equity Awards Transferred Pursuant to Divorce."