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Divorce & Family Law Blog by Attorney Jamie Elmer of Berkeley, California

Employee Stock benefits: When do they constitute income for purposes of income tax, and for calculating child & spousal support?

Employee Stock benefits: When do they constitute income for purposes of income tax, and for calculating child & spousal support?

These days, tech companies and startups often offer their employees compensation and incentives in the form of stock options, restricted stock units, or employee purchase plans. These grants are almost always conditioned upon further and future employment.

Thus, stock options might not vest for a certain period of time and there is usually a vesting schedule such that a certain amount of stock is available for purchase at a preset price every quarter or other time period. Restricted stock grants are similar in that there will be a schedule of when the stocks become unrestricted and thus are owned by the employee outright.

The benefit to the employee is that the purchase price for the various stock purchasing opportunities is preset and is often lower than the market price at the time of grant, and hopefully much lower than the market value at the time of vesting.

Because the IRS and courts will treat the stock benefits as income under certain conditions it is important to know what triggers the finding of the stock being treated as income for purposes of taxation and/or calculating child and spousal support.

First of all, a little summary of important events involved in stock options and restricted stock grants.

  1. The stock option or Restricted stock grant.  An easily identified event of when the company grants the right to purchase company stock at some future time, or grants restricted stock [the employee not having any real rights to the stock until the restrictions lapse]. 
  2. The date upon which the right to the stock option becomes vested, and thus the stock could be, but doesn't have to be, purchased at a preset price.
  3. The purchase of the stock, or the restrictions lapse on Restricted stock grants, at which time the employee receives the stock to do with as he or she pleases.
  4. The sale of the stock purchased pursuant to option, or of stock whose restrictions have lapsed.

The tax implications involve the issue of which event/s triggers income for tax purposes, and whether it will be treated as ordinary income, or capital gains.

The IRS will not treat the initial grant of either the option or the restricted stock as income for income tax purposes.  Neither will the IRS treat the mere vesting of a stock option as income as the employee has not actually received any assets. However, a court might treat the vesting of the right to exercise the option as income for purposes of calculating child or spousal support. [the current value, less the purchase price = income].

On the other hand, the IRS allows what is called an 83 b election if the employee wants to be taxed  [as ordinary income] at a time prior to vesting, or prior to the lapse of restrictions, in order to have any increase in value [and profit] taxed at capital gains rates [almost always less than ordinary income rates] instead of ordinary income (assuming the employee holds the stock for at least one year from the date of the election).  

Absent the 83 b election, when the stock option has been exercised, and the employee purchases the stock for less than its market value, the IRS will treat that profit [even though only on paper] as ordinary income for tax purposes. Likewise, when stock becomes unrestricted the court will treat the market value at the time of the lapse of restrictions [or current value less purchase price, if any], as ordinary income for tax purposes. This is true even though the employee has not liquidated the value of the stock but merely holds it. If the employee has previously made an 83b election, the increase in profit will be taxed at capital gains rates (assuming the one year holding period).

More rarely, a company might offer what is called an incentive stock option [ISO] which is also called a qualified stock option, because it's qualified under IRS rules if it meets certain restrictions that allows no income taxation until the stock is actually sold. [However, alternative minimum tax may apply to the exercise of an ISO.]  Although more attractive to the employee, there are reasons why it is not as attractive for the company.

Upon sale of the ISO or qualified stock, the entire profit on the sale is considered ordinary income for tax purposes. Some of the limitations on this kind of stock option include that it amounts to no more than $100,000 maximum per year, that it not be sold within two years of the grant, (or one year of vesting) and the stock must remain in the employee's name.

Not surprisingly, upon the sale of either unrestricted stock or stock purchased pursuant to the option, [but not the qualified stock (ISO)], the IRS will treat any appreciation since the vesting [or lapsing of restrictions] as profit subject to capital gains tax [as the court has already taxed the previous value as ordinary income]. In the case of the selling of the ISO purchased stock, the profit will be taxed as ordinary income. 

When are employee stock benefits treated as income for purposes of child and spousal support?

There is a presumption under California Family Law that income within the meaning of IRS rules is income for purposes of calculating support. However, the courts are not limited to the IRS's interpretation of what constitutes income. Thus, while all income for purposes of income tax is presumed to be income for purposes of calculating spousal and child support, some "income" not considered income for tax purposes may nonetheless be considered income for purposes of calculating support.

For instance, some courts  treat the mere vesting of a stock option as income for calculating support on the theory that the employee should not be able to deny his or her child or spouse of the added support merely by failing to realize the profit available by the purchase and sale of the vested stock. [See Murray v Murray (Oh App 1999) 716 NE2d 288, 293-295.]

Income triggered by an 83 b election would probably be income for purposes of calculating support, but often the income under such an election is relatively small [and sometimes zero if the value and purchase price are the same]. And, one could argue that since there is no real money received from the election, the presumption that the only-on-paper profit is income should be considered overcome by the reality that no real cash has been received.

It is unclear whether exercise of the option to purchase qualified stock [ISO], would trigger income for support purposes, since the IRS will not treat that as income. The same argument could be made as to the vesting under the Murray case above, that it should be treated as income as the employee is merely deferring the income at his or her choice and whether that is fair to the support recipient. 

Another argument in favor of treating exercise of the qualified option as income is that it would be unfair to treat the exercise of the non-qualified stock option as income by the Family Court and not the qualified stock, because there is no real difference as to money received by the employee. The point may be too fine for a family court judge, and perhaps they would just choose to follow the IRS rules of when there is income. [That is, treating on-paper profit as income in exercising the purchase option for non-qualified stock and not income for exercise of qualified stock]. 

It is probably obvious to say that where stock is sold, any profit will be income available for purposes of calculating support, regardless of whether it is ordinary income or capital gains income.

Not to muddy the waters, but often a nonrecurring capital gains wont be included in calculating support per se, but most likely will be treated as income subject to the support calculation software's bonus tables, which allocates a certain percentage of bonus income as additional support.

What may not be as obvious, is that when an option is exercised and the stock purchased and held [but not sold] or where a restricted stock grant becomes unrestricted, then there will be income for purposes of calculating support [as the IRS will treat that as ordinary income]. In the case of the stock option, the difference between the purchase price and its present market value, and in the case of a restricted stock grant, the market value at the time the restrictions lapse [or current value less purchase price, if any], will both be considered income in calculating spousal and child support.

If  you have further questions regarding employee stock benefits in the context of taxation or support, please contact Martin "Jamie" Elmer, family law attorney in Berkeley, California, at (510) 644-2411 or by email, for a free initial consultation.