Divorce: Dividing Pensions and Employee Benefits
Dividing pensions and employee benefits in Divorce proceedings, including deferred compensation plans (401k’s, 403b’s and IRA’s), Stock Options, EPPs (Employee Purchase Plans), RSUs (Restricted Stock Units), and bonuses.
The various types of employee benefits (see above) commonly available raise the following issues in divorce proceedings:
- Determining the community interest [vs the employee’s separate interest] in the employee spouse’s benefits
- Tax implications of dividing the community interest in the employee spouse’s benefits
- Effect on Spouses’ income in calculating child and spousal support.
Here we will deal only with the first issue: that is, determining the community and separate interest in the employee spouses’ benefits. Next month’s newsletter will deal with the tax effect and the extent to which the benefits might be included as income for purposes of calculating support [as opposed to being treated as a division of assets].
Community & Separate Property
Anything of value acquired during the marriage by either spouse as a result of personal efforts is community property, and is divided equally in a divorce action. This includes employee benefits such as pensions, deferred compensation plans, and the various stock options plans, as well as year-end bonuses. Anything of value acquired prior to the marriage, or after separation is the separate property of the person generating the money or value.
Thus, the issue of apportionment between community interest and the employee’s separate interest arises when some part of the benefit is accrued/earned either before marriage, or after separation.
No need for Vesting. There is a community interest in such benefits whether they are vested or not. If the benefits never vest [or the restrictions on stock grants never lapse], then of course there will ultimately be no interest. But, if the benefits vest after the date of separation the nonemployee spouse will still be entitled to a portion of those benefits, and that portion may be awarded in the divorce.
Measuring the community interest in the benefit and apportioning the benefits between the community interest and the separate interest.
Defined contribution type plans such as IRAs, 401(k)s and 403b’s, as well as employee bonuses are the easiest to calculate. The generally accepted way to apportion the amount of such accounts is called “The Time Rule.” The community interest is simply determined by the ratio of the length of marriage [from the date of marriage to the date of separation] to the accrual period [the period of time during which the employee’s spouse has been contributing to such account].
This is fairly straightforward and pretty easy to understand. For example, if the employee spouse has been working for 20 years and been part of the plan for that time, and has been married for 10 of those years, then the community would have a 50% interest in the account. Therefore, each spouse would be entitled to one half of that community interest, and the employee spouse would be entitled to the other half of the account [leaving the employee spouse with 75% of the account]. If the employee began the employment after the date of marriage than all of the account will be community property, except for any post-separation contributions.
Another accepted method of determining the community interest would require an actual recapitulation of the contributions prior to marriage [and/or after separation] versus the contributions during the marriage, as well as any appreciation or depreciation attributable to each period’s contributions. Although this can be expensive, it might be worth it if there were greater contributions during one period versus the other.
True Pensions [Defined benefit plans], will be subject to the contractual terms between the employee and the employer. Often, the benefit is based on factors such as the participant’s salary, age and the number of years he or she worked for the employer. Apportioning the community interest in a pension will generally also be a ratio of the length of employment to the date of retirement [or right to retire] compared to the length of the marriage.
Division of Pensions & Contribution Plans in Divorce
Both kinds of accounts can be divided in a divorce pursuant to a Qualified Domestic Relations Order. [QDRO (pronounced “Quadro”], with the “qualified” meaning that it qualifies with the IRS as not being a taxable distribution and therefore not subject to taxes at the time of division. [However, a simple IRA can be divided without a QDRO and is still nontaxable to the non-employee spouse if made pursuant to a divorce agreement/judgment.]
Although defined contribution plans, such as 401k’s and 403b’s and IRA’s, can be divided and even cashed out by the nonemployee spouse upon division, pensions, while they can be divided in the divorce, are not actually paid out until the employee spouse retires.
When the nonemployee spouse cashes out a defined contribution plan after division, the money the non-employee spouse takes will be subject to ordinary income taxation [but without an early withdrawal penalty]. The nonemployee spouse may otherwise choose to rollover their share into a tax-deferred IRA, and keeping the tax-deferred status until withdrawals are actually taken.
Division of Unvested (as well as Restricted) Stock Options in Divorce
The concept of apportioning the unvested and unrestricted stock options is somewhat similar to apportioning other employee benefits, and yet different. All apportionment of employee benefits is aimed at awarding the nonemployee spouse an equitable amount of the benefit that resulted from efforts during the marriage.
Stock options can be valuable where the price of the stock [which is specified at a certain price as part of the grant] at the time of exercise is lower than the actual stock value.
The apportionment of unvested stock options between the community interest and the employee’s separate interest will be a ratio of two time periods, measured in one of two ways. The first time period can either begin at the date of the stock grant or the date the employees is hired, and both end at the date of separation. The second length of time begins at the same date selected for the first time period, but ends at the date that the stocks rights vest.
Because using the date-of-hire will always result in a longer time period than using the date-of-grant, using the date-of-hire will result in a larger community interest. In general, courts will use the date-of-hire where the stock is granted to reward prior efforts or to entice employment [In re Marriage of Hug (1984) 154 Cal.App.3d 780], and to use the date-of-grant where it is intended to reward future efforts [In re Marriage of Nelson (1986) 177 Cal.App.3d 150].
Thus, the Hug formula is (Date-of-Hire to Date-of-Separation) / (Date-of-Hire to date-of-Vesting) x option shares, and weights the percentage towards community property.
The Nelson formula is (Date-of-Grant to Date-of-Separation) / (Date-of-Grant to date-of-Vesting) x option shares, and results in a smaller community percentage.
|------------------------------(first period)-------------------------------→| (Hug)
|---------(first period)---------→| (Nelson)
|------------------------------(second period)---------------------------------------------------------------------→| (Hug)
|------------------------(second period)--------------------------------→| (Nelson)
Unlike pensions and plans that can be divided pursuant to a QDRO, a divorce judgment dividing unvested stock options and restricted stock units, will usually (but not always) provide that the stock rights stay in the name of the employee, but the employee will hold the non-employee’s share as constructive trustee for the benefit of the nonemployee spouse until they are exercised [or the restrictions lapse], and/or sold, whereupon they will be transferred, or the proceeds given to, the nonemployee spouse.
The judgment or agreement will also have to deal with when to exercise the options once they become vested, and whether the stock should be sold or transferred to the nonemployee spouse. Restricted stock units, having already been granted will become unrestricted according to the terms of their grant and thus need not be exercised, but will also involve a decision of whether to sell and/or award to non-employee spouse.
In a subsequent blog we will look at the tax implications involved in stock grants, exercising the option to purchase [or the lapse of the restrictions] and the timing of the sale of the stock. In addition, we will explore the possible implications of whether the grant, exercise and/or sale of stock will be treated as a division of assets or will be treated as income for purposes of calculating child and spousal support.
If you have further questions regarding dividing pensions and employee benefits in divorce cases, please contact Martin "Jamie" Elmer, family law attorney in Berkeley, California, at (510) 644-2411 or by email, for a free initial consultation.