DEFERRED COMP: THE ICEBERG OF MODERN INCOME
When this writer began his career in 1980, wages were pretty much the only form of employment compensation and life was easy. For regular wage earners, there was a bonus at years’ end. For executives, employers liked to see how the tax year played out and then would create a bonus “pool” which would be paid to eligible executives in January or February of the following year.
About 1990 people began to notice that common stocks were a pretty good place to put money. The Standard and Poor 500 Index tripled between 1980 and 1990. Thus, we began to see the rise of stock-based compensation plans. It started with options. If you were awarded options in General Electric in January 1980 you would have the ability to buy the common shares for $3.40 a share. A decade later the shares would sell for $18.50. A decade later in 2000 the stock was at $225. From that date forward General Electric began to wobble, and the wobble has never ended. The hope and increasingly, the expectation, became that while your salary and bonus would pay the bills, deferred compensation could make you RICH. And for many that came to be true. Unfortunately, news reports tend to focus on the people who had very good jobs and became what was once termed “dot.com millionaires.” Five thousand options to buy GE acquired on January 1, 1990 made you a millionaire a decade later. Tesla stock never reach $3.00 a share until 2013. And, until the Covid shutdown it had never cracked $70.00. Less than two years later Tesla shares cost $400. Three thousand options at $70 made you a millionaire by November 2021.
These are publicly traded companies. They are supposed to be less volatile. But after kind of crashing in 2022, Tesla has doubled so far in 2023. For unlisted businesses (not on an exchange) the volatility can be crazy. Pharmaceutical startups and those in the tech industry have been among those most reported. We have had clients who had options at pennies a share who have sold them for $80.00 a share when the company went public.
For those who are the holders of these employer issued options to acquire stock there seem to be two approaches. To generalize (always a danger) there are the research pharmacist types. They look at options and their cousins, stock units, as a kind of funny money. Much as with holders of cryptocurrency, they understand that these investments could someday make them rich, but they don’t really grasp how. Meanwhile, they will plug away at getting approval of the drug they are researching. Some of these employees don’t really pay attention to the multipage “agreements” they sign to obtain options or to participate in these restricted or performance unit plans. Suffice to say these are not easy documents to digest. There are vesting clauses, acceleration clauses and clawback clauses.
The second approach to these forms of deferred compensation* is that usually found by folks who work in the finance and marketing side of the business. In those households, stock price or possible “offering price” for stock not yet on the market is often a daily conversation. We live in an age when many senior executives are searching for employment based not on the salary or regular compensation offered. They have little interest in 401(K) matches or even traditional deferred compensation packages (non qualified retirement plans). They want 200,000 options at a dime (10 cents) a piece because if the stock goes public at $70.00 they are looking at a $13,800,000 payday. As Ira Gershwin put it: “Nice work if you can get it….”
For awards of this kind which are unvested or involve stock not yet readily traded in open markets, the value is like an iceberg. You can’t really measure it with accuracy. The investment industry uses a method known as Black-Scholes, named for two economists who developed it. It has been around for half a century. It’s complicated. But most importantly, not many courts feel confident in using it because it is formula based rather than reflective of real transactions.
So, assume you are involved in a divorce and you don’t really understand your spouse’s compensation. You may live in our Type B household, the one where these assets and “going public” or selling to “private equity” are tossed about freely. Still, what does this mean to you? If you live in the Type “A” house, you may have no idea whether your spouse has any of these assets, let alone how they affect the value of the marital estate you may be dividing.
- You Need to Know
These kinds of assets could be an insignificant part of the marital estate you will divide. On the other hand, if you and your spouse divide $500,000 to $1,000,000 of home value, retirement accounts, common stock portfolios and “stuff” only to learn that your ex later cashed in 200,000 options when her employer went public you will not be happy to learn that the options vested a year after your divorce and the payoff was a pre-tax $14 million. It’s your job to make certain this stone is “turned” before you begin any mediation or negotiation. Divorce statutes are designed to provide disclosure as part of the judicial process but there are many ways to dodge that.
How do you find out? If you have filed for divorce, make certain your lawyer has issued a subpoena to your spouse’s employers for (a) all plans in which the employed spouse has participated during the marriage and (b) all agreements between the spouse and the employer. This is not a “do it yourself” operation. You really do need skilled counsel to do this properly; asking the right questions.
- You Need to Understand What Comes to You.
Even if your spouse hands over the documents just referenced above, you don’t know if they are the “current” plans or “complete.” That’s why the smart move is to get them from the employer. The employer has a legal obligation to provide everything you legitimately request and could be sanctioned if they try to provide cover for your spouse by hiding things. Realize as well that many of these plans are amended over time, some from year to year. You don’t want to be evaluating stale data or agreements. It’s a waste of your time and legal investment (what you pay the lawyer and experts).
When the documents you requested come into your attorneys’ hands you need to have a high priority meeting with the attorney to understand his/her analysis of what forms of non salaried compensation exist. If you don’t leave that meeting with high confidence that you have complete documents and your counsel completely understands them, it may be time to find an expert. Some lawyers may welcome this involvement. Some may bristle that you don’t trust them. That’s a poor answer and its merits a few follow up questions to the quarrelsome attorney:
“What happens to these units or options if my spouse is terminated or quits?” “Suppose she is fired to cause?”
“What happens if my spouse’s employer is acquired by another company or business. Like when Elon Musk bought Twitter?”
“Can these assets be transferred by my spouse to me and how does that affect vesting and/or tax consequence?”
The problems associated with termination are mostly self-evident. But many companies have something called a “poison pill” built into their employment agreements. These provisions often trigger larger than contracted payouts if a company is acquired. Pfizer’s acquisition of Wyeth Laboratories in January 2009 caused huge numbers of compensation arrangements to vest, not because the time for vesting had occurred but simply because Wyeth was acquired.
If your lawyer can’t facilely respond to these questions about termination and acquisition, you need an expert unless it appears that the money involved is small. You don’t need a fancy expert to evaluate what will happen to the 1,000 options that exist at $40 a share when the stock is trading for $60. The fees could consume the asset you are quibbling over. But, again, caution is the watchword.
- Beware the issues of the “Job Hop” and the “Acquisition Bounce”
This is a legal draftsman’s quagmire. The typical option or stock unit document says: “If you leave before your options or units vest, you lose them. Same hold if employer fires you for cause.” So, your spouse has 10,000 performance units that will vest next year. If you are separated when they vest, there may be a fight over how to divide them. But’s let assume you and your spouse agree that when they vest you will get half (50%) of the value net of income taxes. They will vest and payout in two years. After the first year your now ex-spouse goes job shopping with a new employer. The new employer is ready to make an offer. Your ex says: “Don’t forget, if I quit my current job to come with you, I forfeit $50,000 worth of performance units that will vest in a year. I need to be made whole.” Many prospective employers will respond “OK, we will give you $70,000 of performance units in our company (new employer) if you come to us and stay two years.” Or “Well give you a $50,000 signing bonus to join us.”
That kind of deal is made. Your 5,000 performance units went down the well the moment your ex spouse quit the job he had while married to you. But what about the new units or bonus he got in exchange for giving up the old ones at the former employer. This is a tough issue and there is no slam dunk answer. Technically, the new units were acquired after your divorce and they were not acquired in exchange for the old units, although it certainly “feels” that way. Or, your ex could tell his new employer not to give him “performance units” but stock options instead. Then it even looks like these are different animals in the compensation kingdom.
The other challenge is that it is the 2008 problem. Your spouse works for Wyeth. In 2008 you make a deal on the options based upon what was vested when you separated. It’s fine because you got a healthy percentage of what was vested rather than fight over how to split options that vested after separation. But then January 2009 comes along, and Pfizer announces the acquisition. That transaction triggered a clause in the Wyeth plans that had all unvested options instantly vest. This post separation event effectively doubled the value of his options. But what about your options-the ones assigned to you in your 2008 property agreement? Again, this is dicey and there is no clear answer. But the money involved can be significant.
- Are these things “assets” or “income?”
Glad you asked. When things like stock equivalents vest they are undeniably “income” under the federal tax law. So that when $10,000 worth of performance units vest the employee has to report the income and pay the relevant taxes. But once the taxes are paid, the balance is his/her asset. Pennsylvania divorce case law says that you can treat the vested property as income for support or an asset subject to distribution; but not both. That’s double dipping the same asset. A choice has to be made. You need to ask your lawyer which approach is best for you. In most cases, the answer will be “asset” and not “income.” But all rules have exceptions and the differences in approach can be significant
In 2008 when the stock market fell hard, there was discussion that these forms of compensation might sunset. But companies love them, and the stock market has been generous in providing great returns on stock based compensation. So, they appear to be part of the asset landscape for some time to come and they merit careful consideration in any equitable distribution scheme. Step 1 is finding out if they exist in your world.
