Characterization and Allocation of Stock Options

Stock options, restricted stock, stock appreciation rights (SARs), phantom stock, and restricted stock units (RSUs) may be granted to employees as a part of a compensation package. Generally, these type of assets have a risk of forfeiture and are not taxable until they vest.

Once they vest, the employee has a contractual right to their ownership. Vesting may occur proportionally over several years (e.g. four or five years) which is referred to as tiered or “graded vesting” or the vesting may all occur after a specific number of years which is referred to as “cliff vesting.”

Allocation of Stock Options

In a California divorce, stock options and similar assets granted during the marriage and/or partially vested during the marriage may have a community property component. Stock options that are earned partially during the marriage are allocated between community property and separate property. The foundation for the allocation is the statutory law that provides that “earnings” during the marriage are community property. If a spouse is compensated during the marriage, in part, with a grant of stock options that partially vest during the marriage, the stock options will most likely be partially community property. If a spouse’s employment during the marriage results in partial vesting of stock options granted before the date of the marriage, the options will also most likely have a community property component. The number of options allocated between separate property and community property can vary depending upon which formula is used by the court.

There are three basic formulas (Nelson, Hug and Harrison) used to allocate options between separate property and community property. Generally, the community’s percentage interest in stock options that vest after the date of separation decreases as each year lapses.

Divorce courts look to a number of factors in determining which formula to use:

  • when was the grant made
  • was the stock option granted to attract and retain the employee
  • was the stock option granted for past service
  • was the stock option granted to offset under-compensation
  • what are the forfeiture provisions
  • what are the vesting dates
  • what are the vesting provisions
  • are the stock options designed as “golden handshakes” to retain the employee
  • what was the strike price at the time of grant
  • when did the parties separate
  • when did the parties marry