Equity-Based Compensation: When is it included as Income for Support?

Employees may receive stock options, restricted stock units (RSUs), or performance stock units (PSUs) as a part of their total compensation package. Are these grants an asset, since what they receive upon vesting/exercise is stock, or is it income to the employee? Can it be both?

What is a stock option?

A stock option gives the holder the right to buy the underlying common stock at the exercise price set on the date of grant. So, if the exercise price is $1, and the stock is worth $5, then the holder can buy a $5 stock for only $1, with the net gain being $4. This is called being “in-the-money”. Stock options are not typically exercisable on the date of grant. Instead, they can only be exercised after they vest, typically over a number of years (typically between three and five years). The stock option grant notice to the employee will specify the vesting schedule.

When is a stock option taxed?

A stock option is taxed when it is exercised in exchange for stock in the company, even if the stock received on the exercise is not sold. For privately held companies, the stock option is rarely exercised unless there is a sale of the company, the company goes public, or the period to exercise the option expires. The reason is that there is typically little to no ability to sell shares of a privately held company.

When is an RSU taxed?

Restricted stock units (RSUs) are shares subject to SEC Rule 144 that have restrictions as to when they can be sold. RSUs are taxed when they vest and are no longer subject to forfeiture. The value of the common stock at the time of vesting is included on the employee’s W-2 and is taxable. If the company is private, the vesting creates a taxable event with no cash flow to pay the tax due, because the employee has little or no ability to sell the shares. For public company RSUs, upon vesting, typically the employer withholds and sells shares to pay the taxes due upon the vesting, with the employee receiving the net shares after-tax. The employee then can choose to sell the shares or hold them for investment.

What is a Performance Stock Option?

With a Performance-Based Stock Option, the stock option only vests upon specific performance milestones being met. With this type of option, the board is attempting to tie the vesting of the option to the performance of the employee. The stock option grant document will identify what event needs to occur for the stock option to vest, such as the achievement of a certain revenue or profit milestone, or FDA approval of a drug, etc. Performance Stock Options are taxed when they are exercised.

What is a Performance Stock Unit (PSU)?

A PSU is a stock grant, not a stock option, that is awarded only if certain specific performance milestones are met, similar to a Performance-Based Stock Option. The difference is that there is no exercise price, so the employee is granted the stock once the performance metric is met. PSUs are taxed when they vest and are no longer subject to forfeiture.

When is a stock option considered income per FC §4058?

Per Macilwaine (filed Aug. 22, 2018), the available compensation from stock options (the market price less the “strike” price) should be included in gross income, once there are no legal restrictions (i.e., insider trading rules, etc.) on the employee-parent’s ability to exercise stock options and sell his/her shares. Thus, when the options vest, they may be included as income, assuming the market price is greater than the strike price; otherwise, the options would be considered worthless.

When is an RSU or PSU considered income per FC §4058?

An RSU or PSU is considered income for child support purposes when it vests, assuming the stock is no longer restricted (following Macilwaine), consistent with IRS treatment, whether the company is public or private.

What if the company is private?

For private companies, there may be no ability to sell the shares; thus, an argument can be made to the Court to exclude the income from the RSU or stock option vesting. In fact, typically, stock options are not exercised in a private company until a liquidity event occurs due to the inability to sell shares to pay the tax on the exercise. For a private company, a liquidity event would be either a sale of a portion of the equity of the company to a private equity or other buyer, a sale of 100% of the company, or, in some rare instances, an initial public offering.

How do Capital Gains on the Sale of Stock Affect Income for Support?

Per Macilwaine:
“However, in the support years after vesting, John’s options—or, if actually exercised, sold and the proceeds reinvested—would constitute assets which have the potential to generate income for child support purposes. (Cheriton, supra, 92 Cal.App.4th at pp. 290-292; see also Pearlstein, supra, 137 Cal.App.4th at p. 1375 [while value of unsold asset received in connection with sale of business does not constitute income, actual net gain from sale of asset, provided it is not reinvested, constitutes income for purpose of child support]; In re Marriage of Destein, supra, 91 Cal.App.4th at p. 1394.)  If he exercised and sold options during a subsequent support year, and spent (rather than reinvesting) the proceeds, the net annual gain would constitute income. (Pearlstein, at p. 1376.)”

Based on the cases quoted in Macilwaine above, if employee stock or stock options are sold and reinvested, it appears they would be treated as an asset; therefore, if reinvested into publicly traded stock, the dividends would be considered income for support. Or if the proceeds are reinvested into real estate, the rental income would be considered income for support. 

On the other hand, if the stock or stock options are sold and the proceeds are NOT reinvested, the capital gains on the sale would be treated as income for support. Typically, we see this as part of an Ostler & Smith calculation. 

Conclusion

For stock options (either time or performance-based), in publicly traded companies, the available compensation should be included in gross income, once there are no legal restrictions (i.e., insider trading rules, restrictions, etc.) on the employee-parent’s ability to exercise the stock options and sell his/her shares.

For RSUs and PSUs, the value of the common stock at the time of vesting is included on the employee’s W-2 and is taxable and would be included as Income for Support at the time of vesting.

Important to Note

Care should be taken not to divide the community property stock options/RSUs/PSUs (using Nelson, Hug or Harrison) among the parties and then award support on the income from the same options/RSUs, to avoid double counting.

Also, it may be appropriate to use an Ostler & Smith bonus calculation for the separate property stock options/ RSUs/PSUs vest.