Arizona law provides for the equitable division of community property upon divorce, no matter what your total net worth. For the average American this entails dividing real property, personal property, vehicles, financial accounts, and maybe a retirement account or pension. In addition to these common assets, many high net worth individuals accumulate assets of a more complex nature, such as a business or some form of non-qualified deferred compensation. If you are a high net worth individual, this article will help you understand some of the considerations and strategies that go into dividing these less common, but highly valuable assets.
Figuring Business Value In Divorce
In order to determine the community’s interest in a business, the first question to ask is: “when was the business started?” If the business in question was built during the marriage, the community generally has an ownership interest in the entire value of the business. On the other hand, if the business was opened prior to the marriage, or funded entirely with separate money, while the community would not have an ownership interest, the non-owner spouse may have a community lien against a portion of the business’s value if the value of the business increased substantially during the marriage. In either case, it is necessary to hire an experienced business appraiser to calculate the value of the business as of the date of service.
Most attorneys simply hand the case over to the appraiser and wait for the appraiser to produce an opinion of value. At Modern Law, we understand that the appraiser’s ultimate opinion of value depends on the methodology used by the appraiser. There are three valuation methodologies commonly used by business appraisers: (1) investment value; (2) fair value; and (3) fair market value. Because each of these methodologies produces a different end value, it is imperative to establish which one should be applied by the appraiser before they begin the valuation.
Fair Market Value: The fair market value on a business is the price a willing buyer would pay to a willing seller, assuming both parties are under no compulsion to buy or sell and have knowledge of the relevant facts. The fair market value methodology provides for discounts based on lack of marketability and lack of control. For example, if a business is not sellable (there are no willing buyers), then the value of the business would decrease.
Fair Value: Fair value is similar to fair market value, but with the key difference that it does not provide for discounts based on lack of marketability or control.
Investment Value: Investment value is the value of the business to the holder. This methodology recognizes that some businesses are more or less valuable to specific individuals than they would be to others. For example, a business may create value to the owner beyond the fair value or fair market value if the owner runs personal expenses through the business.
Deferred compensation plans allow the employer to delay payment of compensation to an employee until a later date. This arrangement can be beneficial to the employee by deferring taxation until a later date when his/her rate of taxation would be expected to be lower. Contributions to a deferred compensation plan arising from an employee’s work during the marriage are subject to division as community property even if the plan does not pay out until after the marriage.
Deferred compensation plans fall into two categories: (1) qualified, and (2) non-qualified. Without knowing it, most people have a basic understanding of qualified deferred compensation plans. For example, if you’ve heard of an IRA or a 401(k), then you’ve heard of a qualified deferred compensation plan. Generally speaking, qualified deferred compensation plans meet the requirements of § 401(a) of the Internal Revenue Code and are subject to relevant federal rules and regulations such as the Employee Retirement Income Security Act of 1974 (ERISA), whereas non-qualified plans do not.
Non-Qualified Deferred Compensation
Non-qualified compensation plans are often used by corporate employers to bypass federal limits on traditional deferred compensation plans in order to attract high-talent executive personal.
Incentive Stock Options: A stock option entitles the employee to purchase a stock at a pre-determined price on a future date. To illustrate, assume an employee is granted the right to exercise 100 shares of a company’s stock after three years for the price of $20 per share. Next, assume the current value of the stock is $15 dollars per share. In this instance, the option incentivizes the employee to participate in the growth of the company because he/she reaps the benefit of any increase in the company’s stock beyond the strike price. For example, if the fair market value of the stock on the exercise date is $40 per share, the employee will have earned $2,000.
Phantom Stock Plan: Phantom Stock Plans are similar to stock options in that they entitle the holder to a cash payment based on the market value of a company’s stock at particular time. Other than the lack of a “strike price,” the key difference between a phantom stock plan and a stock option plan is that no stock or securities are actually issued. This incentivizes the employee to pursue company growth without requiring the company to issue additional shares or stock.
Stock Appreciation Rights (SARS): A stock appreciation right entitles the holder to receive cash or in-kind compensation directly proportionate to the change in value of a particular stock (usually the employer’s) over a set period of time. As a result, SARS allow an employee to reap the benefit of a stock’s appreciation without incurring the risk associated with issuing the stock outright. For example, imagine an employee is issued 100 SARs of a company’s stock to be exercised two years after the issuance date. Under this example, if the value of the stock on the issuance date was $50/share and the value of the stock at the end of the two-year period was $100/share, then holder of the SARs would be entitled to $5,000 (100*50) on the exercise date.
Restricted Stock Plans: Restricted Stock Plans award stock to an employee subject to specific restrictions and conditions. For example, stock awarded under this type of plan may be conditioned on criteria such as the employee’s performance under specific metrics or duration of service to the company. Once the specified criteria are met the stock “vests” and the stock becomes unrestricted. Upon termination, the employee is only entitled to the vested portion of the plan.
Non-Qualified Stock Options: Non-qualified stock options operate the same way as incentive stock options, but have less favorable treatment under the relevant tax code. The key difference is that non-qualified stock options can trigger a taxable event upon transfer whereas incentive (qualified) stock options only trigger a taxable event when they are exercised. This is important because it can be argued the options become “transferable” upon vesting because they are not subject to loss.
Tax Liability, Offsets and Apples
One of the most crucial aspects to consider when dividing deferred compensation assets is how the associated tax liability is assigned to the parties. Under the Internal Revenue Code § 1041, transfers of property related to a divorce are generally tax-free. This applies to vested assets and unrestricted stock, but not necessarily to unvested assets. Unvested assets include non-qualified employment benefits, and employment benefits that are subject to substantial contingencies at the time of transfer. Thus, while the tax implications of dividing vested assets are relatively straightforward, determining the tax treatment of unvested and non-qualified benefits must be done on a case-by-case basis and can become complicated.
As a general rule, the spouse receiving the property should bear the tax liability associated with its use or exercise. For vested assets, the receiving spouse is responsible by default for any income tax associated with the property. However, the employment tax burden, which is typically calculated using the W-2 wages of the employee spouse, is not attributed to the receiving spouse by default. A well-crafted settlement agreement should specify that the receiving spouse is responsible for all of the tax liability associated with the transferred asset, not just the income tax liability.
Despite the general rule, even if the transfer of unvested rights and non-qualified benefits does not result in a taxable event upon divorce, an argument can be made that the employee spouse should be liable for the tax upon the subsequent taxable event. For example, the Ninth Circuit Court of Appeals held a personal injury attorney who transferred half of an un-matured contingency fee upon his divorce was liable for the associated taxes upon maturation. This means the attorney was stuck with the tax bill on the whole contingency fee even though his ex-spouse received half.
There are three ways you can protect yourself if your case raises substantial tax concerns. First, avoiding the transfer of unvested rights or non-qualified benefits can eliminate the problem altogether (see below). Second, a well-crafted settlement agreement with specific and intentional provisions regarding tax liabilities can go a long way toward mitigating any future issues. Finally, if the stakes are high enough, you can request a private letter ruling from the IRS and find out in advance how they will determine the tax liability associated with each transfer upon divorce and future taxable event. Obtaining a private letter ruling entails advising the IRS of the facts of your specific case and asking in advance how they will treat the situation. Private letter rulings are only binding on the specific parties associated with the ruling and do not create precedent for third-parties.
Many high net worth clients are able to avoid the headache associated with tax liability by devising a settlement using offsets to limit the exchange of unvested and non-qualified assets. For example, if the community has acquired a significant amount of liquid assets in addition to the non-liquid ones, the employee spouse can elect to offset the non-employee spouse’s share of the non-liquid assets by offering her a greater portion of the liquid assets.
Of course, in order for this to result in a fair division, care must be taken to ensure the offsets account for the cash value of the property being divided. For example, while on paper $1,000 in a checking account appears equal to $1,000 in a 401(k), the cash value of the 401(k) is substantially less than $1,000 after taxes and early withdrawal penalties are considered. Some assets, such as stock options, cannot be perfectly offset because the cash value of the option cannot be determined until the exercise date.
However, if the stock in question is relatively stable, it may be possible and reasonable for the parties to facilitate a global settlement by agreeing to use a projected cash value for offset purposes. On the other hand, if the stock in question is more speculative and volatile such that the risk is relatively low and the potential payoff is astronomical, the non-employee spouse may want to receive her shares of the stock or options instead of exploring offset options.