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Stock Options and Divorce in Community Property States: Who Gets What?

Stock Options and Divorce in Community Property States: Who Gets What?

May 03, 2024

Many employees receive stock options from their employers as an incentive to encourage loyalty, reward past and future performance, or maximize the company's tax advantage. However, many issues can arise during asset division for employees going through a divorce in community property states.

Here is what to expect in such situations.

How Are Stock Options Treated in a Community Property State?

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), any assets obtained when a couple is legally married are co-owned, except for gifts and inheritance. Upon annulment, such assets get split equally between each spouse.

The rule also applies to stock options acquired or vested during the marriage. You can override the state rule with a prenuptial agreement stipulating asset distribution after a divorce or the treatment of certain assets during marriage. The stock options remain yours if you had acquired them before marriage, but the spouse is entitled to 50% of the stock value when vested during the marriage. Your spouse is also entitled to 50% of earnings of stock options acquired during marriage but vest after divorce.

Brebaugh v. Deane

The Arizona Court of Appeal ruled in favor of the defendant in the Brebaugh v. Deane case, where the dispute was on classifying unvested stock options that the plaintiff received during the marriage but remained unusable until after they filed for divorce. In this case, the reason for awarding the stock options also held water in the court's decision.

Brebaugh, the plaintiff, claimed that only the vested stock options awarded for past performance were community property, but the unvested stock options were his company's incentive to increase employee commitment, making them separate property. Deane, the defendant, argued the contrary, stating both stock options were a performance reward. The court ruled in the defendant's favor because the plaintiff failed to prove beyond reasonable doubt the reason behind the equity compensation.

Texas Family Code

Texas inclusion of the Family Code Section 3.007 on September 1, 2005, to their community property state rule eliminates the need for the court's intervention in vested or unvested stock options during marriage with detailed formulas for calculating how much of the vested or unvested stock options (called a tranche) is separate property before and during marriage.

The Formula for Calculating Options Granted Before Marriage that Vested During Marriage 

Percentage of grant that is spouse's separate property = Number of days between the grant date and marriage date divided by the number of days between the grant date and vesting date.

Formula for Options Granted During Marriage That Vest After Divorce

Percentage of grant that is spouse's separate property = Number of days between divorce date and vesting date divided by the number of days between the grant date and vesting date.

Regarding incentive stock options (ISOs), the intention for reward matters. If the ISOs were awarded based on past performance during a marriage, it counts as community property. If the incentive was for future performance, it falls under separate property. However, ISOs have employee-dependent tax advantages, which get disqualified when a non-employee exercises them. You can retain the tax advantages by converting ISOs into non-qualified stock options (NQSOs), which have a different tax treatment. 

If one spouse starts a company during marriage and awards themselves stock options, the asset becomes community property. Upon divorce, the other spouse gets 50% of the stock options. As a founder, you may lose voting rights after the transfer, lose the majority share in the company, or risk your spouse selling the options to your competitor. Your company has a right of first refusal and can buy the stock options before outsiders claim them. You can avoid these stock option transfer complexities with a prenup, postnup, separating marital and non-marital assets, and formulating a buy-sell agreement.

How Does a Court Determine Whether My Soon-To-Be-Former Spouse Should Receive Any Part of My Stock Grant?

The court first determines if the marital property includes the unvested or vested stock grants and was acquired during the marriage. It then establishes the stock grant portion it considers marital property, transferable to your ex-spouse.

The court also reviews your company's stock plan to determine if the specified grants are transferable to non-employees by court order or under another legal plan. If the stock options are untransferable, the court will set up an alternative structure or substitute the property with another of equal value during the division.