Options — Valuation, Taxability, and Alimony

Over the past decade, options have been widely used as an incentive tool to lure an employee into a company and/or keep valuable employees from leaving. Employers love them because they are generally cashless compensation. I have many tax clients that have become far wealthier due to their annual option awards than their pension plans and/or regular savings could ever make them. I had one client come to me for tax planning who had 100,000 options shares with an exercise (strike) price of 50 cents a share. These were awarded at a time when his employer was almost bankrupt. His regular salary had been between $100,000 and $120,000 per year. The stock in 2000 hit $160 a share and the options were worth more than $16,000,000. There was very little chance that he could have amassed this kind of wealth on his regular salary.

Soon after, my client’s administrative assistant came to see me. She makes $35,000 a year but had 15,000 options shares at 50 cents a share. Need I say more? That’s $2.4 million for the secretary!

I have many examples of clients becoming very wealthy due to options. Recently, I have also had many clients who were almost worth a lot due to their unvested options — only to see their employer’s stock price plummet and their options no longer in the money. This is especially true with very volatile high tech companies. Such valuations need to be handled carefully because these stocks may have as much upside potential as downside risk.

The purpose of this article is to educate readers about options, how they are valued, their taxability and impact on alimony.

Definitions:

• Option — right (not obligation) to purchase shares of stock at a specified price
• Strike or exercise price — the specified price at which one can buy the underlying stock
• Vested shares — the number of shares allowed to be exercised at any given time
• Short sale — the act of selling a stock before it is bought. The stock must be bought back at a later date
• Spread Value — difference between the option exercise price and the price of the stock
• Volatility — a measurement of how much a stock goes up and down in short periods of time
• In the money — the stock price exceeds the exercise price of the option

Why Options are so Valuable?

Options are valuable in several different ways. One of the most basic elements of value is that the holder theoretically holds stock that he/she doesn’t have to pay for, and therefore there’s value in the leveraging of those shares. The following is an example of option holder vs. stockholder value.

Assumptions

1. Owner has a five year option to buy 1000 shares of stock in ABC Corp for $10 – a total exercise cost of $10,000
2. Assume the $10,000 of exercise cost is invested in risk free investments for 5 years at 5%
3. Assume that the stock price increases 12% a year through year 5

By leveraging the investment through the options, the options holder realized a greater value because of the ability of not having to lay out cash upon grant of the option.

The above illustrates the potential value of just one aspect of holding a long-term option.

Another benefit (for illustrative purposes only) is that a person who trades a stock on a regular basis can use the open market to hedge his option in the stock. Without belaboring this issue I offer the following example:

Assumptions

1. Owner has a five-year option to buy 1000 shares of stock in ABC Corp for $10
2. Through a series of good news, the stock goes up to $20 (this is common with a volatile company) and the holder sells short 1000 shares of stock and receives $20,000. This is commonly called a hedge. At this point the holder cannot lose any money (but has theoretically capped his/her profit on the options except as follows:
   The company stock price recedes back to $10 and the holder covers his short (buys back). The holder has just earned $10,000 and still owns the option, which still has value. Therefore the option has “put” value upon hedging. A put is a bet that the stock will go down.

This type of trading (hedging) is not always prohibited under an option agreement. Where there is a high level executive however, there is generally a restriction on shorting his/her employer’s stock.

Valuing Options

There are over one hundred variations and formulas on valuing options. The most widely used method of valuing options is the Black Scholes method. In 1997 the creators of this method won the Nobel Prize in economics. The calculation is very complicated, but simplified by the use of computers and various Internet sites and financial tools. The basic components for the calculation are:

1. stock price
2. exercise or “strike” price of options
3. risk free rate of return (T bills) commensurate with the duration of the option
4. volatility of the stock (see next section)
5. dividend yield (if the company pays dividends)
6. duration of the option

The above will yield a theoretical value of the options based on the Black Scholes model when input into a Black Scholes formula. One can be found on the Internet at www.numa.com. This model has been tested against a calculator that a client of ours uses with their subscription to Bloomberg. Our client manages a $250 million hedge fund that our firm audits.

Volatility and Time Components

The volatility of a stock is its most complex component, but feasible to calculate if one has the right tools. Volatility is one of two value drivers of an option (the higher the volatility the higher the value). Volatility is calculated by taking the periodic percentage changes in the historical stock prices and calculating the standard deviation of the changes. The length of the option is the other value driver (the longer the option, the more valuable it is).

Call Value and Put Value

It is important to remember that a stock’s option value works both ways. There is value to a call option where the bet is the stock will go up, and there is value to the put option where the bet is that the value will go down. The employee option is always a hope that the stock will go up — unless the holder is a savvy investor who is hedging (shorting) and betting the stock will go up or down at specified timing cycles. This was previously discussed.

Put value calculations have been offered as an alternative way to measure marketability discounts because marketability discounts are related to the potential negative value that may occur as a result the amount of time it takes to sell an interest in a non marketable company.

To illustrate, consider how the market has come down in the past year. The most volatile stocks came down the hardest (and fastest). The best example of this is owning stock in a company like Priceline.com. Let’s say you owned stock in Priceline.com and a private company similar to Priceline.com. On May 1, 2000, Priceline was $64 a share and on October 1, 2000 the stock was $12. If on May 1, 2000, you decided to sell your 1% interest in Priceline, you could call up your broker and execute this trade within hours, if not minutes (not losing much). With your private company ownership it would no doubt take months if not a year to sell. There is a potential negative value to the lack of marketability. Time and time again studies have shown that marketable securities and restricted securities have a value difference due to the disparity in their respective marketability. And what better way to measure potential down value than a put options calculation. At least that is what some experts believe.

The Taxability of Options

There are two basic types of options granted to employees — Incentive Stock Options (ISO) and Non Qualified Stock Options (NQ).

NQ’s are taxed at the time of exercise as wages subject to regular and state income taxes as well as wages for FICA and Medicare purposes. The top tax rate combined is 46% after taking into consideration the federal tax saving of the state tax deduction. This tax is applied whether the stock is held or sold at the time of exercise.

ISOs are a bit (OK — much) more complicated because they are not taxed at the time of exercise for regular tax purposes, but are taxed for Alternative Minimum Tax (AMT) purposes. If they are sold within a year of exercise, they are taxed as ordinary income (wages) but are not taxed for FICA and Medicare purposes (combined top rate of approximately 45%). Therefore if sold within the year, the spread value is taxed at ordinary rates as ordinary income, the incremental value from date of exercise is taxed as short-term capital gains. If sold after one year of exercise, the entire gain (sale price less option price) is taxed as long-term capital gains (20% federal vs. up to 40% federal on ordinary income).

The fly in the ointment for ISOs is the AMT. Even though the ISOs that are exercised and held are not taxed for regular tax purposes, they are subject to the AMT. Without killing you with the mechanics of this, in most cases where there is a significant spread value at time of exercise (over $75,000) there will be a tax to pay due to the AMT. The tax rate is either 26% or 28% depending on how much other income there is on the person’s tax return. The amount of AMT that is attributed to the ISOs does get credited in the year the stock is sold. In reality, the big difference between the held ISO stock and the NQ is a 12% tax rate differential on the exercise spread value.

Options in Equitable Distributions

Without giving an opinion on which method works best and most equitably, obviously life would be easy if the options could be split with the spouse. But as most of us know, options are not assignable to a spouse — nor can they be QDRO’d.

The following are some of the alternative ways I have seen option splitting handled:

1. The value at a given time is split and the optioned spouse pays a lump sum settlement. This is generally done post tax. This occurs when the spouse does not want to ride with the risk of the stock. I have also seen some spouses make bad decisions. In one case it cost the spouse over $25 million. But in some other cases it turned out to be the correct move. Attorneys must be very careful to cover their hides in these cases.
2. The non-optioned spouse has a quasi trust set up where he/she controls the decision on his/her divided share of options. When the options are exercised and sold, the net after tax amount is given to the spouse controlling the decision by the optioned spouse under the terms of the agreement.
3. The vested options are liquidated and the unvested portions are dealt with similar to items 1 and 2 above.

Options and Alimony Considerations

There is a strong argument that annual awards of options can be considered as compensation for the purposes of determining alimony. This argument probably fails if the following conditions do not exist:

1. the employee is a long-time employee of the employer
2. the employee is granted options consistently year after year
3. the stock of the company has a track record of increasing
4. the company is and has been publicly traded for years

Let’s look again at the reasons for granting options to employees of public companies.

1. it provides a reward for past service or coming on board
2. it provides an incentive to stay on and grow with the company through vesting
3. it is a basically cashless compensation for the employer

Based on the above, if the spouse with the options received grants for new options year after year and his or her employment is long-term, then there is an argument that the value of the options granted are added to salary (on average) for the purposes of alimony.

The first argument we hear when proposing the above is that there is double dipping because the options are valued at the time of complaint or later and divided in some fashion. The counter to that argument: suppose a person is earning $150,000 a year in base salary and consistently receives bonuses totaling anywhere from $50,000 and $75,000 a year. Suppose further that most of the after-tax bonus is saved and invested. Therefore, for alimony purposes, the salary would be between $200,000 and $225,000. If the investments mostly saved through bonuses (because they were saved — weren’t needed to maintain lifestyle) at the time of the complaint were worth $500,000, that amount would be subject to division. In this case, what is the conceptual difference between receiving cash bonuses and saving same and receiving annual awards of options? In a way the options are forced savings and most of the time ultimately amount to a lot of money. Therefore, shouldn’t the value of the annual option awards be added to salary for purposes of alimony?

The second and more esoteric argument is, how are the option awards valued? Again I refer to the Black Scholes model, because it is the most widely accepted measure of value. However, the counter to that argument is that when using an options model, it assumes that the option is freely tradable and can be hedged to maximize the theoretical value. Although this is a valid argument in some respects, it does not counter the argument that these annual awards have value and that the Black Scholes model is the most widely accepted valuation model for option valuation.

In conclusion, it is pretty safe to say that options will remain a popular compensation tool for many years to come. They will always be a subject of controversy when it comes to splitting them up and/or valuing them. Using annual option awards’ value and adding then to cash salary in alimony cases will be a subject of many debates.

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Leonard M. Friedman, CPA/ABV, CBA, is a partner and Director of Matrimonial and Valuation Services at Rosenberg Rich Baker Berman & Company, P.A., with offices in Bridgewater and Maplewood, New Jersey. He has devoted much of his professional career to business valuation and complex corporate and individual taxation. He is a member of three business valuation organizations including the Institute of Business Appraisers where is he one of only 350 CBA designees in the country. He also specializes in hedge-fund accounting and taxation and mergers and acquisitions. Mr. Friedman has written several articles and book chapters in several publications on the topics of divorce taxation, general taxation, and business valuations. He also has given speeches on the topics of corporate and individual taxation, stock option valuation, and business valuations.