Stock Options Part 3: How do stock options become income?

Posted by Brian Waller | Sep 23, 2021

As explained in our first post on this topic, stock options are considered income for the purposes of child support. There are a few hurdles between an employee being granted stock options and turning those stock options into income. In our second post, we explained the mechanics of stock option grants to employees, including vesting. The final step is the actual stock transaction that converts the employee's stock option into real shares of stock or cash. This is referred to as an "exercise" of stock options. 

What does it mean to “exercise” stock options?

Exercising stock options has nothing to do with physical activity as the name may imply (and I may or may not have spent way too long searching for a picture of someone exercising in a sweater vest for this post. If you hear someone say you can find anything on the internet, don't believe them). Exercising in this context refers simply to transacting or purchasing the stock options that were granted after they have vested. After waiting for the stock options to vest, an employee has several methods to consider: 

  1. Cash Purchase (Exercise and Hold): Simple. The employee uses their own cash to purchase the options, and then they own shares of stock in the employer. In our example from Part 2, the employee would pay $250 out of pocket to exercise the options and would own 250 shares of the company's stock. This is probably the least common way of exercising options because the employee has to come up with cash that they pay to the company for the shares of stock, and then they bear the risk that the stock will increase or decrease in value from that date forward.
  2. Exercise and sell enough shares to cover the cost of the options (Exercise and Sell-to-Cover): Similar to method 1, but a little more complicated. Using this method, the employee would exercise their options but only sell enough of the options to cover the cost of the exercise. In our example, if the company's stock price was $10 per share, the employee would exercise all 250 options then sell 25 shares of stock (25 shares X $10/share) to cover the $250 cost of the vested options (250 options at $1.00). This is a simplistic explanation because it ignores transaction fees and taxes, but this is the concept. The broker or agent that manages the company's stock option plan can usually do this very easily for employees.
  3. Cashless Sale (Exercise and Sell): This is probably the most common. Using this method, the employee exercises their options and sells their shares in one single transaction. The employee receives (as income) the difference between the option price and the stock price. In our example, if the company's stock price is $10.00/share, the sale of the shares of stock generates $2,500 in proceeds (250 shares X $10/share), from which the $250 cost of the options (250 X $1.00 per option) is deducted. The employee would receive $2,250 of income at the time of the transaction. Again, this ignores transaction fees and tax withholdings but is just meant to illustrate the concept. 

When are stock option proceeds considered income for child support?

As the most common way to exercise stock options is cashless or "exercise-and-sell", in most cases, the income would be includable for child support purposes when the stock options are exercised and the employee receives the net proceeds. I will warn you though, this is where having an attorney who understands stock options would really be beneficial. Don't assume that your attorney understands the nuances of stock options, make sure you ask questions if you or the opposing party has been granted stock options. There are a lot of moving parts and misunderstanding any of these moving parts could mean overpaying child support on income you have never received or the opposing party may avoid providing the correct amount of financial support for their child that they rightfully should. 

As always, you can use this link to schedule a consultation with me to discuss your case. 

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Brian Waller

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