Compensation issues in divorce usually come up in discussions about spousal support or alimony, and child support. While child support can be pretty formulaic with well-established rules for addressing different compensation concerns, spousal support is much more variable and often is not as straightforward as simply taking a number off a pay stub.
Other compensation issues such as stock options and deferred compensation impact division of assets negotiations. These arrangements can be complex and confusing with even the recipient not fully understanding the benefit they have. If that’s the case, how is the STBX expected to decipher them and determine whether or not they have value?
Often times, with things we don’t understand, the tendency is to ignore them. We accept a reason to discount them, such as the options have no current value. Ignoring these compensation issues in divorce however is not the answer. It’s not going to create a path to making the decisions that are right for you.
Understanding these issues starts with seeking more information, becoming familiar with the more common compensation challenges and how they can be addressed. And that’s the topic for this Conversations About Divorce. Joining me is Michael Wayland, assistant professor in business at Methodist University. Michael is also a mediator with Christian Divorce Services. Listen in below (email subscribers click here) or keep reading for a synopsis.
Should The Stay-At-Home Parent Return To Work?
Barring some extenuating circumstances such as a chronic health issue or a special needs child, spousal support/alimony is generally rehabilitative in nature. That means it’s for a limited period of time and is intended to help the lower-earning or stay-at-home parent transition back to financially supporting themselves.
The fact is that sooner or later, most stay-at-home parents are going to have to go back to work. Thus the question is more one of when as opposed to if. Clients often ask if returning to work before the divorce is final is likely to lower the amount of support.
“What I always tell clients is to take a step back and think about what’s the right thing to do,” said Wayland. “What would you be doing if you weren’t getting divorced? Would you be going back to work?”
Whether you return to work or not, your STBX can ask the court to impute income to you. That means that in determining the amount of alimony, the court can make an assumption of what you are capable of earning. Returning to work and being able to provide solid evidence of the market rate for your skills could work in your favor.
And to Wayland’s point, returning to work is often a crucial element to divorce recovery and can make a significant contribution to self-worth, confidence and independence.
It’s worth noting that even if the court does impute income to you, the court can’t force you to return to work or force you to do work you dislike. You get to choose what you want to do but recognize that your choice will impact your future financial health.
Should You Start Your Own Business?
It’s not uncommon for a stay-at-home parent to consider starting their own business or even for an employed spouse to consider starting afresh. I think this is all part of the divorce territory that causes people to reinvent themselves. But the question is whether now is the right time.
Wayland evaluates this by looking to see the motivation for starting the business. Wanting to lower your income so the court would assign less spousal support and child support to you is the wrong reason and will likely also harm you financially.
“If you’re not doing it for bad purposes, it’s fine to start but you have to recognize the realities of the income,” said Wayland. “The first few years are pretty lean. There’s not a lot of money there.”
If you do decide to go ahead and start your own business, then one way to address the lower income is to build into the spousal support calculations stair steps as your business is expected to ramp up. Whether you also include step ups in your spouse’s income depends on their situation and on what you are both able to agree is reasonable.
What About Variable Bonuses Or Commissions?
When it comes to calculating alimony and child support, it’s typical to use total income. Bonuses and commissions are part of total income. But clearly, if bonus amounts change from year to year, it’s not fair to base spousal support solely on the most recent payment which may or may not be representative of the pattern of payments.
“A common approach assuming that there isn’t something different happening now, is to look at the last three years or the last five years and average it,” said Wayland.
How Do Know Self-Employment Income Is Accurate?
First, when we talk about someone being self-employed we’re referring to anyone who is generating their income. It is not specific to a particular type of entity. And remember, every business has two components: the income it generates and its value.
Next, it’s a well-known fact that self-employed people have significant discretion over their income. It’s not unusual for a self-employed person to have their business cover what are clearly personal expenses, such as having the grounds maintenance crew maintain both the office landscaping and home landscaping.
While Wayland says you could take an average of income over three or five years just as you would for someone with variable compensation, he prefers to get to what he calls ‘owner’s discretionary income.’ That’s basically the amount of money you would have as the owner of the business to spend. That’s going to entail reviewing the expenses of the business.
“We have to get to not just what they say on paper they make but what do they really have as owner’s discretionary income,” said Wayland.
What About Stock Options?
Very simplistically, a stock option gives the holder the choice to buy the stock at a certain price. If the stock price goes down, then you wouldn’t bother with the option. If the stock price goes up, you’d exercise the option, buy the stock and then sell it so you can profit from the difference in price.
“I think there is value in having the option even if it has zero current market value,” said Wayland. “You don’t have to actually buy the stock, you just want to see if it goes up and if it does you exercise the option.”
Wayland recommends valuing stock options using the ‘Black Scholes‘ method which is based on nuclear physics and is accepted by the IRS and major corporations. To run the calculation yourself you’ll need:
- Stock price: what is the stock price today
- Exercise price: what is the price that the option allows you to buy the stock for
- Time to maturity: how long do you have to wait until you can exercise the option (buy the stock)
- Annual risk free interest rate: the current interest rate paid on government bonds
- Volatility: simplistically, about what percent does the stock fluctuate up and down in the stock mark
And it’s worth running the calculation (or getting someone else to do it for you) just to find out if this is something that needs to be included in the division of assets.
“Even if it has zero intrinsic value today, there is value in simply having the option,” said Wayland.
Stock options typically cannot be transferred between an employee and their spouse so once you have a current value of the option you can use other assets to balance that in the overall division of assets.
The value of the option will change over time, as the stock price changes so another approach would be to agree how the proceeds of the stock option will be divided when the option is eventually exercised. While such an approach does address some of the uncertainty around the proceeds of a stock option, pushing the division off into the future creates other risks such as the employee leaving the company and losing the stock options or the company going under. This is where you have to know what your risk tolerance is and assess how much risk your STBX presents.
How Is Deferred Compensation Handled?
Deferred compensation falls into two broad categories: qualified and non-qualified. Qualified plans are arrangements like 401(k)’s and pensions that have been approved for special treatment by the IRS. Given that qualified plans have to meet certain IRS conditions, how these get handled in divorce is pretty well-established.
Non-qualified deferred compensation plans have no set format and they can be very creative. Typically you can get a non-qualified plan valued but it depends on how it’s structured.
One example of a non-qualified plan is a ‘Rabbi Trust.’ Basically, this allows an employee to set aside an amount of compensation. It stays as an asset of the company. Then at retirement or other defined event the employee is able to collect the deferred compensation, sometimes with interest.
“The risk is that if the employer goes out of business then it is the employer’s asset and you can lose the whole thing,” said Wayland.
Similar to stock options, deferred compensation plans are not transferable so that means a division has to be accounted for through other assets. You also have to decide whether to agree on the division of the deferred compensation account at the time of the divorce or at the time of payout which will depend in large part on the stability of the company and your own risk tolerance. The risk with a Fortune 500 company like Pepsi for example is very different from a startup.
Pay Attention To Your QDRO
A Qualified Domestic Relations Order is needed to divide any Qualified compensation plan such as a 401(k) or a pension plan. Wayland says the most common mistake he sees is people not understanding what goes into the QDRO.
For example, one way of dividing the pension is a ‘shared interest’ and this means when the pension owner retires and starts to draw the pension, an agreed portion is paid to the former spouse.
Contrast this with a ‘separate interest’ under which, the interest in the pension is divided at the time of the divorce and each spouse will start drawing their interest when they retire. The difference between the two methods maybe negligible when spouses are close in age but when there is a significant age difference, the younger party could be waiting many years to receive any benefit under a separate interest division.
Wayland advises taking the time to make sure you read the draft QDRO and understand the terms. This is particularly important if your STBX’s attorney has drafted the QDRO because it’s likely the attorney will have drafted it to be as much in their client’s best interests as possible and those may not align with yours.
Are You Paid Every Two Weeks Or Twice A Month?
A very common mistake is miscalculating earnings and deductions. If you’re monthly paid, then monthly amounts come from your pay stub. If you’re paid more frequently, then are you paid twice a month or every two weeks? If you are paid every two weeks, then it means you have to multiply the amounts on your pay stub by 26 and then divide by 12 to arrive at your monthly earnings. If you are paid twice a month, then you multiply by 24 and then divide by 12.
Michael Wayland is assistant professor of Business at Methodist University in Fayetteville, North Caroline where he teaches classes in Personal Finance, Business Strategy and Business Management. Wayland is also a family and divorce mediator for Christian Divorce Services.