Jim Reed-Divorce Related Issues

Overview of Divorce-Related Issues Involving Highly Compensated Executives and Business Owners

IndyBar Las Vegas Destination CLE The Mirage Hotel & Casino Las Vegas, Nevada October 13-16, 2011

Speaker:

JAMES A. REED
With written materials by:

MICHAEL R. KOHLHAAS JAMES A. REED BINGHAM • MCHALE LLP

TABLE OF CONTENTS I. Business Valuations and Goodwill Issues .................................................................................. 3 A. Statutory Foundation for Business Valuations ................................................................... 3 B. Practical Importance of Business Valuation ....................................................................... 3 C. Standard of Review and Burden of Evidence ..................................................................... 3 D. Practical Legal Clarifications and Methodologies .............................................................. 4 1. “Range of Values” Presented in Evidence .......................................................................... 4 2. Valuation Date .................................................................................................................... 5 3. Goodwill: Personal vs. Enterprise Goodwill ...................................................................... 7 4. Importance (or Lack Thereof) of Buy-Sell Agreements ................................................... 11 5. Covenants Not To Compete .............................................................................................. 12 6. Hearsay Issues ................................................................................................................... 13 II. Stock Options ........................................................................................................................... 15 A. Option Primer.................................................................................................................... 15 B. Stock Options as Marital Property .................................................................................... 16 C. What Are the Options Worth? .......................................................................................... 18 1. Valuation Methods ............................................................................................................ 19 2. Tax Considerations ........................................................................................................... 21 D. Division Issues: How Can the Options Be Divided? ........................................................ 22 III. Direct Stock Awards and Restricted Stock Units (RSU’s) .................................................... 26 A. Direct Stock Awards ......................................................................................................... 26 B. Restricted Stock Units (RSU’s) ........................................................................................ 28 C. Stock Awards and Divorce ............................................................................................... 28 D. Conclusion ........................................................................................................................ 30 IV. Nonqualified Retirement Plans .............................................................................................. 31 A. Nonqualified Plan Basics .................................................................................................. 31 B. Addressing Nonqualified Plans in the Divorce Context ................................................... 33 C. Conclusion ........................................................................................................................ 33 V. Child Support, 2010 Changes Affecting High-Income Earners, the “21.88% Normalization Calculation,” and “Phantom Income” ........................................................................................... 35 A. A Brief History of the Guidelines ..................................................................................... 35 B. Reliance on Gross Income, Rather than Net-of-Tax Income ............................................ 35 C. 2010 Revisions to the Indiana Child Support Guidelines ................................................. 36 D. Calculation of “Normalized Gross Income” ..................................................................... 38 E. “Phantom Income” ............................................................................................................ 40 F. Conclusion ........................................................................................................................ 40 VI. Trust and Real Estate Remainder Interests ............................................................................. 42 A. Is the Remainder Interest Marital Property Subject to Division? ..................................... 42 B. How Can the Remainder Interest Be Valued? .................................................................. 45 C. Can the Remainder Interest Be Divided?.......................................................................... 46

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I. Business Valuations and Goodwill Issues A. Statutory Foundation for Business Valuations Indiana statute guides a trial court, sitting in a marital dissolution action, to divide the marital estate in a just and reasonable fashion. See Ind. Code § 31-15-7-4, -5. There is a rebuttable presumption that an equal division of the marital estate is just and reasonable. See I.C. § 31-15-7-5. Implied with this obligation is that the trial court divide the marital property in an arithmetically-based, just and reasonable manner, in that the assets of the marital estate be valued appropriately. This includes, of course, any business interests of the marital estate. B. Practical Importance of Business Valuation In many marriage dissolutions, the parties’ ownership interest in a business is the dominant and overarching asset of the marriage. To use an extreme example, in the Bobrow case, the trial court determined the net marital estate of the parties to be approximately $25,000,000. Of that amount, however, approximately $20,000,000 was attributable to the Husband’s interest in Ernst & Young, of which he was the CEO. Bobrow v. Bobrow, 2002 WL 32001420 (Ind. 2002) (unpublished opinion). Therefore, in many cases – even in which the scale of values is much smaller than existed in Bobrow – the substantial gravitas of the dissolution rests within litigating the value of the business interest; the balance of the marital estate is comparatively less important. C. Standard of Review and Burden of Evidence A trial court has broad discretion in ascertaining the value of marital property, and the trial court’s determination of value will not be disturbed by an appellate court absent running afoul of the highly deferential “abuse of discretion” standard. Nill v. Nill, 584 N.E.2d 602, 603 (Ind. Ct. App. 1992). In the event of an appeal, there is a strong presumption that the trial court

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valued the marital property appropriately. Id. The burden is on the parties to produce evidence of the value of the marital property at the dissolution hearing, and a party is bound by the evidence he or she presented at trial. Stetler v. Stetler, 657 N.E.2d 395, 399 (Ind. Ct. App. 1995). D. Practical Legal Clarifications and Methodologies 1. “Range of Values” Presented in Evidence Indiana case law as to business valuations has developed what is named here as the “range-of-values doctrine.” Range-of-values is one of the most important legal factors in litigating a business value before an Indiana trial court. Under the range-of-values doctrine, a trial court’s determination of value will almost never be disturbed on appeal if the trial court’s finding of value is within the range of values that were presented into evidence during the trial. For example, consider the recent case of Balicki v. Balicki, 2005 WL 3071588. In Balicki, the trial court heard evidence of three expert valuations of Husband’s business, which ranged from $145,000 to $433,000. In its Decree, the trial court found the value of Husband’s business to be $400,000. Since this value was within the range of values presented into evidence, the Court of Appeals refused to disturb the trial court’s finding: “[t]he trial court’s chosen valuation . . . falls within this range and, therefore, is supported by the evidence and not clearly erroneous.” Balicki, 2005 WL 3071588 at 2. A similar analysis was offered by the Court of Appeals in Nowels v. Nowels, 836 N.E.2d 481 (Ind. Ct. App. 2005). In Nowels, Husband owned an interest in a lumber company. The trial court received testimony from Wife’s expert that Husband’s interest in the company was worth $3,550,000. Husband’s expert testified the value to be $818,000. The trial court eventually concluded the value to be $2,500,000. In affirming the value determination, the Court of Appeals reasoned that “[t]he value placed on the [business] by the trial court was within the bounds of the

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evidence presented and within the trial court’s broad discretion.” Nowels, 836 N.E.2d at 487. Thus, Nowels, Balicki, and predecessor cases stand for the proposition that a trial court has tremendous discretion, bordering on irreversible discretion, to make a finding of value on a business interest, provided its determination of value is within the range of values presented into evidence. It is unclear, in light of the range-of-values doctrine, to what extent certain interesting dicta survives from Axsom v. Axsom, 565 N.E.2d 1097, 1100-02 (Ind. Ct. App. 1991). At issue in Axsom was the value of Husband’s barbershop. The only evidence of specific value presented to the trial court was Wife’s expert witness, who opined the barbershop had a value of $30,000. The Court of Appeals reversed the trial court’s finding that the barbershop was worth $3,000, concluding that such a finding was unsupported by any evidence. However, in dicta, the Court of Appeals observed: [A]lthough the only evidence of a specific market value was [Wife’s expert’s] estimate, there is evidence that the assumption on which he relied in making the estimate . . . could be questioned. Based on the evidence, the court could have discounted the value of the business as not being worth $30,000 . . . . Thus, this language in Axsom suggests that a trial court may go outside the range of values presented in evidence, if there is an evidentiary basis to do so. It remains unclear to what extent this Axsom dicta survives in light of the seemingly clear range-of-values holding in more recent cases, such as Balicki discussed above. Or, perhaps the distinguishing characteristic of Axsom is that the trial court received into evidence only one value, which is a fairly unusual circumstance. 2. Valuation Date Frequently, many months – or even years – can pass from the date that one party files a petition for dissolution of marriage until the trial court conducts a final hearing and, later, issues

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its decree of dissolution of marriage and related orders. As this time passes by, changes in circumstances can affect the value of marital assets, including that of a business. For example, suppose a petition for dissolution is filed in July 15, 2004, and in the marital estate is a business that sells home heating oil. The case goes to trial in December 2005. To be certain, there has been tremendous volatility in home heating oil prices from July 2004 through December 2005 and, presumably, that has affected the value of the marital business interest. Thus, what valuation date should be used in determining the value of the home heating oil company? Historically, a trial court has had unfettered discretion to value a marital asset as of (1) the date that the petition for dissolution is filed, (2) the date of the final hearing, or (3) any date in between. See, e.g., Eyler v. Eyler, 492 N.E.2d 1071, 1074 (Ind. 1986). This doctrine was squarely tested, however, in Quillen v. Quillen, 671 N.E.2d 98 (Ind. 1996). In Quillen, the Husband operated a construction business. Husband “was arrested and incarcerated on child molesting charges” and, three days later, Wife filed for dissolution of marriage. At the final hearing, Wife presented expert testimony that, as of the date of filing, Husband’s interest in the construction company was worth $328,000. On appeal, the Indiana Court of Appeals concluded that the trial court’s valuation of the business as of the date of filing was an abuse of discretion because the value of the business changed “radically” after the date of separation, due to Husband’s criminal legal problems and related stigma. Quillen v. Quillen, 659, N.E.2d 566, 573 (Ind. Ct. App. 1995). However, after granting transfer, the Indiana Supreme Court affirmed the trial court’s valuation date decision, disapproving of the Court of Appeals’ intention of reviewing with a heightened standard the valuation date selected by the trial court. Quillen, 671 N.E.2d at 102-03. Thus, in light of Quillen, it is difficult to envision a scenario in which the trial court’s valuation date – provided

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the trial court selects for that valuation date either the date the petition is filed, the date of filing, or some date in between – would be reversed on appeal. There is no statutory or case law guidance in this regard, however, practitioners in this area generally follow an unwritten rule that the best valuation date for any marital asset, including a business interest, that changes in value during the pendency, is to use the most recent valuation date available provided that the change in value during the pendency is not substantially attributable to the actions of one of the parties. By way of example, if, after the date of filing, the Husband, the sole owner of a barbershop, decided to start working 6 days a week, instead of 5, and this decision, in turn, made the barbershop more profitable and more valuable, then everything else constant, the proper valuation date would probably be the date of filing, because the substantial cause of the change in value during the pendency is attributable entirely to Husband’s individual, post-filing efforts. Suppose, on the other hand, the only change in circumstances during the pendency was a decision by Wal-Mart to build a store immediately adjacent to the barbershop, thereby increasing both the value of the barbershop’s real estate, as well as its prospects for steady business. That decision by Wal-Mart, presumably, was sheer luck and not attributable to Husband’s individual efforts; therefore, a most-current valuation would likely be considered appropriate. 3. Goodwill: Personal vs. Enterprise Goodwill One of the most interesting and important business valuation cases of the last decade has been Yoon v. Yoon, 711 N.E.2d 1265 (Ind. 1999). To understand the significance of Yoon, it is important to first understand the concept of “goodwill.” A widely accepted definition of “goodwill” is the value of a business beyond the combined value of its net assets. That “goodwill,” in turn, can be thought of having two distinct components: “enterprise goodwill” is

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the portion of the goodwill that is derived from the benefit enjoyed by the business of having established relationships with customers, employees, and suppliers; “personal goodwill,” on the other hand, is goodwill that is attributable to the presence and continued existence of a particular individual (or individuals) associated with the business. To illustrate the example, suppose a group of people elect to eat at McDonald’s rather than other fast food establishments; these patrons are loyal to McDonald’s, presumably in part because they prefer McDonald’s food; they recognize McDonald’s brand name, they may visit a McDonald’s restaurant while traveling after simply seeing and recognizing the McDonald’s sign, and their continued patronage can be reasonably expected. These same patrons do not choose to eat at McDonald’s because of the presence of any particular employee that works at McDonald’s and, were the entire staff of McDonald’s to turn over, they likely would continue to patronize McDonald’s. It can reasonably said in this example, then, that McDonald’s has significant “enterprise goodwill,” but little or no “personal goodwill.” Other businesses, especially professional practices, are heavily dependent upon the personality providing the services. Suppose, for example, that Dr. Smith is a very highlyregarded pediatrician in a small community. Dr. Smith is a sole practitioner. Based upon Dr. Smith’s reputation, he is very busy and attracts more new patients that he can accept. If Dr. Smith were to sell his practice to a pediatrician that just moved to the community, but then Dr. Smith opened up a new practice across town, would we expect the new pediatrician to continue to be as busy, and to receive as many new patients, as did Dr. Smith? Probably not. We would expect that Dr. Smith would continue to be very busy in his new practice, and prospective patients that knew of Dr. Smith’s favorable reputation would seek him out at his new location, instead of opting for the new pediatrician. Because the financial well-being of Dr. Smith’s

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medical practice is so inextricably intertwined with Dr. Smith personally, it could be said that Dr. Smith’s practice had significant “personal goodwill,” but little or no “enterprise goodwill.” 1 Prior to Yoon, Indiana law did not draw a distinction between personal goodwill and enterprise goodwill, and instead the total goodwill – as assigned value by an expert – was includable as a marital asset. Yoon was significant because it drew the distinction between personal goodwill and enterprise goodwill and, moreover, held that while enterprise goodwill could be properly included as an asset of the marriage, personal goodwill could not. The Indiana Supreme Court’s stated rationale in Yoon was that personal goodwill is essentially a measure of an individual’s ability to generate future income in the business and, since under Indiana law an individual’s future income is expressly not marital property subject to division in a dissolution, neither should be personal goodwill. Yoon, 711 N.E.2d at 1269. (This distinction was critical in the facts of Yoon because Dr. Yoon’s medical practice was valued at a total of roughly $2,519,000 by Mrs. Yoon’s expert, of which 93% of that value was attributable to Dr. Yoon’s personal goodwill.) The dicta of Yoon did note, however, that personal goodwill is not entirely irrelevant, and it can be used to evaluate the future income earning ability of a party, which, in turn, can be used as a basis to deviate from the presumed equal division of the marital estate. Yoon, 711 N.E.2d at 1269. Another noteworthy post-Yoon case is Bertholet v. Bertholet, 725 N.E.2d 487 (Ind. Ct. App. 2000). In Bertholet, the Husband owned a bail bond business, but Wife was actively involved in its day-to-day operations. The trial court heard expert testimony that the bail bond business was worth $1,150,000 if Husband continued to run it, but it would be worth only

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The example of professional practices being rich in “personal goodwill” does not necessarily hold true as the size of the practice takes on additional professionals. For example, prospective clients may contact a large, regional law firm based upon the reputation of the enterprise as a whole, and not based upon the individual attorneys practicing at the firm.

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$950,000 if retained by Wife. The trial court awarded the business to Husband, finding its value to be $1,150,000. Following Husband’s appeal, the Indiana Court of Appeals remanded the valuation issue to the trial court to determine the value of the business, excluding Husband’s personal goodwill; Husband argued that, assuming the business would be worth $950,000 if Wife retained it, then the difference in values could be explained only by Husband’s personal goodwill. The Court of Appeals in Bertholet agreed with Husband, and remanded the issue for further analysis and findings by the trial court as to personal goodwill. Yoon has had two general implications for marriage dissolution litigation. First, a new but very important angle on the litigation of a business value concerns its personal goodwill versus its enterprise goodwill; to be certain, as with business valuation generally, this distinction is part science and part art. Second, stripped of its personal goodwill, most professional practices – especially medical and law practices – have very little value relative to the income generated for its principals. It is also critical that, when representing a spouse who owns a business that may have personal goodwill, to be certain to put on evidence of that personal goodwill and its value. If personal goodwill is erroneously included in the business valuation, the Indiana Court of Appeals is generally inclined to remand that matter for further consideration by the trial court if evidence of personal goodwill is in the record. See, e.g., Bertholet v. Bertholet, 725 N.E.2d 487 (Ind. Ct. App. 2000); see also, Frazier v. Frazier, 737 N.E.2d 1220 (Ind. Ct. App. 2000). However, where the record is silent on personal goodwill, the Court of Appeals seems less inclined to consider remand of that determination, deeming it a waived issue since it was not appropriately raised at trial. See, e.g., Houchens v. Boschert, N.E.2d 585 (Ind. Ct. App. 2001). In fact, to the extent that Bertholet and Frazier were immediately post-Yoon cases that seem to stand for the proposition

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that a trial court held the burden to make a personal goodwill determination and see that it was properly excluded from division, the Houchens case makes clear that this burden is not on the trial court, but on the litigant seeking the personal goodwill exclusion. 4. Importance (or Lack Thereof) of Buy-Sell Agreements Some practitioners assume that if a marriage dissolution litigant has a business interest that is subject to a buy-sell agreement, that the buy-sell value is dispositive as to the value of the business interest for purposes of marriage dissolution. This conclusion, while perhaps intuitive, is nevertheless inconsistent with Indiana law and, therefore, is incorrect. The Indiana Court of Appeals addressed this issue squarely in Nill v. Nill, 584 N.E.2d 602 (Ind. Ct. App. 1992), reh’g denied, trans. denied. In Nill, Husband was the owner of certain shares in a closely held company (“Pease”). At trial, the Pease CFO testified that Husband’s stock was subject to a buy-sell agreement and, pursuant to the buy-sell, Husband’s stock had a value of $186,431. However, Wife presented expert testimony that valued Husband’s Pease interest in a “traditional” fashion, using six variously weighted values for the stock: adjusted book value, recent sale of Pease stock to a new shareholder, two formulas based upon the buysell, and two formulas based upon the company’s goodwill. Using this method, Wife’s expert opined the value to be $523,600. After hearing this evidence, the trial court adopted a value for Husband’s interest in Pease at $350,000. On appeal, Husband argued that the buy-sell value should be dispositive. The Court of Appeals disagreed, concluding that, where a buy-sell exists it must be considered as a factor when determining the value of the business interest, but it certainly is not conclusive. Therefore, the existence of a buy-sell agreement is not the end of the story. A similar result was reached in Houchens v. Boschert, 758 N.E.2d 585 (Ind. Ct. App.

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2001). In Houchens, Wife was a 1/3 owner of an LLC. The LLC was subject to an operating agreement that included buy-sell language that calculated value as “the book value as determined by the Company’s accountant.” Houchens, 758 N.E.2d at 590. However, the trial court’s final valuation used a higher value – a value concluded by Husband’s expert – but which ostensibly gave some consideration to the buy-sell issue. So, in light of Nill and Houchens, buy-sell agreements are certainly to be considered by the trial court in making a determination of value, but the trial court certainly is not constrained to follow the buy-sell value determination. 5. Covenants Not To Compete It is well-settled law that a party’s post-filing income is generally not marital property and, thus, those funds are not subject to division in the marital estate. See, e.g., Bressler v. Bressler, 601 N.E.2d 392, 397 (Ind. Ct. App. 1992). However, it remains something of an open question as to whether the proceeds of a covenant not to compete that is executed during the marriage, but payable – at least in part – after the date of filing, is subject to the same rule of exclusion. Several pre-Yoon cases stand for the proposition that “a restrictive covenant which is signed in conjunction with the sale of a business represents the goodwill of that business” and, thus, should be included as a marital asset because “[t]he value of the goodwill of a business is included in the marital estate.” Reese v. Reese, 671 N.E.2d 187 (Ind. Ct. App. 1996), trans. denied; see also Berger v. Berger, 648 N.E.2d 378, 384 (Ind. Ct. App. 1995) (noting for remand that the “portion of the restrictive covenant which is in the nature of compensation for the goodwill of husband's [dental] practice should be included in the marital estate for distribution.)

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There have been no restrictive covenant cases since Yoon. However, in light of Yoon’s central holding – that personal goodwill is not a marital asset subject to division – coupled with the general consensus that restrictive covenants incident to the sale of a business are representative of that seller’s personal goodwill, it would seem improbable that the average restrictive covenant would be considered marital property subject to division. But it is possible to envision an argument that the payments made pursuant to a restrictive covenant represented not future income or personal goodwill (which would not be divisible), but instead represented a portion of the payment for the purchase of the business, re-characterized as future income. 6. Hearsay Issues Often times, business valuators rely upon third-party appraisal work to provide estimates of value as to business assets. For example, a business may own real estate, and the business valuation expert will rely upon a real estate appraiser to provide a value for that asset which, in turn, is a factor relied upon by the business valuator in determining the overall value of the business. To avoid hearsay objections, prudence indicates that careful litigation should seek either a stipulation with opposing counsel as to the admissibility of an underlying appraisal (even if the value of the business remains in dispute) or, if necessary, to have the third-party appraiser prepared to testify. This hearsay issues was raised on appeal in Showalter v. Brubaker, 650 N.E.2d 693 (Ind. Ct. App. 1995). In Showalter, Husband’s expert performed a business valuation that, in turn, relied upon an equipment valuation by a third-party appraiser. That third-party appraiser never testified in the trial court. However, Husband did affirm in his trial court testimony the findings of the equipment appraiser for all but one item of equipment. Because Husband provided this

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testimony that corroborated nearly all of the equipment appraiser’s values, the Court of Appeals concluded that the business valuation overcame any hearsay issues. The clear lesson of Showalter is, though, to have independent means of admissibility as to materials that may be nested within the business valuation.

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II. Stock Options Stock options can become a tricky issue in the course of a dissolution of marriage, usually arising from one (or more) of the following issues: (1) Are the stock options marital property?, (2) How much are the stock options worth?, and (3) How can the stock options be divided between the parties? A. Option Primer A stock option is simply a contractual right to buy a share of stock at a pre-determined price (usually referred to as the “strike price”). For example, a stock option might grant its owner the right to purchase one share of stock in XYZ, Inc. at a strike price of $30. If, at the time, shares of XYZ, Inc. are trading above the strike price – say, trading at $40 per share – the value of owning the option is obvious because, at the option owner’s election, he can immediately exercise the option and buy a share of XYZ, Inc. for $30, immediately sell it on the market for $40, thereby making an immediate $10 profit. As a practical matter, most individuals who own stock options acquired those options from his employer as part of his compensation (often referred to as “employee stock options,” or “ESOs”). Options are often viewed by companies as a good form of incentive compensation for employees because, typically, at the time the options are given to the employee (or “granted” to the employee), the strike price for the option is set at the then-prevailing market price of the underlying stock. So, if Husband is granted 100 options in XYZ, Inc., as of January 1, 2006, and shares of XYZ, Inc. are then-trading at $30 per share, then the strike price of the options granted to Husband will usually be set at $30 as well. (The preceding generalization notwithstanding, there was a mini-scandal on Wall Street involving improperly back-dated options used to mask the true value of the grant.) The important thing to know about the option grant is that, because

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the strike price is usually set at the share price at the time of the grant, options tend to be worthless at the time of the grant, and will acquire value – if at all – only if the share price of the company climbs following the date the options are granted. This is why options are considered a form of incentive compensation, because the ultimate future value of the options is dictated entirely by the future share value of the company’s stock. Typically, option grants also have “vesting dates” and “expiration dates.” The vesting date provides that the options may not be exercised unless the employee remains with the company for some period of service after the grant date, typically two or three years, thus providing an incentive for retention of the employee; the options are usually subject to forfeiture in the event of termination, quitting, or death. Additionally, a grant of options will typically set forth an expiration date by which the options must be exercised, if at all. Options commonly expire five or ten years after the grant date. B. Stock Options as Marital Property When a party to a divorce is an owner of stock options, there may be a legitimate dispute as to whether the options are marital property or not. Usually, this dispute arises from a question over the vesting status of the options. Suppose, for example, that Husband files for divorce on October 1, 2005, at which time he is an owner of 100 XYZ, Inc. stock options that do not vest until December 21, 2005. Is this grant of options marital property subject to division? In 1995, the Indiana Court of Appeals held that “only those stock options granted to an employee by his or her employer which are exercisable upon the date of dissolution or separation which cannot be forfeited upon termination of employment [are] marital property.” Hann v. Hann, 655 N.E.2d 566, 570 (Ind. Ct. App. 1995), trans. denied. In reaching its conclusion, the Hann majority looked at the history of Indiana law requiring property interests to be vested in

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order to be included in the marital estate. The Court viewed stock options as similar to pension benefits, and relied upon the prior law requiring pension benefits to be vested to be included in the marital estate. (A dissenting Judge Chezem unsuccessfully advanced several arguments that unvested options should be included in the marital estate, including that: (a) the options were granted during the marriage and had the employee not received them, presumably he would have received additional cash or other marital property instead; and (b) as a practical matter, the overwhelming majority of stock options do proceed to a vesting status, so there is not a substantial issue of uncertainty of vesting with options.) The Court of Appeals tackled a slightly different vesting issue in Henry v. Henry, 758 N.E.2d 991 (Ind. Ct. App. 2001). In Henry, as of the date of Decree, Husband held substantial options that were entirely exercisable, but nevertheless remained subject to forfeiture in the event of Husband’s termination. They were nevertheless immediately exercisable (if Husband opted to do so) and would not be forfeited upon Husband’s death or disability. Thus, the Court held the Henry options were, unlike those reviewed in Hann, marital property subject to division because they were immediately exercisable. The issue not yet expressly resolved by Indiana case law concerns options that are not vested at the date of filing, but then subsequently vest while the case is pending. Dicta in Hann and Henry suggest that such options are marital property subject to division. In addition, Indiana courts repeatedly find an analogue to stock options in retirement benefits. Of course, Indiana had long held that a retirement interest, not vested at filing but which vests while a divorce is pending, is marital property subject to division. See, e.g., In re the Marriage of Adams, 535 N.E.2d 124 (Ind. 1989). However, the recent Granzow case seems inconsistent with Adams and its progeny. Granzow v. Granzow, 855 N.E.2d 680 (Ind. Ct. App. 2006). The issue in Granzow was similar to that faced in Adams. The Husband was a long-time

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employee at USX and he participated in the USX pension plan. Under the terms of the plan, Husband was eligible for a substantial pension enhancement on the 30th anniversary of his employment. Husband experienced this anniversary, and the related pension enhancement vested, after the divorce had been filed but while the case was still pending. The issue before the Court was: was the pension enhancement a marital asset subject to division. The Court of Appeals held: The enhanced portion of Husband's pension, which would accrue when he reached thirty years of employment with USX, was forfeitable upon termination of employment and was not yet vested when the petition for dissolution was filed. Thus, the trial court did not err when it determined that the enhancement was not part of the marital estate subject to division. Granzow, at 855 N.E2d at 686. Because the Indiana’s stock options cases rely so heavily on the analysis in pension cases, it appeared prior to Granzow stock options that were awarded but unvested at filing of the divorce, yet which vested during the pendency, were properly included in the marital estate. However, Granzow has made that outcome less clear, and there is now legitimate legal argument to be advanced on both sides of the issue. Either way, a careful practitioner will review the vesting schedule of any options owned by either party to the dissolution, and will prudently monitor the pace of the case accordingly. As an aside, also note that, even if unvested stock options are not part of the marital estate, it may be prudent to calculate the value of the unvested options to include as part of an “economic circumstances” argument that could affect the percentage division of the overall marital estate. By way of example, the trial court in Henry was reversed because it had improperly excluded approximately $582,000 of Husband’s exercisable options from the marital estate (see discussion, above); however, the Henry trial court had used that issue as an economic circumstance to allocate the remaining property 75/25% in favor of Wife. C. What Are the Options Worth? 18

1. Valuation Methods The valuation of stock options is not an issue that has received substantial attention in the scarce amount of Indiana case law that addresses options. Presumably, as with any other valuation issue, the trial court could receive varying evidence of value and would be acting within its discretion to select any value at, or in between, the goal posts established by that competent evidence. The main purpose of this section is to set forth the method by which stock options are typically valued at the trial court level, but also to offer a valuation alternative. In most cases, stock options are valued essentially as the difference between prevailing market value of the underlying stock, less the strike price of the option. Thus, if Husband owns one option in XYZ, Inc. with a $30 strike price, and shares of XYZ, Inc. are then selling for $40, then Husband’s option is worth $10, since it costs Husband $30 to exercise the option, but he will receive $40 when he promptly sells the resulting share of XYZ, Inc. Indeed, in a footnote, the Indiana Court of Appeals has spoken approvingly of precisely this valuation method: “We would suggest that the value of [Husband’s] options be determined by the difference between the ‘striking price,’ which is typically the market price when the option was written, and the value of the stock on the day of the final hearing, times the total number of shares involved.” Henry v. Henry, 758 N.E.2d 991, 995 fn 2 (Ind. Ct. App. 2001). Thus, when options are “in the money” – which is to say, when options have value – this method is by far the easiest and probably the most common valuation method used for stock options. The more difficult valuation issue arises when stock options are “under water,” that is, when the market price of the stock remains below the strike price. Using the above methodology will always produce a value of $0 for under water options. However, the authors of this text believe that in certain instances (especially when a party to a divorce has a large number of

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options, that are only slightly under water and which do not expire for a significant period of time), the prudent practitioner will explore other valuation methods. The most common “alternative” valuation method for stock options, though one not widely used in the divorce context due to its complexity, is called the “Black-Scholes” optionpricing formula. Black-Scholes was derived by economists Myron Scholes, Robert Merton, and the late Fischer Black which, in fact, earned Scholes and Merton the Nobel Prize in Economics in 1997. Black-Scholes is a complicated equation, the details of which are beyond the scope of this article. For what it’s worth, the Black-Scholes equation is as follows:

where

We are not going to discuss this equation in any detail here (thankfully), but consider it worthwhile to take two pieces of information away from this Black-Scholes introduction: a. Under Black-Scholes, an option’s value is a function of, among other factors, the price of the stock, the strike price, and the time until the option expires. Thus, under Black-Scholes, an option that is technically under-water can still have a positive value, especially if the market value of the stock is only slightly below the strike price and there is significant time remaining until the option expires.

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b. Black-Scholes is, obviously, very complicated and one should strongly consider retaining an expert, such as an actuary with Black-Scholes experience, for assistance and/or testimony in developing a Black-Scholes valuation argument. Black-Scholes essentially attempts to quantify what is intuitive: a stock option, even if it is under water, is not entire worthless because there remains some chance that, between the valuation date and the option’s expiration date, the value of the underlying stock will increase, thereby putting the option in the money. 2. Tax Considerations As with most tax-sensitive property that is not sold incident to the dissolution of the marriage, stock options are to be valued and allocated to a party (or to both parties) based upon their fair market, pre-tax value. It is error for a trial court to value stock options with their prospective future tax consequences factored in. The Court of Appeals addressed precisely this issue in the stock option arena in Knotts v. Knotts, 693 N.E.2d 962 (Ind. Ct. App. 1998). In Knotts, the trial court awarded Husband various Lilly stock options, but allocated those options to Husband at a value that Husband prepared and which included a discount for taxes that Husband would pay in the event the options were exercised. Wife appealed, and the Court of Appeals concluded that, “[i]n the present case, the trial court improperly considered tax consequences incident to the future disposition of the Lilly stock option.” Knotts, 693 N.E.2d at 968. Compare Knotts to another case decided the same year, Hiser v. Hiser, 692 N.E.2d 925 (Ind. Ct. App. 1998). In Hiser, Husband owned various stock options that were indisputably an asset of the marriage. After the divorce was on file, but before the final hearing, Husband unilaterally exercised the options and sold the resulting stock, yielding gross proceeds of approximately $147,000. Critically, Husband undertook this exercise without Wife’s consent or any Court order. At the final hearing, since the exercise had tax consequences, Husband 21

requested that the trial court give Husband a credit of approximately $53,000 to reflect the tax consequences Husband would be required to pay as a result of the option exercise. The trial court agreed with Husband, in part, but allowed Husband a credit only based upon the taxes Husband would have paid had he exercised the stock on the date of filing, when the options were worth less (and, thus, the tax consequences would have been smaller). Wife appealed, but the Court of Appeals concluded that it was within the trial court’s discretion to award the credit for the taxes to Husband. It may be difficult to articulate what public policy objective is advanced, but the lesson of Knotts and Hiser seems to be – and it is easy to extend this reasoning beyond stock options to any marital asset – that if a client owns property with substantial tax consequences, and it is likely the client would be awarded that property in the divorce, then it may be prudent to consider liquidation so that the resulting tax consequences are essentially shared with the spouse. (On the flip side, it may be prudent to seek a Trial Rule 65 restraining order on assets if your client’s spouse is in that position, so as to preclude a Hiser-type liquidation.) D. Division Issues: How Can the Options Be Divided? The short answer is that the stock options probably cannot be divided. Most employer sponsored option plans do not permit a transfer of stock options from the employer-participant to any third party, including a spouse incident to a divorce. In these cases, the parties (or the trial court) have only two options. First, of course, all of the options can be awarded to the owner spouse at some value, and the other spouse receives other property of off-setting value. Second, the options can be constructively divided between the parties, even though they will need to remain nominally titled in the name of the owner spouse until exercise. If electing this second choice, the most important potential pitfall to be mindful of the option tax consequence.

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Most employee stock options are “non-qualified” options. 2 In the interest of brevity, the most important aspect of non-qualified options is that, upon exercise, the owner incurs ordinary income taxes based upon the difference between the stock’s market price and the strike price, multiplied by the number of options exercised, and irrespective of whether the stock is held or promptly liquidated. Moreover, plan administrators typically withhold only 25% of the option proceeds for taxes, which results in under-withholding for most taxpayers. The following is an example of a starting point for language in a final settlement agreement that can effectively divide one party’s non-qualified stock options, even though the options remain technically and nominally titled solely in the name of the participant spouse. Please note the special treatment of taxes: 1.01 XYZ, Inc. Stock Options.

(a) Summary of Husband’s XYZ, Inc. Options. As of February 1, 2006, Husband held 100,000 vested non-qualified stock options in XYZ, Inc. (“Vested XYZ Options”) which shall be divided equally between Husband and Wife. Husband also owns 20,000 XYZ, Inc. Options that were not vested on February 1, 2006, and these shall be Husband’s separate property, free and clear of any and all claims by Wife. (b) Wife’s Option Allotment. It is the parties’ intention and agreement that one-half (1/2) of Husband’s Vested XYZ Options shall belong to Wife (“Wife’s XYZ Option Allotment”), with the exercise of such options described more particularly below. This division shall be accomplished within each applicable Vested XYZ Options grant (that is, Wife’s allocation shall include one half of each of Husband’s option grants that comprise the Vested XYZ Options). The remaining one-half (1/2) of the Vested XYZ Options shall be Husband’s separate property, free and clear of any and all claims by Wife. The parties understand and agree that, due to restrictions on the Vested XYZ Options, Wife’s XYZ Option Allotment shall need to remain nominally titled in Husband’s name, even though both parties agree that Wife’s XYZ Option Allotment shall constructively belong to Wife.
2

The other common variety of employee option is an “Incentive Stock Option” or “ISO.” ISO’s are generally awarded, if at all, to top-level management. The tax treatment of ISO’s is considerably different than that of nonqualified options. ISO’s are not subject to regular income tax at the time of exercise but, instead, are taxed at the time the shares that result from the option exercise are sold. Further, and importantly, if the shares resulting from the ISO exercise are held for in excess of a year, the resulting income is potentially eligible for the preferable capital gain tax rate, rather than an ordinary income rate. However, holding ISO’s can trigger the Alternative Minimum Tax, too. Best advice: include your client’s accountant at every step of the decision making process concerning the disposition of stock options.

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(c) Wife’s Exercise of Wife’s XYZ Option Allotment. Wife may instruct Husband to exercise Wife’s XYZ Option Allotment as Wife wishes to exercise her share of these options; provided, however, that at the time of any given exercise, Wife must exercise her entire one-half (1/2) share of any given Vested XYZ Options grant, rather than exercising options on a piecemeal basis. That is, at any given exercise, Wife must instruct Husband to exercise all of Wife’s options within a given grant, but not necessarily all of Wife’s XYZ Option Allotment in its entirety. Husband shall then execute Wife’s instructions to exercise the options as soon as is practical thereafter, but in no event longer than three (3) business days after receipt of instruction, subject to applicable blackout and other policies pertaining to the Vested XYZ Options, and then transfer to Wife the net, after-tax withholding proceeds (as set forth herein) of the exercise upon his receipt of same. This transfer from Husband to Wife shall be as a taxfree property settlement transfer. (d) Tax Withholding. The parties agree that, for purposes of this option sale Husband shall be presumed to have a total and combined (federal, state, and local) marginal tax rate of Forty Percent (40%). Therefore, upon the exercise of Wife’s XYZ Options, Forty Percent (40%) of the gross proceeds of the exercise shall be retained by Husband, in a restricted interest-bearing joint account, requiring joint signatures (“Tax Account”), less any tax withholding by XYZ, Inc. on Husband’s behalf, for purposes of paying the tax liability arising from that exercise of Wife’s XYZ Options. The remaining Sixty Percent (60%) of Wife’s share of the exercise shall be transferred to Wife, as taxfree property settlement. (That is, by way of example, if an exercise on behalf of Wife generates proceeds of $10,000, and XYZ, Inc. withholds $2,500 for taxes, Husband shall retain an additional $1,500 in the Tax Account and then tender the remaining $6,000 to Wife.) (e) Settling Up of Tax Liability. The parties acknowledge that the precise tax liability to Husband arising from the sale of Wife’s XYZ Options is neither known nor knowable at this time. Therefore, within thirty (30) days of the filing of any tax return(s) by Husband containing any income arising from the sale of Wife’s XYZ Options, or any portion thereof, Husband shall furnish to Wife a summary calculating the actual tax liability to Husband arising from the sale of Wife’s XYZ Options, or any portion thereof (“the Option Tax Summary”). Within fourteen (14) days thereafter, the parties will settle up between them all resulting tax liability obligations. That is, in the event that XYZ, Inc.’s withholding from the option sale combined with the Tax Account withholding were insufficient to cover the taxes accruing to Husband as a direct result of the exercise of Wife’s XYZ Options, or any portion thereof, then Wife shall immediately pay to Husband any shortfall. Conversely, in the event that XYZ, Inc.’s withholding from the option sale combined with the Tax Account withholding resulted in over-withholding to cover the taxes accruing to Husband as a direct result of the exercise of Wife’s XYZ Options, or any portion thereof, then Husband shall immediately pay to Wife any overwithholding (along with any interest accrued on the Tax Account, which interest shall be claimed by Wife on her tax return as Wife’s income). Notwithstanding any other provision in this Agreement, it is the parties’ express intention that Wife be responsible for all taxes accruing to Husband as a direct result of the exercise of Wife’s XYZ Options. 24

(f) Blackout Periods and Other Applicable Rules. The parties understand and acknowledge that the exercise of the options is subject to various rules and regulations, including “blackout periods,” during which options may not be exercised. If, during a “blackout period” or other restricted term, Husband is instructed by Wife to exercise any of Wife’s XYZ Option Allotment, Husband shall exercise the options as reasonably soon thereafter that he becomes able to do so. (g) Husband’s Options. Husband may exercise, may not exercise, or may otherwise dispose of his half of the options solely at his discretion. Hopefully, the above information and draft language provides useful information for the potentially complex issue of treatment of stock options during dissolution of marriage.

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III. Direct Stock Awards and Restricted Stock Units (RSU’s) A. Direct Stock Awards As discussed above, stock options became a widely used compensation benefit for key executives (and, later, rank-and-file employees) during the 1990s. The appeal of stock options as compensation was that, as opposed to a larger salary or other immediately received benefits, stock options typically have no value at the time they are awarded, and will acquire value only if the company does well. Therefore, stock options were viewed as form of compensation that had the added benefit of providing a strong financial incentive to the executive that the company share price increase. With the crash of the high-flying technology stocks in 2000, and the generally cool stock market that followed for the next few years, a shortcoming to stock options manifested itself: stock options provide a stronger performance incentive for executives in a strong market than they do in a weak market. To address this situation, many companies sought to offer more predictable long-term rewards for their employees. In many cases, companies committed to a pay-for-performance compensation approach, which began to replace option grants with restricted stock awards. These companies believed that with this direct-ownership approach, employees would begin to focus on the benefits of sustained, long-term company performance as opposed to the get-rich-quick attitude of the 1990s. To better understand restricted stock, first recall a stock option. A stock option represents a contractual right to buy a share of stock at a predetermined price (“ the strike price”). If the market value of the stock is above the strike price, then the option has value (or, it is “in the money”); but, if the market value of the stock is below the strike price, then the option has no immediate value (or, it is “underwater”) unless and until the share price rises above the strike

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price. Companies have tried to address previously-awarded options going underwater by granting the executive new options at the lower, prevailing stock price. However, critics of stock options have two major reservations with this approach to executive compensation. First, they contend that the economic interests of the employees are not well matched with those of the shareholders because the nature of an option’s value is inherently different from the nature of stock’s value (even if the value of the former is derived, in large part, from the value of the latter). The incentives of the option-owning executive may not be well aligned to the interests of the company’s shareholders. For example, if an executive can always count on receiving a new option grant when the company's stock price goes down, the executive never incurs any real “loss” as a result of the company’s decline in value. Rather, the shareholders bear that burden, alone. Second, the company shareholders face increased stock dilution if the company's stock price decreases, additional overlapping option grants are issued, and then the stock price returns to higher values. The exercise of options ultimately represents a cost to the company (and, thus, to its shareholders), which cost is only increased when options are issued during dips in share value. In response to these concerns (and others), enter the restricted stock award. Under a restricted stock program, the company awards a number of shares of the company’s stock to an employee, subject to vesting restrictions. A common vesting restriction is that the employee remains employed by the company for one year before the stock award vests. The employee becomes the “owner” of the restricted shares at the time of the award – even if they are not yet vested – and the employee is entitled to vote and receive dividends on those restricted shares. If the shares never vest (e.g., because the employee quits before the vesting date), the company has the right, effectively, to cancel the stock award. The vesting of the restricted stock award

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typically creates a taxable event for the employee. To generate money to pay the income tax on the stock, the employee typically sells some portion of the awarded stock, with the employee retaining the remaining shares. The employee’s interests are now better aligned with the company's shareholders generally: when the company's stock price goes down, the employee suffers along with all its other owners. As such, restricted stock awards are becoming an increasingly favored tool for executive compensation, being used either in place of, or in concert with, traditional stock option awards. B. Restricted Stock Units (RSU’s) A more versatile permutation of direct stock award is the “restricted stock unit,” or “RSU.” An employee who is awarded RSU’s obtains a right to receive shares of stock when the RSU’s become vested. Upon vesting, the company issues the shares and the recipient then becomes a shareholder. The RSU contrasts with a direct stock award, where the employee receives the shares up front subject to forfeiture if the stock does not vest. Most large companies like RSU programs because they are easier to administer and ensure that employees are only entitled to dividends and voting rights upon vesting of the shares. C. Stock Awards and Divorce Of course, these stock awards, like stock options, can feature prominently in a divorce case. As with stock options and nonqualified retirement plans, it is important to be certain that discovery requests are tailored to address stock awards in the event an executive is the opposing party. Fortunately, the valuation of stock awards is potentially more straightforward than with options. The critical distinction is whether the stock award has yet vested. If the stock award has vested, then the executive is the outright owner of the shares, and the, say, 100 shares of XYZ, Inc., would be included in the marital estate and valued just as

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though the executive had purchased those 100 shares of XYZ, Inc., on the open market during the marriage. (Or course, if the vesting is recent, the value of the stock award may be partly offset by an outstanding tax liability for the executive’s receipt of the stock.) The more complicated stock award issue arises if the executive has been granted a stock award as of the date the petition for dissolution is filed, but the stock award has not yet vested. There are several, not-mutually exclusive means by which this situation can be addressed: 1. Arguments on Vesting. Under the above scenario, it is quite possible that the stock award, though not vested when the petition for dissolution was filed, will vest while the divorce is pending. There is an argument that stock awards that are not vested on the date of filing, but which vest during the pendency, should be included in the marital estate. See, e.g., Adams v. Adams, 535 N.E.2d 124 (Ind. 1989) (holding that “pension rights were [] subject to disposition as marital property, notwithstanding that the pension rights did not become marital ‘property’ . . . until after the separation.”). This Adams holding is supported, in the stock option realm, by Henry v. Henry, 758 N.E.2d 991 (Ind. Ct. App. 2001). In Henry, the Court of Appeals opined that, “inasmuch as [Husband] had a present right to exercise the GE stock options and obtain their benefit up to the time of the final dissolution hearing, it was error for the trial court not to have included the values of the GE options in the marital estate.” (emphasis added). Thus, Henry suggests that the central holding of Adams – that property interests acquired during the marriage, but which vest while the divorce is pending, are marital property – is extended to stock options. However, this line of cases has a more recent wrinkle in Granzow v. Granzow, 855 N.E.2d 680 (Ind. Ct. App. 2006). The issue in Granzow was similar to that faced in Adams. The Husband was a long-time employee at USX and he participated in the USX pension plan. Under the terms of the plan, Husband was eligible for a substantial pension enhancement on the 30th anniversary of his employment. Husband experienced this anniversary, and the related pension enhancement vested, after the divorce had been filed but while the case was still pending. The issue before the Court: was the pension enhancement a marital asset subject to division? The Court of Appeals held: The enhanced portion of Husband's pension, which would accrue when he reached thirty years of employment with USX, was forfeitable upon termination of employment and was not yet vested when the petition for dissolution was filed. Thus, the trial court did not err when it determined that the enhancement was not part of the marital estate subject to division. Granzow, at 855 N.E2d at 686. Prior to Granzow, it appeared probable that property interests (whether pension, stock option, stock award, or otherwise) that were awarded but unvested at filing of the divorce, and which vested during the pendency, were properly included in the marital estate under Adams and its progeny. However,

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Granzow has muddied these waters, and there is now legitimate legal argument to be advanced on both sides of the issue. 2. Arguments of Economic Circumstances. At bare minimum, even if an awarded but unvested stock award is deemed excluded from the marital estate, the executive’s ownership of the unvested stock award is arguably an economic circumstance in favor of the executive for purposes of determining whether the trial court should deviate from the statutorily presumed equal division of the marital estate under Ind. Code 3115-7-5. The existence of the unvested stock award – and its value to the executive when it does vest – may be part of a multi-pronged argument in favor of the executive’s spouse receiving more than 50% of the marital estate (e.g., the executive has much greater earning ability than the spouse, the spouse has been out of the workforce for 20 years as a homemaker, and the executive will have $500,000 of stock awards – that are not included in the marital estate – that vest in 6 months, etc.). 3. Arguments on Valuation. In some circumstances it may be useful to determine the value of an unvested stock award. In the past, the authors have retained an actuary to determine the present, discounted value of unvested stock awards (and unvested stock options). As with all valuation, there is a subjective component to this process. Typically, the actuary will focus in on the period of time between the date of valuation and the date of vesting, and then make appropriate discounts on the value of the stock based upon the probability that the executive will depart employment with the company in the interim. There are various published schedules that provide guidance on the turnover of executives, which may guide the actuary in making this determination. In short, give consideration to valuing even unvested stock and option interests, if doing so can advance your case. D. Conclusion

Stock awards and RSU’s are an increasingly common component of compensation to today’s executive. It is important to be aware of how this asset plays a role in a divorce case, and the arguments (on either side) about how stock that is awarded but is unvested at filing can be handled to your client’s strategic advantage.

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IV. Nonqualified Retirement Plans A. Nonqualified Plan Basics Attorneys that have been involved in divorce work are very familiar with the concept of a party’s employer-sponsored retirement interest being marital property that is subject to valuation and division as part of the marriage dissolution. Usually, however, the retirement interest involved is a part of a “qualified plan.” That is, the retirement plan has been specifically designed to meet the various requirements of Section 401 of the Internal Revenue code (or Section 403, in the case of public employers). The advantage that “qualification” gives to the retirement plan is that the employer is entitled to a current deduction for contributions to the plan, the participants are not taxed on the retirement benefits until they are received, and the plan’s earnings grow tax-free. Qualified plans may include defined benefit plans (which commit to paying the employee a specific monthly amount from retirement for life), or defined contribution plans (such as 401(k)s, Profit Sharing Plans, SEPs, and 403(b)’s.) By contrast, “nonqualified plans” have failed to meet the requirements set forth under federal law to acquire favorable tax treatment. In addition, though not coextensively, nonqualified plans generally fall outside of, or are exempt from, the Employee Retirement Income Security Act of 1974 (ERISA). When it comes to qualified retirement plans, the rules generally require that an employer’s basic compensation package be equally available to all employees in order to get the associated tax benefits. Nonqualified plans, by contrast, are generally used to provide augmented benefits for top management, or other key employees, whom the employer wishes to give special consideration not available to employees generally. The employer can use nonqualified plans to compensate important employees above and beyond the basic compensation package provided to rank-and-file employees.

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Broadly defined, a nonqualified plan is a contractual agreement in which an employee (or independent contractor) agrees to be paid in a future year for services rendered. Deferred compensation payments generally commence upon termination of employment (e.g., retirement), or pre-retirement death or disability. Nonqualified plans are often geared toward anticipated retirement in order to provide cash payments to the retiree and to defer taxation to a year when the recipient is in a lower bracket. Although the employer’s contractual obligation to pay the nonqualified plan benefit is typically unsecured, the obligation still constitutes a contractual promise. Nonqualified plans are not without their inherent disadvantages, including that the participants may be taxed on the retirement benefits even before they receive them, the plan might not be funded, and the plan will not be bailed out by the government in the event of default – all of which creates added cost and risk to the participant. However, nonqualified plans can be created with substantially more flexibility than qualified plans, as they simply represent a contract that the employer will pay certain defined sums (or, more frequently, sums based upon formulas set forth in the plan documents) to the employee at a future date, usually commencing at retirement. Nonqualified plans offer advantages to both the employee and the employer. To the employee, a high income earning executive is likely unable to save, under the annual contribution limitations of a qualified plan, sufficient money to provide for continuity of lifestyle after retirement. The nonqualified plan helps to bridge this shortfall. For employers, nonqualified plans offer the advantage of being a benefit that helps to retain key employees, but need not be paid (or necessarily even funded) until many years into the future, and perhaps not at all (for example, if the employee quits the company prematurely).

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B.

Addressing Nonqualified Plans in the Divorce Context For purposes of divorce litigation, here are some tips for dealing with the high-earner

executive and related nonqualified plans: 1. Inquire About Nonqualified Plans Specifically. Do not assume that the existence of a nonqualified plan will be volunteered to you. If you inquire vaguely about “retirement” interests, nonqualified plans may not be disclosed. In addition, some executives do not have keen awareness about their own nonqualified plan interests, since there usually is not a monthly statement or other periodic reminder of the nonqualified plan’s existence. Be sure that discovery requests are carefully drafted to include nonqualified plans by their commonly used names (e.g., “top hat” plans, supplemental executive retirement plans (SERP’s), etc.). Make sure to request copies of any documents that evidence any contractual obligations, whether current or future, that the employer may have for the benefit of the executive. If you remain concerned that nonqualified plans may exist but were not disclosed, consider a nonparty discovery request to the employer for copies of all documents related to the employee’s compensation, including nonqualified plans. 2. Involve a Professional for Valuation. As with qualified plans, there is a subjective nature to the valuation of nonqualified retirement plans. 3 It would be quite difficult to present any meaningful evidence of a nonqualified plan’s value without expert, actuarial testimony. So, if you learn that nonqualified plans exist in the marital estate, it is best to involve an expert early. 3. Do Not Rely on Potential for Division. Part of the reason that valuation of the nonqualified plan, discussed above, is so important is because rights to receive money under a nonqualified plan generally cannot be directly assigned. The nonqualified plan will almost certainly not be subject to ERISA and, therefore, the participant’s interest in the nonqualified plan cannot be divided and awarded to your client by way of a QDRO. Therefore, often the only option is to have the nonqualified plan valued and placed in the participant’s column of the marital balance sheet so that an increased and offsetting amount of other marital property can be awarded to the nonparticipant spouse. C. Conclusion

In sum, the award of nonqualified retirement plans and similar deferred compensation agreements are becoming increasingly common in the higher echelons of corporate governance and management. Whenever involved with a divorce to which an executive is a party, be keenly
Beyond the scope of these materials, but nevertheless very relevant to a divorce that includes nonqualified plan interests, is the more fundamental question of whether the executive’s interest in the plan is marital property at all. Every plan can differ, but some nonqualified interests may be well-suited for the executive participant to argue that he has no vested interest in the plan until he retires and, thus, the nonqualified plan interest is not marital property. This analysis will be highly fact-dependent and, thus, will vary from plan to plan depending upon the plan’s specific terms.
3

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aware of the prospect that nonqualified deferred compensation may be in the marital estate. Unfortunately, these plans do not always leave their fingerprints on other financial documents (there may be no statements, no reference to them in personal tax returns, etc.). Therefore, discovery requests need to be specifically tailored to address the prospect that nonqualified plan interests exist. And, a suitable expert should be involved early in the case both to value the executive’s interest in the plan, and to prepare for litigation in the event trial on the plan interest value is necessary.

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V. Child Support, 2010 Changes Affecting High-Income Earners, the “21.88% Normalization Calculation,” and “Phantom Income” A. A Brief History of the Guidelines In 1989, Indiana adopted the Indiana Child Support Guidelines (“the Guidelines”). The Guidelines were adopted for various reasons, but primarily so as to establish a statewide methodology for the calculation of child support in divorce and paternity cases. The Guidelines were advanced with a rationale that they would assist in providing uniformity to the means by which child support was calculated from county to county, and from judge to judge. The Guidelines would also provide a more objective and quantitative means by which child support orders could be reviewed on appeal. At the heart of the Indiana Guidelines is the “Income Shares Model.” The “Income Shares Model” is a term of art based on the concept that the child should receive the same proportion of parental income that he or she would have received if the parents remained together; in an intact household, the income of both parents is generally pooled and spent for the benefit of all household members, including any children. There are models, other than the Income Shares Model, that are used by other jurisdictions as the foundation for their child support frameworks. 4 B. Reliance on Gross Income, Rather than Net-of-Tax Income For these materials, the critical point is that child support under the Indiana Guidelines is based upon the incomes of the parents. And, more specifically, the Guidelines rely upon the gross incomes of the parents. Some other jurisdictions base their child support calculations upon
These include primarily: the “Percentage of Income Model,” in which the non-custodial parent is ordered to pay a percentage of his income as child support, irrespective of and without relation to the income of the custodial parent; the “Melson Formula,” used in Delaware, Hawaii, and Montana, is a more complex version of the Income Shares Model, which seeks to establish a base level of child support and then adds to that base child support amount as the non-custodial parent’s additional income allows; and, various “Hybrid” models which generally endeavor to pick among the favorable characteristics of the Income Shares Model and the Percentage of Income Model.
4

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net, after-tax incomes of the parents. However, the Guidelines recite that Indiana considered using net, after-tax incomes to calculate child support, but that approached was rejected out of concern that the additional amount of discovery that could be required to make the extra calculation of net, after-tax income. Child Supp. G. 1. So, instead of using net, after-tax income to determine child support, the Indiana Guidelines elected to use gross pre-tax incomes, but in addition to assume that every parent has an effective, overall tax rate of 21.88%. Child Supp. G. 1. But the Guidelines also observe as follows: Of course, taxes vary for different individuals. This is the case whether a gross or net income approach is used. Under the Indiana Guidelines, where taxes vary significantly from the assumed rate of 21.88 percent, a trial court may choose to deviate from the guideline amount where the variance is substantiated by evidence at the support hearing. Child Supp. G. 1. As a practical matter, most parents fall so close to the 21.88% presumed tax rate that it is cost prohibitive or otherwise not worthwhile to demonstrate a basis for a deviation in favor of that parent because his or her actual tax rate differs from 21.88%. However, as tax rates get substantially higher than the 21.88% presumed rate, a normalization calculation and related argument to the Court should be considered. C. 2010 Revisions to the Indiana Child Support Guidelines There were several important revisions to the Indiana Child Support Guidelines that became effective on January 1, 2010. Most of the changes are beyond the scope of these materials about high income earners, but one change dramatically changed the child support calculation process for parents with combined income over about $400,000 per year. The subject high-earned change can be found in Guideline 3(D). The new Guidelines retain a substantially similar means of calculating the parties’ Combined Weekly Adjusted Income. Likewise, the Combined Weekly Adjusted Income is still plugged into the Guidelines’ “Schedules Table” to determine the parties’ Basic Child Support Obligation. The Basic Child

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Support Obligation which is simply a function of: (1) the parents’ Combined Weekly Adjusted Income; and (2) the number of children. However, under the old Guidelines, the Schedules maxed out at $4,000 per week (or $208,000 per year) of Combined Weekly Adjusted Income. For income levels in excess of $4,000 per week, the Guidelines applied a complicated formula which had the effect of causing support amounts to “plateau” as income increased further. Under the new Guidelines, the Schedules max out at $10,000 per week (or $520,000 per year) of Combined Weekly Adjusted Income. Further, for income levels in excess of $10,000 per week, the plateau-causing formula has been jettisoned in favor of a simple linear calculation. For all income above $10,000 per week, the Basic Child Support Obligation will increase at a fixed percentage of the income above $10,000 per week, depending upon the number of children (e.g., 7.1% for one child, 10% for two children, 11.5% for three children, 12.9% for four children, etc.). Examples. To give a sense of how the old Guidelines and new Guidelines create diverging results for high income earners, consider the following. For simplicity, suppose that Father is the sole income earner and that Father and Mother are calculating support for one child. Below, for each level of income, is what Father would pay to Mother in weekly child support (again, for ease of calculation, we are not factoring in parenting time or other credits) under the old Guidelines and the new Guidelines: Father’s Annual Income $208,000/yr $260,000/yr $312,000/yr $364,000/yr $416,000/yr $468,000/yr Support Amount Under “Old Guidelines” $330/week $350/week $367/week $380/week $392/week $403/week Support Amount Under “New Guidelines” $330/week $413/week $457/week $500/week $584/week $648/week

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$520,000/yr

$412/week

$712/week

The new Guidelines also provide that, beyond $10,000 per week, the support obligation increases in a linear fashion at 7.1% of combined weekly income for one child. So, there never is any "plateau" in support obligation. Everything else held constant, child support for someone earning $20,000 per week will be roughly twice what it would be earning $10,000 per week. This is a substantial departure from the operation of the old Guidelines, greatly affecting high-earners and making the litigation of their incomes more important in the course of calculating child support. D. Calculation of “Normalized Gross Income” One technique to employ on behalf of a higher-earner is to argue for a deviation for a high-income earner (or, more accurately, a high rate tax payer) is to calculate the equivalent gross income for the parent if he or she were paying only 21.88% in taxes, rather than the higher actual tax rate. (See the discussion about the Guidelines’ assumption of tax rate, above.) By way of example, suppose that Father has a gross, pre-tax income of $500,000 per year. Ordinarily, this amount – $9,615 per week – would be the input for Father’s income in a child support worksheet. But, suppose further that a review of Father’s Federal and Indiana tax returns for the last year shows that Father paid total income taxes of $165,000. This represents an overall tax rate for Father of 33% ($165,000 / $500,000 = .33, or 33%), which obviously is much higher than the Guidelines’ presumed tax rate of 21.88%. This disparity of tax rates begs the question: rather than basing Father’s child support on his gross income level of $500,000 per year, what gross annual income would give Father the same, after-tax income were it assumed that Father instead paid only the presumed 21.88% tax rate on his income? To make the calculation for the Father’s “Normalized Gross Income,” one need only to solve the following equation: 38

Normalized Gross Income = Actual Gross Income * (1 – Actual Tax Rate) / (1 - .2188)

Inserting the information from the Father’s hypothetical, above, into the equation and solving:

Normalized Gross Income

= $500,000 * (1 - 0.33) / (1 - 0.2188) = $500,000 * 0.67 / 0.7812 = $335,000 / 0.7812 = $428,827

Thus, the argument can be advanced to the Court that, because Father’s actual tax rate is so different from the Guidelines’ presumed tax rate of 21.88%, Father’s child support calculation should be “normalized” by imputing him to $428,827 gross income. 5 This is true because this is the gross income that Father would need to earn to have the identical net, after-tax income if the Guidelines’ presumption that all parents pay income taxes at a rate of 21.88% were true in his particular case. In addition, the Normalized Gross Income need not be specifically calculated to have strategic value. For example, frequently, the negotiation of a child support amount can be a nebulous process, where opposing counsel each seeks to construe income histories in a light most favorable to his or her client, to include (or exclude) the values of employer perquisites in the parent’s gross income, etc. The threat of gross income normalization can play a role in those negotiations. For example, “If we can agree to calculate support with my client at $435,000 per
5

The authors have prepared a simple Excel spreadsheet that performs this calculation automatically. You need to input only your client’s Actual Gross Income and his Actual Tax Rate. The Normalized Gross Income will then be calculated for you. Please feel free to e-mail [email protected] for a copy of the spreadsheet.

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year, then I will not push to lower it further based upon his income tax rate being well over the Guidelines’ presumed rate of 21.88%.” E. “Phantom Income” When working with cases involving business owners or investors, it is important to resist the temptation to look only to the first page of the tax return to determine party income. This is because a tax return will include as income – and taxes will be due upon – pass-through income that is attributable to the parent’s ownership in a company, but which was never actually distributed to the parent. The Tebbe case held that, when calculating child support, pass-through income attributable to a parent, but not actually distributed by the underlying company to the parent, should not be included as income for child support purposes. Tebbe v. Tebbe, 815 N.E.2d 180 (Ind. Ct. App. 2004), reh’g denied. It should be noted, however, that the father in Tebbe was the 49% minority owner of the company, and thus, lacked the control to determine whether earnings would be distributed. The decision of the Tebbe case suggests it would be resolved differently – and the income would be included in the child support calculation – if the parent is a control owner, or if there was evidence that corporate income was deliberately retained to avoid child support. F. Conclusion In sum, in any case involving child support in which a high-income earner is represented, it is worthwhile to review recent tax returns to determine the existing of any pass-through income, and to calculate the client’s overall effective tax rate. To the extent a parent’s actual overall tax rate deviates substantially from the Guidelines presumed rate of 21.88%, it may be worth undertaking a gross income normalization calculation, and including related argument in

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the child support establishment process.

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VI. Trust and Real Estate Remainder Interests As estate planning has become more sophisticated, and as sophisticated estate planning has become more accessible, divorce counsel see increasing numbers of cases in which at least one of the parties has a remainder interest in a trust or a real estate parcel. Sometimes, this is simply a case of being a beneficiary of a trust that was established by a parent or grandparent. In other cases, the relative may have conveyed real estate to the party, subject to the life estate of another relative that is still alive. Are these remainder trust and real estate interests marital property under Indiana law? If so, how are they valued? And can they be divided? A. Is the Remainder Interest Marital Property Subject to Division? Pursuant to Ind. Code 31-9-2-98, “property,” as the term is used in Indiana’s dissolution of marriage statute, is defined broadly as all of the parties’ assets whether owned jointly or individually. It is well established under Indiana law that the Court must divide the property of the parties at the time of dissolution in a just and reasonable manner, if the property was owned by either of them before the marriage, after the marriage but before final separation, or acquired by the parties’ joint efforts. See I.C. 31-15-7-4. Indiana law prohibits the exclusion of any asset in which a party has a vested interest from the scope of the trial court’s power to divide and award. See, e.g., Moyars v. Moyars, 717 N.E.2d 976 (Ind. Ct. App. 1999). Whether or not remainder interests are considered marital property is without clear and authoritative disposition in Indiana due to the rather confused evolution of Indiana case law, and intertwined legislative developments, affecting this issue. But, several cases offer important guidance.

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The seminal case in Indiana with respect to trust interests and divorce was Loeb v. Loeb, 301 N.E.2d 349 (Ind. 1973). In Loeb, the Indiana Supreme Court ruled that Husband’s beneficial trust interest, in a trust settled by his mother, was not marital property subject to division. The Court’s rationale, and it proved a rather fact-sensitive one, turned on the particulars of the subject trust, which provided that, in the event Husband predeceased his mother, Husband’s estate would receive no property, and Husband’s interest in the trust would be divested. The Loeb Court engaged in a rather extensive discussion of whether or not Husband’s interest was “contingent” or “vested,” eventually deciding that the interest was in fact vested, but subject to complete defeasance should Husband predecease his mother. Importantly, the Court also stated that “the central question is not whether the interest is vested or contingent, but, rather, the issue is whether the future interest is so remote that it should not have been included in the property settlement award.” Loeb, 301 N.E.2d at 352 (emphasis supplied). The Loeb decision, however, never defines or otherwise lists the elements to be considered in determining whether an interest is “too remote.” Subsequent cases would grapple with that uncertainty. Later decisions suggest that the primary focus should be on actual possession of the property. See, e.g., Hirsch v. Hirsch, 385 N.E.2d 193 (Ind. Ct. App. 1979). In Hirsch, the Indiana Court of Appeals, in an opinion guided by Loeb, held that Husband’s remainder interest in a trust was properly omitted from the marital estate because Husband did not have a “present possessory” interest in the trust and that his remainder interest did not have a pecuniary value of which the court could have disposed. The Hirsch Court, like the Court in Loeb, offered very little direction in defining the elements or factors to be considered in determining what vested interests are “too remote” for inclusion in the marital estate.

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The next substantial case in this line was Fiste v. Fiste, 627 N.E.2d 1368 (Ind. Ct. App. 1994). In Fiste, Husband owned a remainder interest in certain real estate. Husband’s grandfather had died with a will that conveyed real estate to his wife for her life (Husband’s grandmother), then to daughter for her life (Husband’s mother), then finally to her children (which included Husband). The trial court found Husband’s remainder interest to be too remote to include in the marital estate. On appeal, the Court of Appeals, relying on Loeb, agreed that Husband’s remainder interest in the parcel was too remote for inclusion in the marital estate, particularly because it was subject to complete defeasance in the event Husband died before his mother. There was arguably a shift in the law with Moyars v. Moyars, 717 N.E.2d 976 (Ind. Ct. App. 1999), trans. denied. In Moyars, Husband inherited a remainder interest in a parcel of land as a tenant in common with his two siblings, subject to a life estate in his mother. Husband received the remainder interest immediately upon his father’s death, which occurred during the marriage. As in Loeb, Husband would not receive actual possession of the land until sometime in the future, following his mother’s death. The Court in Moyars ruled, however, that Husband’s remainder interest was properly includable in the marital estate, even though Husband had no present possessory interest. The Moyars Court distinguished its case from Loeb by pointing out that the Husband in Moyars, while not able to possess the land, nevertheless had a legal right to the land which he could sell, mortgage or transfer as he pleased pursuant to real property law. Two interesting footnotes appear in Moyars. In the first, the Moyars Court suggests that the central holding of the 1973 Loeb case was tempered by the legislature’s subsequent adoption of Ind. Code 31-9-2-98, which substantially expanded the statutory definition of “property” for divorce purposes.6 Thus, Moyars suggests, the statutory definition of marital property is broader now than it

Ind. Code 31-9-2-98 broadly provides, in relevant part, that “Property . . . means all the assets of either party or both parties . . . .”

6

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was when Loeb was decided. In a second footnote, Moyars references the Fiste decision (discussed, above), but seeks to limit its holding: “[T]o the extent that Fiste can be read to stand for the proposition that all remainder interests are too remote to be part of the marital estate, we disapprove of the holding.” Moyars, 717 N.E.2d at 979, fn 2. So, at minimum, Moyars appears to take at least a step or two back from the holdings of Loeb and its progeny, which had strictly applied the possibility of defeasance to determine that a property interest is “too remote” to be marital property. Absent a post-Moyars development, the current status of the law appears more broadly receptive to the concept that remainder trust and real estate interests are marital property subject to division in the event of a divorce. To be sure, absent clarification, many remainders are subject to reasonable disagreement – and, thus, the prospect of litigation – about whether they are marital property. B. How Can the Remainder Interest Be Valued? Clearly, this falls into the purview of expert analysis. In terms of real estate remainders, most real estate appraisers are not comfortable valuing less than a fee simple interest in property. Therefore, it is usually necessary to involve the expertise of a qualified valuation expert. Many business valuation experts feel comfortable valuing partial interests in real estate, if a real estate appraiser can provide a fee simple appraisal to use as a starting point. The valuator will then usually take appropriate reductions from fee simple value to reflect the prevailing circumstances of the given case. For example, a party who shares his remainder interest with three siblings would be subject to a larger, fractional discount than a party who shares his remainder interest with only two siblings. Minority or non-control discounts might also be applied. Also, the significance of a life estate now in being may be factored into the remainder value, often making actuarial assumptions about the life expectancy of the current life estate holder

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to discount the eventual remainder interest to present value. For example, the remainder interest would be subject to a greater discount if the life estate is currently held by a healthy 30-year-old, as opposed to a sickly 80-year-old. Trust interests can be valued in much the same way. First the trust corpus must be valued. Some of the trust corpus may have self-evident values (e.g., widely traded stocks). Other components of a trust’s corpus may require specialized appraisals (e.g., real estate or closely-held businesses). But, once the corpus is valued, the valuator can make appropriate adjustments to the beneficiary’s interest based upon actuarial determinations and other assumptions arising from the terms of the trust instrument. C. Can the Remainder Interest Be Divided? Theoretically, the remainder interest may be divisible as part of the divorce. Usually, though, there are practical limitations that make an in-kind division improvident. For example, if Husband holds a 1/3 remainder interest in real estate along with his two siblings, why would Wife want to leave the divorce with a portion of that property interest? She would have no control over the property, obviously, and would remain financial entangled with her former spouse and his family. More difficult, or certainly more unwieldy, would be an attempt to allocate to a spouse an interest in a trust. Again, theoretically perhaps, the trust could be joined into the divorce action for some type of equitable reformation of the trust instrument to allocate an interest to the spouse. Where the spouse has been interested in keeping a piece of the trust, instead of actually dividing the trust interest in-kind, it is not uncommon for the Decree to provide – much like the division of a PERF pension – that each time the trust beneficiary receives some type of a income or principal distribution from the trust, he or she must give X% of the distribution to the former spouse. This

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resolution has complications of own (including enforcement and tax issues), and is usually done only when the trust interest is such a large percentage of the marital estate that there are insufficient other assets to give the spouse and still have a reasonable division of the overall marital estate. In the overwhelming majority of the cases, though, remainder interests – whether real estate, trust, or otherwise – are not divided in-kind in the course of the dissolution but, instead, are retained by the party that owns them at some appraised (or otherwise agreed upon) value.

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