In California’s robust tech and start-up sector, companies often lure top talent with stock options which, if the company is successful, may eventually be worth millions. But how should a court value those options when calculating a parent’s child support obligations?

That was the issue in a case recently decided by the California Court of Appeal (In Re the Marriage of Macilwaine).

John and Patricia Macilwaine married in 1996, and had four children by the time they separated in 2010. Two years later, John became a senior executive for a San Francisco-based technology company that, at the time, was privately held. John’s compensation package included a salary, a bonus of up to half of his annual pay, and stock options.

The couple’s divorce became final at the end of 2012. The judgment of dissolution, which incorporated the parties' Marital Settlement Agreement, called for John to pay support for the children, who at the time ranged in age from 4 to 15, of $5,200 per month in base child support plus 14% of his earnings over his annual base salary as "bonus" support.

John’s stock options began to vest (that is, he gained ownership of some of the shares) in July of 2013. That gave John the right to purchase the vested shares in the company at a designated price. His employer went public in December of 2014.

John’s income soared from less than $800,000 in 2012 to almost $2.6 million in 2014, by which time his child support payments were about $32,000 per month.

John went back to court in August of 2014, seeking to cap his total earnings for purposes of calculating child support,  which would in turn limit his child support obligation to $15,700 per month. He later amended the request, seeking to cap his child support obligation at about $23,600 per month.

It is undisputed that stock options in the form of employment compensation constitute income for purposes of calculation of child support. However, a key issue before the trial court was how and when do stock options factor into gross income – at the time the options vest, or when they are exercised and the shares are sold.

John pointed out that stock options are not taxable until they are exercised. In addition, he noted that, even after his stock options vested, he was not free to sell the shares without the approval of his company’s management. His sales were a matter of public record, and could be perceived as a sign that he lacked confidence in the company’s future.

There were other limits on his ability to sell shares, John told the court. Because he was a senior executive of the company with “material nonpublic information,” he was subject to securities laws regulating insider trading.

An accountant hired by Patricia said that if John's vested shares were a source of cash flow available to him, but John's proposed exercise and sale rule was adopted, it would allow him to shield that income from support. 

The Contra Costa Superior Court decision noted that “California law on when employer stock options constitute income for purposes of child support is unsettled.”

The trial judge decided that options should be treated as income at the time they are exercised and the shares are sold, not when they vested. The only exception would be if treating options as income at vesting is “necessary to assure the child’s needs are met.”

The judge acknowledged that “the legal restrictions on John’s ability to sell stock are real, but manageable,” and a rule treating the options as income at the time of vesting would not cause him financial hardship.

Nevertheless, he ruled that taking the “exercise and sale” approach was appropriate in this case because a vesting rule “might be costly to everyone in the long run,” an apparent reference to the possibility that the stock might appreciate in value if it was held rather than sold.

The court included in John’s income only the proceeds of his sales of stock, rather than the much larger net gain that was available to him on the vested shares he chose not to sell. Using that calculation, it granted his request to cap his income for purposes of his child support obligation. Patricia then appealed.

The appellate court rejected the trial court’s logic and reversed its decision. Vested, mature stock options are “income” for purposes of child support, it declared.

“California has a strong public policy in favor of adequate child support,” the appellate justices noted. Its child support laws assume that “a parent’s first and principal obligation is to support his or her minor children according to the parent’s circumstances and station in life,” and that “each parent should pay for the support of the children according to his or her ability.”

Statutes mandate uniform child support guidelines statewide, including a strict mathematical formula for calculating support that is based in part on “the total net monthly disposable income of both parties,” the appellate court said.

Income may come from wages, salary, commissions, royalties, bonuses and other sources, and “is not limited to money compensation received or taxable income.” If it were limited to money actually received, the justices pointed out, owners of companies could defer profits to reduce child support obligations. Taxability is also not a useful criterion, because some forms of income are not subject to taxation.

The justices noted that even courts in other states have held that stock options must constitute income for purposes of child support once they are vested and mature. Consistent with California legislation that child support orders be based on a parent's ability, and not a parent's desire, to support his or her children, the justices said, “a vested, mature stock option makes objectively measurable compensation immediately available.”

John could choose to delay selling the shares as an investment strategy, but “his choices do not alter the fact that, once an option is vested and mature, his employer has made actual compensation available to him.” Therefore, they said, the options must be counted as “income” for calculating John’s support obligation.

The justices ordered the lower court to recalculate John’s income and child support payments, and awarded Patricia her costs on appeal.

By Nitasha Khanna