M. P. FRANK and Beatrice Frank, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
No. 18582.
United States Court of Appeals, Seventh Circuit.
June 14, 1971.
Rehearing Denied, Sept. 29, 1971.
Pell, Circuit Judge, dissented and filed opinion.
Marvin E. Klitsner, William J. Willis, Timothy C. Frautschi, Milwaukee, Wis., for appellants; Foley & Lardner, Milwaukee, Wis., of counsel.
Johnnie M. Walters, Asst. Atty. Gen., Tax Division, Daniel B. Rosenbaum, Joseph M. Howard, Harry Baum, Attys., Tax Division, Dept, of Justice, Washington, D. C., for appellee.
Before SWYGERT, Chief Judge, and FAIRCHILD and PELL, Circuit Judges.
SWYGERT, Chief Judge.
This is a petition to review a decision of the United States Tax Court which determined deficiencies in the federal income taxes for calendar year 1960 paid by petitioners-appellants. The Tax Court determined that taxpayer realized ordinary income in the amount of $530,328.66 during that year due to the exercise on September 28, 1960 of stock options granted in 1958 to M. P. Frank by Mortgage Guaranty Insurance Company (“MGIC”) and Guaranty Insurance Agency, Inc. (“GIAI”), both Wisconsin corporations. Taxpayer appeals the determinations of the Tax Court that: (1) M. P. Frank was an employee of both corporations, and the options were granted by reason of such employment; (2) the options did not have a readily ascertainable market value at the time they were granted; (3) the stock subject to the options was not subject to any restriction which had a significant effect upon its value within the intendment of Treasury Regulations, § 1.421-6(d) (2) (i), so as to preclude taxation of any gain at the time of exercise of the options; and (4) the stock underlying the options had a fair market value of $18.50 per adjusted share at the time of exercise of the options. We affirm the decision of the Tax Court in all respects.
The facts relevant to a determination of this review are recited in meticulous detail in the opinion of the Tax Court, and the statement of facts which follows is only so much as is necessary to understand our disposition of this review. In 1956 taxpayer and two others organized and promoted a Wisconsin corporation under the name of Mortgage Guaranty Insurance Corporation for the purpose of engaging in the business of insuring mortgagees against losses on residential first-mortgage loans. Prior to incorporation, the incorporators adopted a resolution that, in return for their activities (then uncompleted) in organizing the corporation and promoting the sale of the original issuance of stock, the promoters, including taxpayer, would receive an option to purchase 100 shares of stock of MGIC at any time prior to December 31, 1959 for $500 per share, $25 less than the issue price.
In 1957 the organizers and promoters of MGIC also organized and promoted a second Wisconsin corporation under the name of Guaranty Insurance Agency, Inc., for the purpose of selling insurance issued by MGIC and financing the payment of commissions. On January 9, 1957 taxpayer was elected to the board of directors of MGIC and was also made its first secretary-treasurer. On May 6, 1957 he was elected to the GIAI board, and on May 23, 1957 he became GIAI’s first president. Also in 1957 MGIC executed a four-for-one stock split, and the original issue of GIAI stock was distributed to MGIC shareholders at a ratio of one share of GIAI per four shares of MGIC stock held at a price of $25 per share.
Then in 1958, and before any of the three promoters had exercised their 1956 MGIC options, the boards of MGIC and GIAI adopted similar resolutions granting options to taxpayer and the other two promoters to purchase 400 shares at $125 per share and 100 shares at $25 per share, respectively, at any time up to December 31, 1962. In mid-1959 both MGIC and GIAI split their stock eight-for-one, and early in 1960 the 1958 options granted to taxpayer by MGIC and GIAI were revised to reflect the stock splits. Other stock splits occurred before taxpayer’s exercise of the options which were taken into account upon exercise of the options, although no other amendments were made to the options themselves.
Initially, we note that the scope of our review of the trial court’s decision is circumscribed by the proposition that we may reverse findings of fact by the Tax Court only if they are clearly erroneous. That being the case, we conclude that there is sufficiently substantial evidence stated in the opinion of the Tax Court to justify its determinations that taxpayer was an employee of MGIC and GIAI, that both corporations granted the options here in question by reason of such employment, and that the stock underlying the options had a fair market value of $18.50 per adjusted share on September 28, 1960 when the options were exercised. Accordingly, we affirm those determinations without further comment.
As to the determination that the stock subject to the options had no readily ascertainable market value at the time of the granting of the options, we believe we are similarly bound by Duberstein to the clearly erroneous standard. However, because of the importance placed upon that issue by the taxpayer, we are impelled to discuss that issue in spite of the Tax Court’s extensive discussion of it.
Taxpayer contends that the granting of the options to taxpayer in 1958 is the taxable event, if any there be, deriving from the options. He asserts that the stock underlying the options and the options themselves could be valued at the date of granting, and any income taxable to taxpayer must be calculated on the basis of the value of the options at grant. We disagree.
In Commissioner v. LoBue, the Supreme Court held that a compensatory, nontransferable stock option granted by a corporation to an employee generated income to the employee which was taxable at exercise. The Court stated:
It is of course possible for the recipient of a stock option to realize an immediate taxable gain [i. e., at grant]. -x- -x- * The option might have a readily ascertainable market value and the recipient might be free to sell his option.
That statement led by negative implication to the adoption of- Treasury Regulations, § 1.421-6, which incorporates the readily ascertainable standard. Section I. 421-6(c) (3) (ii) of the regulations provides:
[T]he fair market value of the option is not readily ascertainable unless the value of the option privilege can be measured with reasonable accuracy. In determining whether the value of the option privilege is readily ascertainable, and in determining the amount of such value when such value is readily ascertainable, it is necessary to consider—
(a) Whether the value of the property subject to the option can be ascertained ;
(b) The probability of any ascertainable value of such property increasing or decreasing.
The Tax Court held that the options did not have a readily acertainable fair market value at grant, noting that there was conflicting evidence as to whether the underlying stock could be valued and preferring to believe the evidence tending to establish that it could not. The determination of the Tax Court that “the fair market value of the stock here involved, and the probability that such stock would increase or decrease in value could not be ascertained with reasonable accuracy” is clearly correct. The stock of MGIC and GIAI had been the subject of only a few isolated sales to third parties when the options were granted, and there was no market price then available. Indeed, taxpayer’s expert seems to have relied exclusively on the issue price of the stock as the base from which he attempted to determine the value of the options. Moreover, the customary method of using “compara-bles” — stocks of similar businesses which are publicly traded — to ascertain the value of a closely held corporation’s stock could not be used here because MGIC and GIAI were unique in that no other private businesses in the country were involved in a similar enterprise. In addition, MGIC had been in business less than two years, had suffered a net loss of $53,283.14 during 1957 and was to suffer a net loss of $15,770.00 during 1958. GIAI was also a new business and suffered a net loss of $26,722.00 in 1958. Nor has anyone contended that book value has any relation to the fair market value of these stocks. It is clear, therefore, that the stock underlying the options could have no “readily ascertainable market ' value” as envisioned by the Supreme Court in LoBue.
Taxpayer contends in the alternative that, assuming the options were compensatory and had no readily ascertainable market value at grant, he is not required to recognize any income at the date of exercise because the stock underlying the options was subject to a restriction which had a significant effect on its value within the meaning of Treasury Regulations, § 1.421-6(d) (2) (i). Taxpayer asserts as alternative bases for this contention the following facts: (1) the stock was not registered with the Securities and Exchange Commission, and taxpayer would suffer limitations on the types and amounts of possible dispositions deriving from the lack of registration and his position as an insider with the corporation; (2) registration of taxpayer’s shares with the SEC would be unreasonably expensive when viewed with regard to the number and value of shares involved; (3) registration was probably not possible in any event, “since the company was new, struggling and a public offering would look like a ‘bail-out’ to the investing public;” (4) redemption of the shares was not possible because the company was suffering liquidity problems; (5) stock sold by taxpayer would have to be sold subject to investment letter restrictions on the purchaser. In support of his position, taxpayer cites Ira Hirsch, 51 T.C. 121 (1968), as standing for the proposition that restrictions on the transfer of stock deriving from the operation of the Securities Act of 1933 constitute restrictions having a significant effect on the value of stock within the intendment of the regulation. We agree with the taxpayer that Ira Hirsch is indistinguishable from this ease on that point, in spite of the trial court’s efforts to distinguish it. We believe, however, that Ira Hirsch was wrongly decided on this issue, and we decline to follow it.
Ira Hirsch involved the taxability at exercise of the receipt of compensatory stock options relating to stock in a closely held corporation. The stock subject to the option was issued pursuant to a regulation A exemption from registration. The SEC took the position that any sale by Hirsch without prior registration of the stock obtained pursuant to the option would constitute a violation of the Securities Act of 1933. The Tax Court found in Hirsch that the foregoing restriction on transfer deriving from the operation of the Securities Act of 1933 constituted the type of restriction contemplated in Treasury Regulations, § 1.-421-6(d) (2) (i), and recognition of any income deriving from Hirseh’s exercise of the options was deferred.
We believe the Tax Court’s decision in Ira Hirsch is erroneous in that we do not believe restrictions on transferability arising by operation of securities law were intended to be included within the meaning of the applicable Treasury Regulation. Rather, the purpose of the regulation was to defer taxation on exercise of options only where the underlying stock was subject to a contractual limitation which prevented the sale of the stock at its fair market value. In Hirsch the Tax Court makes no mention of Treasury Regulations, § 1.421-6(d) (2) (ii), which contains examples of the operation of section 1.-421-6(d) (2) (i) and provides:
The provisions of subdivision (i) of this subparagraph may be illustrated by the following examples:
Example (1). On November 1, 1959, X Corporation grants to E, an
employee, an option to purchase 100 shares of X Corporation stock at $10 per share. Under the terms of the option, E will be subject to a binding commitment to resell the stock to X Corporation at the price he paid for it in the event that his employment terminates within 2 years after he acquires the stock, for any reason except his death. Evidence of this commitment will be stamped on the face of E’s stock certificate. E exercises the option and acquires the stock at a time when the stock, determined without regard to the restriction, has a fair market value of $18 per share. Two years after he acquires the stock, at which time the stock has a fair market value of $30 per share, E is still employed by X Corporation. E realizes compensation upon the expiration of the 2-year restriction and the amount of the compensation is $800. The $800 represents the difference between the amount paid for the stock ($1,000) and the fair market value of the stock (determined without regard to the restriction) at the time of its acquisition ($1,800), since such value is less than the fair market value of the stock at the time the restriction lapsed ($3,000).
Example (2). Assume, in example (1), that E dies one year after he acquires the stock, at which time the stock has a fair market value of $25 per share. Since the restriction lapses upon E’s death, he realizes compensation of $800 ($1,800 less $1,000) and this amount is includible in E’s gross income for the taxable year closing with his death.
Example (S). Assume that, pursuant to the exercise of an option not having a readily ascertainable fair market value to which this section applies, an employee acquires stock subject to the sole condition that, if he desires to dispose of such stock during the period of his employment, he is obligated to offer to sell the stock to his employer at its fair market value at the time of such sale. Since this condition is not a restriction which has a significant effect on value, the employee realizes compensation upon acquisition of the stock.
Example (k). Assume, in example (3), that the employee is obligated to offer to sell the stock to his employer at its book value rather than at its fair market value. Since this condition amounts to a restriction which has a significant effect on value, the employee does not realize compensation upon acquisition of the stock, but he does realize such compensation upon the lapse of the restriction, such as, for example, his death or the termination of his employment.
We note that each of the four examples contained in the regulation are of the same genre — all which deferred taxation are contractual limitations which prevented the sale of the stock at its fair market value until the limitation lapsed or was otherwise lifted. Moreover, in Revenue Ruling 68-286 the Commissioner advised that the fact that section 16(b) of the Securities Exchange Act of 1934 made a taxpayer liable as an insider to the corporation for profit realized on a sale of stock within six months of its acquisition did not amount to “a restriction which has a significant effect on [the stock’s] value” within the meaning of Treasury Regulations, § 1.-421-6(d) (2) (i). By the same token, the way in which the instant taxpayer is restricted as to the manner in which he may sell his stock by the threat of violating the Securities Act of 1933 is not sufficient in our view to constitute the type of restriction contemplated by the regulation.
In addition, some of the reasons taxpayer has asserted as supporting the proposition that his stock is restricted so as to require deferral of taxation sound in the nature of blockage. Since we here hold that the restrictions to which reference is made in section 1.-421-6 (d) (2) (i) are only limitations of a contractual nature which prevent the sale of the stock at its fair market value, it is obvious that the element of blockage is insufficient to defer recognition of income under the regulation.
Finally, taxpayer asserts that if the option was compensatory then the income derived therefrom must be taxed upon receipt of the option pursuant to the sixteenth amendment to the Constitution. He urges that section 61 of the Internal Revenue Code of 1954 taxes all income when received and that taxing at a later date pursuant to Treasury Regulations, § 1.421-6(d) (1), would exceed the authority conferred by the statute and violate the sixteenth amendment. We reject that contention.
For the foregoing reasons, the decision of the Tax Court is affirmed.
. M. P. Frank, 54 T.C. 75 (1970).
. M. P. Frank and Beatrice Frank filed a joint individual income tax return for the calendar year here in question as husband and wife. Otherwise, Beatrice Frank has no connection with these matters, and the term “taxpayer,” which is sometimes used hereinafter, refers to M. P. Frank.
. At the time of the exercise of the options, MGIC stock and GIAI stock were sold in units consisting of four shares of MGIC and one share of GIAI. The $18.50 per adjusted share value, therefore, refers to the combined value of one share of MGIC stock and one-quarter share of GIAI stock, adjusted to reflect all stock splits occurring between the date of the granting of the options and the date of their exercise.
. M. P. Frank, 54 T.C. 75, 76-85 (1970).
. Commissioner v. Duberstein, 363 U.S. 278, 290-291, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960).
. M. P. Frank, 54 T.C. 75, 89-92 (1970).
. 351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142 (1956).
. Id. at 249, 76 S.Ct. at 804.
. T.D. 6540, 1961-1 Cum.Bull. 161.
. M. P. Frank, 54 T.C. 75, 90-92 (1970).
. Id. at 92.
. M. P. Frank, 54 T.C. 75, 96 (1970).
. 17 C.F.R. §§ 230.251-.263 (1970).
. Ira Hirsch, 51 T.C. 121, 135-137 (1968).
. 1966-1 Cum.Bull. 185.
. See Commissioner of Internal Revenue v. LoBue, 351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142 (1956).