Ninth Circuit Decides First of Its Kind Stock Option Case

Ninth Circuit Decides First of Its Kind Stock Option Case

While not quite the prevalent practice it wasduring the internet boom of the late 1990’s, compensating employees through the issuance of stock options is still a popular tax planning technique.Sowhat makes it so attractive?

Assume Employee A provides services for X Co. To reward A for his services, X Co.grants A 1,000 shares of stock options with a value and exercise price on the date of grant of $10. The options vest immediately, so A can exercise them at his leisure. Let’s assume these options are non-qualified stock options.

Generally, the grant of an option is not a taxable event provided the stock did not have a readily ascertainable FMVon that date. Instead, A will not havea taxable event until he chooses to exercise the options and purchase the underlying 2,000 shares, at which point he will recognize compensation income equal to the excess of the FMV of the stock on the exercise date over the $10,000exercise price. In summary, A controls the timing of his compensation income, and can plan accordingly. This is preciselywhy options can be a great form of compensation.

What happens, however, if upon exercise, A cannot sellthe underlying shares due to a restriction on transferability?

Section 83 governs the treatment of restricted property, which includes options, warrants, and other restricted stock issued “in connection with the performance of services.” If restricted property received is 1) subject to a substantial risk of forfeiture, and 2) not freely transferable, Section 83 defers the taxation of the restricted property until the stock is no longer subject to a substantial risk of forfeiture and is freely transferable.

What’s the point? Here, Congress isdoing the taxpayer a favor by attempting to match up the timing of the income recognition with the ability of the taxpayer to sell the stock, if necessary, to pay the resulting tax.

Pursuant to the regulations, one of the examples of stock that is not freely transferable is stock that cannot be sold withinsix months of purchase by a corporate insider, if that salecould subject the insider to suit under Section 16(b) of SEC law. The purpose of 16(b) is to prevent insiders from capitalizing on their access to information to turn a healthy profit on the sale of their stock. Since the stock cannot be sold withinsix months of its purchase, Section 83 defers the income recognition by A until the Section 16(b) restriction lapses, at which time A will recognize compensation equal to the FMV at that time less the exercise price.

Last week, the Ninth Circuit faced the uneviable task of interpreting the interplay between the Internal Revenue Code and securities law for one very important purpose, to determine when stock options are treated as having beenpurchased for purposes of Section 16(b), upon grant or vesting.As discussed above, it is the purchase that will start the clock on the six month restriction window and the related income deferral period.

For the taxpayer in Strom v. U.S., 107 AFTR2d2011-684 (9th Cir., 2011)this purchase date meant the differencebetween deferral and the current recognition of income. Strom was granted stock options subject to a vesting schedule and Section 16(b) restrictions. If the purchase date was held to be the moment when the options vested, Strom could defer the income until six months after the last round of shares vested, even if she had already exercised them.To the contrary, if the purchase date was held to be the grant date, Strom had to recognize the income immediately upon exercise, since it was outside the six-month window starting on the grant date.

The Ninth Circuit, after delving into Section 16(b), determined that the SEC treated the purchase date of options as being the date of grant, not the date of exercise. As a result, Strom had to recognize the compensation income immediatelyupon exercise, since it was more thansix months from the date of grant.

Strom was the first such case to take on this issue, so atleast for those taxpayers whose appeal would lay in the Ninth Circuit, it provides the authority that the six-month Section 16(b) window will start upon thegrant of stock options, not upon their vesting.