RAUM

Herman A. Fischer, Esq., for the petitioner. David F. Long, Esq., for the respondent.

In 1945, corporation gave one of its officers an option to purchase 12,500 shares of its stock at stated intervals over a two-year period at less than market value. Officer exercised option in 1946 and 1947 when the fair market value of the stock exceeded the option price. Held:

1. Gain derived from the option was intended as compensation.

2. The intended compensation was the difference between the option price and the fair market value of the stock on the dates the option was exercised and the stock acquired. Connolly's Estate v. Commissioner, 135 F.2d 64 (C.A. 6), affirming45 B.T.A. 374, and Commissioner v. Smith, 324 U.S. 177,rehearing denied, 324 U.S. 695, 889, followed.

3. Fair market value of stock on dates the option was exercised determined.

The respondent determined deficiencies in the income tax of petitioner in the amounts of $61,244.87 for the year 1946 and $64,215.93 for the year 1947.

The principal question is whether the petitioner realized taxable income in 1946 and 1947, when he exercised an option to purchase 12,500 shares of the common stock of the National Tea Company, which he had acquired in 1945.

FINDINGS OF FACT.

A stipulation of facts filed by the parties is adopted as part of our findings.

Petitioner is a resident of Hinsdale, Illinois. He filed his income tax returns for the years 1945, 1946, and 1947, on the cash receipts and disbursements basis, with the collector of internal revenue for the first district of Illinois.

Prior to March 1945, the petitioner had been employed by the Kroger Grocery and Baking Company for about 27 years. From 1941 to 1945 he had been the manager of its Chicago branch. He received a fixed salary and a percentage of profits.

National Tea Company (hereinafter referred to as National) operated a chain of 749 stores in eight Middle Western States, selling food products and also engaging in certain related activities. Early in 1944 petitioner and John F. Cuneo discussed the possible acquisition by the later of stock of National, which had been selling at a low price. At that time petitioner told Cuneo that he was convinced that National's trouble was management. In April 1944, Cuneo started to purchase stock of National, and, after he had acquired a substantial amount, he talked to petitioner about leaving Kroger and becoming manager of National. Petitioner, who had been unhappy with Kroger after the death of its president and the appointment of his successor, told Cuneo he would be willing to undertake the management of National. Petitioner informed Cuneo of the salary, plus percentage of earnings, he was receiving from Kroger and that he would want a slight increase from National, and also would want an opportunity to acquire some of the stock of National because he ‘felt management should have an interest in the company.‘ Cuneo voiced no objection to petitioner's demands, and agreed to take the matter up with the board of directors of National.

Petitioner resigned his position with Kroger Grocery on February 1, 1945, effective February 28, 1945. On February 20, 1945, when the market price of the common stock of National was $15.25 per share, the petitioner received a letter from Cueno in which the latter stated that he had notified the directors of National of his intention to recommend the employment of petitioner as general manager on the terms set forth in a form of contract attached thereto and that he wished to have petitioner's assurance that he would execute the contract when authorization of the board of directors was procured. The proposed contract provided that petitioner should receive for a term of 1 year beginning in April 1945, a stated salary of $27,500 per year, and additional compensation of 2 per cent of the net profits of National in excess of $300,000, the aggregate compensation, however, to be limited to $60,000. It also provided that ‘In consideration of the Employee's acceptance of employment hereunder, the Company agrees to set aside 12,500 shares of its Capital Stock now in its Treasury subject to an option of purchase by the Employee at any time during the term of this contract at the price of $12.00 per share.‘

Prior to the annual meeting of the shareholders of National on March 21, 1945, they received a notice containing a ‘Proxy Statement‘ which stated, in substance, that Cuneo would recommend to the directors the employment of petitioner as executive vice president and general manager at substantially the same salary and percentage of profits mentioned in the proposed contract, and that he would also recommend that National grant options to the petitioner and Robert V. Rasmussen, president, to purchase within 1 year, at $12 per share, the respective amounts of 12,500 and 5,000 shares of its common capital stock held in treasury, the approximate market price of which as of the close of business on March 13, 1945, was $18.75 per share.

At the shareholder's meeting held on March 21, 1945, petitioner was elected a director of National. At a meeting of the board of directors on the same date, the proposed employment contract between petitioner and National was discussed. The directors decided not to take any action with respect to it until approval of the Wage Stabilization Board had been obtained. They meanwhile authorized a monthly drawing account for petitioner at the rate of $27,500 per year.

Petitioner became the executive vice president and manager of National on March 21, 1945, and served in this capacity until he was elected its president on March 21, 1947.

Prior to 1945, and continuously since that year, the common stock of National has been listed and sold on the New York Stock Exchange.

On May 9, 1945, National filed with the Secretary of the State of Illinois an amendment to its certificate of incorporation, the effect of which was to change the par value of its common stock from no par value to a par value of $10 per share.

On August 18, 1945, the President of the United States by Executive Order 9599 authorized the National War Labor Board and other agencies to provide that employers might, be voluntary action, make wage or salary increases without the necessity of obtaining approval therefor. On August 22, 1945, the Bureau of Internal Revenue issued a press release which, among other things, stated that in accordance with the President's executive order it had on that date modified its salary stabilization rules to permit any employer who desired to increase the salary of any employee to do so immediately, and that, if certain specified conditions were met, the employer might proceed to grant the salary increase without any application for approval.

At a meeting held on August 23, 1945, the executive committee of National, of which petitioner was a member, authorized the treasurer to seek approval from the Salary Stabilization Unit of a salary for petitioner of $27,500 per year from the date of his employment, and recommended that, subject to the approval of the board of directors, options to purchase treasury stock be given to the petitioner and Robert V. Rasmussen in the amount of 12,500 shares and 5,000 shares, respectively, at $16 per share, the options to expire on August 24, 1947. The opening, high, and low prices of National's common stock on the New York Stock Exchange on August 23, 1945, were $18.125, $18.25, and $18.125 per share, respectively, and the number of shares sold on that day was 200.

On August 24, 1945, the board of directors of National, at a special meeting, adopted the following resolutions:

WHEREAS, at its 1945 annual meeting this Board deferred to a subsequent meeting the fixing of the compensation of Harley V. McNamara, as General Manager of this corporation, he in the meantime to draw stated amounts generally on account of salary, and,

WHEREAS, the Executive Committee of this corporation has recommended that, in addition to such stated cash payments on account of salary and such additional contingent compensation as is now in effect, the compensations of Harley V. McNamara and also of Robert V. Rasmussen for the current year shall include the options hereinafter specified;

NOW, THEREFORE, BE IT RESOLVED that the compensation of said officers for the present fiscal year shall be and the same are hereby fixed at cash salaries of $27,500 for said Harley V. McNamara and $20,000 for said Robert V. Rasmussen, and in addition thereto stock options, as provided for in the next succeeding paragraph.

RESOLVED that the Vice President and Secretary be and they are hereby directed to execute the following options to Harley V. McNamara and Robert V. Rasmussen and that the officers of this corporation be and they are hereby authorized and empowered to issue stock certificates to Harley V. McNamara and Robert V. Rasmussen upon the receipt of considerations mentioned in the option agreements and to do any and all things necessary and proper to carry out said option agreements.

On August 24, 1945, National entered into an employment contract with the petitioner, for a term of 2 years beginning March 21, 1945, which, among other things, contained the following provisions:

3. The Employee, for the term of this contract, shall receive a stated salary and additional contingent compensation determined as follows, the aggregate compensation, however, being limited to $60,000.

(a) The Employee's stated salary shall be $27,500 per year, payable in equal monthly installments.

(b) The Employee shall receive additional annual compensation in amounts equal to 2% of the excess of the corporation's net profits for the year 1945 over $300,000.

The petitioner was granted the following option by National on August 24, 1945:

KNOW ALL MEN BY THESE PRESENTS, THAT, WHEREAS, by action of the Board of Directors of this corporation held on August 24, 1945, the Vice President and Secretary were directed to execute in its name, and to deliver to Harley V. McNAMARA, an option under which he and his heirs, executors administrators, and assigns would be entitled to purchase form this corporation 12,500 shares of its common stock at the price of $16 per share;

NOW, THEREFORE, this certifies that an option is hereby extended to said HARLEY V. MCNAMARA, his heirs, executors, administrators and assigns, to expire on August 24, 1947, to purchase 12,500 shares of the common stock of this corporation, out of the shares now held in its treasury, or part or parts of such number of shares, at such times prior to August 24, 1947, as he or they shall elect, upon the payment to this corporation of the cash sum of $16 for each share so purchased.

It is a condition hereof that not more than a total of 3,125 of said 12,500 shares shall be subject to such purchase prior to February 24, 1946, not more than a total of 6,250 shares prior to August 24, 1946, and not more than a total of 9,375 shares prior to February 24, 1947.

The option was signed by the petitioner as follows: ‘Accepted H. V. MCNAMARA September 12, 1945.‘

The fair market value of the common stock of National on August 24, 1945 and September 12, 1945, was $19 and $20 per share, respectively.

The petitioner had no intention of selling the option, and intended to exercise it pursuant to the restrictions therein as he rendered services for National.

The petitioner exercised part of his option and received the stock certificates in respect of 6,250 shares of common stock of National on March 12, 1946, at the option price of $16 per share. The fair market value of this stock on that date was $28.50 per share.

The petitioner exercised the remaining part of his option and received stock certificates in respect of 6,250 shares of the common stock of National on March 6, 1947, at the option price of $16 per share. The fair market value of this stock on that date was $27.50 per share.

The gain derived from the exercise of the option on March 12, 1946 and March 6, 1947, equal in each instance to the excess of the fair market value of the stock acquired over the option price, was intended as compensation to petitioner.

Petitioner has never sold any of the stock of National which he purchased.

The capital structure of National on August 24, 1945, September 12, 1945, March 12, 1946, and March 6, 1947, was as follows:

+----------------------------------------------+ ¦ ¦Common stock¦4 1/2% $50 par¦ +------------------+------------+--------------¦ ¦Date ¦$10 par ¦preferred ¦ +------------------+------------+--------------¦ ¦ ¦outstanding ¦outstanding ¦ +------------------+------------+--------------¦ ¦August 24, 1945 ¦¹ 622,650 ¦40,000 ¦ +------------------+------------+--------------¦ ¦September 12, 1945¦¹ 622,650 ¦40,000 ¦ +------------------+------------+--------------¦ ¦March 12, 1946 ¦¹ 631,400 ¦40,000 ¦ +------------------+------------+--------------¦ ¦March 6, 1947 ¦¹ 651,150 ¦37,800 ¦ +----------------------------------------------+

National had 3,701 stockholders on March 2, 1946, and on March 1, 1947.

The net sales, the net profits before taxes, and the net profits after taxes of National for the years 1944 to 1947, inclusive, were as follows:

+-----------------------------------------+ ¦ ¦ ¦Net profit ¦Net profit ¦ +----+-----------+------------+-----------¦ ¦Year¦Net sales ¦before taxes¦after taxes¦ +----+-----------+------------+-----------¦ ¦1944¦$99,870,475¦$1,766,663 ¦$1,066,663 ¦ +----+-----------+------------+-----------¦ ¦1945¦106,868,995¦1,838,058 ¦913,058 ¦ +----+-----------+------------+-----------¦ ¦1946¦157,641,672¦4,761,473 ¦2,931,473 ¦ +----+-----------+------------+-----------¦ ¦1947¦217,915,297¦5,772,154 ¦3,597,154 ¦ +-----------------------------------------+

In its Federal income tax return for the year 1945, National claimed a deduction for compensation to officers in the amount of $145,830.57 which included a claimed deduction of $16,375, in respect to the option granted the petitioner on August 24, 1945. The claimed deduction of $16,375 was disallowed by the Commissioner. National paid additional Federal taxes for the year 1945 as a result of this disallowance and has not claimed a refund with respect thereto.

In petitioner's income tax return for the year 1945, he among other things, reported as compensation received from National in that year the amount of $16,375. The respondent eliminated this amount from the petitioner's gross income for the year 1945 and determined an overassessment.

In its annual report for the year December 31, 1945, filed with the Securities and Exchange Commission, National reported in substance that the consideration for the granting of the option to the petitioner on August 24, 1945, to purchase 12,500 shares of its common stock was ‘Services rendered and to be rendered.‘

In petitioner's income tax returns for the years 1946 and 1947, he reported the receipt of compensation from National in the amounts of $41,328.49 and $61,791.74, respectively, but did not report any taxable income as a result of the exercise of the option and the acquisition of 6,250 shares of common stock on March 12, 1946, and March 6, 1947, at the option price of $16 per share.

The respondent determined that, under the provisions of section 22(a) of the Internal Revenue Code and applicable regulations, the petitioner received additional compensation in the amounts of $78,125 and $77,343.75 for the taxable years 1946 and 1947, respectively, representing the difference between the fair market value on March 12, 1946, and March 6, 1947, when the option was exercised, and the option price paid by petitioner for the purchase of 6,250 shares of the common stock of National on each of these dates.

OPINION.

RAUM, Judge:

Petitioner became executive vice president and general manager of National Tea Company on March 21, 1945. Although he had an understanding at that time as to his compensation, no contract of employment was then entered into, presumably on account of the salary stabilization regulations, and he was merely given a ‘drawing account.‘ Pursuant to an executive order of the President of the United States issued on August 18, 1945, the Bureau of Internal Revenue on August 22, 1945, announced a relaxation of its salary stabilization rules. On the very next day the executive committee of National authorized its treasury to seek approval from the Salary Stabilization Unit of petitioner's salary from the date of his employment on the same basis as his drawing account, and recommended that the board of directors approve the granting of an option to petitioner to purchase 12,500 shares of National's common stock at $16 per share. The board of directors met on the following day, fixed petitioner's salary, and in the same resolution provided for petitioner's option. On that day, August 24, 1945, petitioner entered into a 2-year employment contract with National, dated March 21, 1945, and also was granted the option which is the subject of this controversy.

Under the terms of the option petitioner was not permitted to acquire the 12,500 shares at once. The option period was divided into 4 parts of 6 months each, corresponding roughly to petitioner's 2-year contract of employment.

In substance petitioner was permitted to exercise the option only to the extent of 3,125 shares during the first 6 months, with an increase of 3,125 additional shares for each 6-month period thereafter. On the date the option was granted, August 24, 1945, the stock sold on the New York Stock Exchange at from $18.50 a share to $19.50 a share, and we have found that its fair market value at that time was $19 a share.

Petitioner exercised his option on two separate occasions, the first time on March 12, 1946, when he obtained 6,250 shares, and on March 6, 1947, when he obtained the remaining 6,250 shares. He paid the option price of $16 a share; on March 12, 1946, the stock was selling on the New York Stock Exchange at $28.50 a share, and on March 6, 1947, at a range of from $28.25 to $28.50 a share. The Commissioner contends that petitioner realized taxable income on each of these two days, in 1946 and 1947, measured by the difference between the fair market value of the stock acquired and the option price. Petitioner, on the other hand, contends that whatever income he received by reason of the option was realized only in 1945, when the option was granted to him and consisted merely of the fair market value of the option, which he has undertaken to establish by expert testimony. In the alternative, he contends that he realized no income whatever by reason of the option or its exercise. We shall consider this latter contention first.

1. The starting point for a consideration of this question is the decision of the Supreme Court in Commissioner v. Smith, 324 U.S. 177, rehearing denied, 324 U.S. 695, 889. In that case the taxpayer was an employee of Western, a corporation which took over the management and rehabilitation of another corporation, Hawley, pursuant to a plan of reorganization. The taxpayer was active in the reorganization, and Western gave him an option to purchase a part of the Hawley stock which Western would acquired. The market price of the stock did not exceed the option price on the date of the option, but when the taxpayer exercised the option in 1938 and 1939, the market price had advanced considerably. The Supreme Court approved a determination that the option was given as compensation for the taxpayer's services and that such compensation was ‘to be derived from the exercise of the option after the anticipated advance in market price of the stock.‘ 324 U.S.at 180. The Court referred to section 22(a) of the statute and to Regulations 1-1. art. 22(a)-1 and Regulations 103, art. 19.22(a)-1, and stated (p. 181):

Section 22(a) of the Revenue Act is broad enough to include in taxable income any economic or financial benefit conferred on the employee as compensation whatever the form or mode by which it is effected. See Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729. The regulation specifically includes in income, property ‘transferred . . . by an employer to an employee, for an amount substantially less than its fair market value,‘ even though the transfer takes the form of a sale or exchange, to the extent that the employee receives compensation.

We have no doubt that the option and the contemplated benefits to petitioner herein were intended as compensation to petitioner. We cannot agree that the option was awarded to him merely to give him a proprietary stake in the enterprise.

When petitioner first discussed with Cuneo his employment as general manager of National, he stated that he would want a fixed salary, a percentage of profits, and the opportunity to acquired stock. The proposed contract which Cuneo submitted to him in February 1945 provided for a fixed salary of $27,500 per year, 2 per cent of the net profits in excess of $300,000, and an option to purchase 12,500 shares of National's stock at $12 per share during the 1-year term of that contract. The stock was then selling at $15.25 per share. Although this proposed contract was discussed at the directors' meeting of March 21, 1945, it was not executed undoubtedly because of salary stabilization difficulties. If the option was not intended to compensate petitioner for services rendered or to be rendered, no question of salary stabilization would have been involved and it could have been executed when petitioner was employed on March 21, 1945. When the directors met on August 24, 1945, shortly after the salary stabilization rules had been relaxed, the executive committee recommended to them not only the cash compensation for petitioner but also the option, and a resolution providing simultaneously for the cash salary and option was adopted at that meeting. In petitioner's return for 1945, he reported the receipt of the option as compensation for services in the amount of $16,375. National in its 1945 return claimed a deduction for compensation to officers which included $16,375 in respect to the option granted to petitioner. In its annual report filed with the Securities and Exchange Commission for the year 1945 National stated that the consideration for the granting of the option to petitioner was ‘Services rendered and to be rendered.‘

The option gave petitioner the opportunity to purchase stock during the period of his employment at less than its market price when issued. It was consistently referred to and treated by both National and petitioner as compensation. It was intended to confer an economic and financial benefit upon him as compensation by enabling him to make a bargain purchase. While it was in the interest of National to grant this benefit, that did not detract from its compensatory nature. Neither did the fact that one of the motives in granting it was ‘to encourage his interested and enthusiastic efforts,‘ for that is frequently one of the objectives of giving employees additional compensation in the form of bonuses and stock options. We are fully satisfied on the record before us that the gain to be derived from the option was intended as compensation to petitioner, and that the option was not awarded to him merely to give him a proprietary interest in the corporation.

2. We are also convinced that the intended compensation was not the ‘value‘ of the option but was the difference between the fair market value of the stock on the date of exercise and the option price. To be sure, the opinion in the Smith case notes that the option there involved was not found to have any market value when given, and it makes plain that (324 U.S.at 182): ‘It of course does not follow that in other circumstances not here present the option itself, rather than the proceeds of its exercise, could not be found to be the only intended compensation.‘ Petitioner herein relies upon that language.

The difficulty with petitioner's position is that, as we view the facts in this record, the option itself was not ‘the only intended compensation.‘ This is not a case of the distribution of a stock option or warrant, which has a clearly ascertainable market value or which the employee could readily sell. there was no provision in the option forbidding assignment, it is nevertheless plain that no assignment or sale was ever contemplated by either party.

The option was of a restrictive type, the number of shares obtainable thereunder depending upon in which of the four half-yearly periods it would be exercised. In this respect, the present case is comparable to Wanda V. Van Dusen, 8 T.C. 388,

affirmed, 166 F.2d 647 (C.A. 9), where, as here the employee could have exercised the option at once only as the block of stock available during the first of a series of periods.

We are fully aware that petitioner's expert witness undertook to place a fair market value upon the option as a whole as of the date it was received by petitioner. However, the witness did not display any particular knowledge of options of this type, nor are we satisfied that he had any experience in the sale or purchase of such options. The option as a whole was highly speculative and depended upon market values ranging over a long period of time. We are not satisfied either that the witness' arithmetic calculations reflect the true value of the option or that the option represented a property interest that could readily be disposed of without a sacrifice. The latter consideration, while perhaps not crucial, is nevertheless relevant in determining whether the option itself may be regarded as ‘the only intended compensation.‘

We think that the facts as a whole in this record point to the conclusion that the ‘intended compensation‘ in this case was not the option itself, but rather the profit to be derived upon the exercise of the option. This conclusion is confirmed by the fact that, although the option was not explicitly tied to petitioner's 2-year contract of employment, such continued employment was nevertheless plainly contemplated. Petitioner himself had told Cuneo that National's lack of success was due to ‘management,‘ and it seems clear that a change in management with petitioner as general manager, was expected to bring improvement. Such improvement would be reflected in a higher market price for National's stock, and thus, to the extent that petitioner's efforts as general manager would be successful, he would be rewarded in part by the rise in value of the stock obtainable under the option. Taking all the facts and circumstances into account, we conclude and find that the option arrangement was intended to represent compensation to petitioner at the time of exercise, in an amount equal to the spread between market value and the option price. This conclusion makes it unnecessary to consider whether T.D. 5507, 1946-1 C.B. 18 and I.T. 3795, 1946-1 C.B. 15, are justified by the decision in the Smith case or are otherwise authorized by statute. See S. Rept. No. 2375, 81st Cong., 2d Sess., p. 59.

That the holding in the Smith case is not limited to cases where there was no spread between market price and the option price at the date of issuance of the option is made clear by Connolly's Estate v. Commissioner, 135 F.2d 64 (C.A. 6), affirming 45 B.T.A. 374. The Connolly's Estate case is particularly significant, because the Smith case had been decided differently by the Court of Appeals for the Ninth Circuit (142 F.2d 818), and certiorari was granted in the Smith case for the purpose of resolving the asserted conflict between the two cases. 324 U.S.at 178. In the Connolly's Estate case each of the taxpayers had been given an option, dated March 1, 1935, to purchase 6,000 shares of his employer's stock, 2,000 of which could be purchased at 50 cents a share within 1 year, 2,000 shares at a dollar a share within 2 years, and 2,000 shares at $1.50 a share within 3 years. At the time the options were granted, the market value of the stock was $2 3/8 per share, nearly two and a half times the average option price. Nevertheless, in the circumstances of that case, it was held that the subsequent exercise of the options in 1936 when the market value of the stock was $5 a share resulted in the realization of taxable income in 1936 measured by the spread between the then market value of the stock and the option price. Surely the decision of the Supreme Court in the Smith case, that was intended to resolve a conflict with the decision in the Connolly's Estate case, cannot be read as disapproving the latter. We understand the holding in the Smith case to apply to situations of this kind, unless it is shown that the option itself was ‘the only intended compensation‘; and the fact that there may or may not be a spread between the option price and market price on the date of the issuance of the option is merely a factor to be taken into account. The Connolly's Estate case certainly demonstrates that existence of such a spread is not fatal to the result reached in the Smith case itself, and we think that the Connolly's Estate case furnishes support for our conclusion here.

Cf. John C. Wahl, 19 T.C. 651.

3. Finally, we reach the question as to the fair market value of the stock when it was acquired by petitioner on March 12, 1946, and March 6, 1947, in blocks of 6,250 shares each. On March 12, 1946, two hundred shares were sold on the New York Stock Exchange, at $28.50 a share; and on March 6, 1947, a total of 200 shares was similarly sold, at prices ranging from $28.25 to $28.50 a share. The Commissioner determined fair market value to be $28.50 a share on March 12, 1946, and $28.375 on March 6, 1947. The petitioner challenges these determinations, contending that a block of 6,250 shares could not have been sold at those times at such prices. Petitioner invokes the familiar ‘blockage‘ principle.

As to the determination of fair market value of $28.50 a share for March 12, 1946, we are satisfied, on the facts before us, that the blockage principle has no application. We have in the record the number of shares sold during each trading day between February 1 and April 30, 1946, together with the open, high, low, close, bid, and asked quotation for each such day, and we think that 6,250 shares could have been sold within a reasonable period at about March 12, 1946, at $28.50 a share. Indeed, when, on April 2 and April 3, 5,800 and 5,500 shares, respectively, were sold, the market rose to over $30 a share, and continued to rise throughout the remainder of the month. We approve the determination of the Commissioner as to value on March 12, 1946.

The situation as of March 6, 1947, however, is different. The record similarly contains the daily quotations and number of shares sold during the comparable 3-month period in 1947, and it seems clear that the market was considerably weaker than during the corresponding period in the previous year. We are satisfied that 6,250 shares could not have been sold at about March 12, 1947, at $28.375 a share, as determined by the Commissioner; it is our best judgment that the 6,250 shares of stock had a fair market value of $27.50 a share on that date, and we have so found as a fact.

Reviewed by this Court.

Decision will be entered under Rule 50.