Opinion
Docket No. 1896-64.
1969-06-18
NATHAN PUTCHAT AND SALLY PUTCHAT, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Robert B. Alexander, Jr., for the petitioners. Gerald Backer, for the respondent.
Robert B. Alexander, Jr., for the petitioners. Gerald Backer, for the respondent.
Held, an amount received by petitioner as consideration for the release of all his rights under an employment contract, including the right to be employed as a project manager, the right to receive 20 percent of net profits, and the right to exercise a stock option, constitutes ordinary income.
DAWSON, Judge:
Respondent determined a deficiency of $16,370.90 in petitioners' Federal income tax for the year 1959 and of $15.94 for 1960.
Petitioners have conceded certain adjustments made by respondent. The only issue remaining for decision is whether a net amount of $58,433.36 received by petitioner Nathan Putchat in consideration of his release of all rights under a contract constitutes ordinary income or capital gain.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Nathan Putchat (herein referred to as petitioner) and Sally Putchat, husband and wife, were residents of Pleasant Valley, Pa., at the time they filed their petition herein. Their joint Federal income tax return for 1959 was filed with the district director of internal revenue at Camden, N. J.
Petitioner is a graduate civil engineer who has had wide experience in the general construction business and who is a member of a number of professional engineering and related technical societies. From 1938 until 1959 he was the administrative head and principal shareholder of two New Jersey corporations engaged in the general construction business. During that period he also was employed as a consultant by other companies.
In 1958 petitioner was approached by Samuel Simkin (herein referred to as Simkin), president of Charles Simkin & Sons, Inc., a corporation engaged primarily in the mechanical construction business, with regard to subcontracts for construction work on an atomic energy facility for the U.S. Atomic Energy Commission and the U.S. Navy (herein referred to as the atomic energy project). Project specifications required that work be awarded to low bidders whose capability to perform had been demonstrated through experience in jobs of like quality and size. Combustion Engineering had been awarded the prime contract. Charles Simkin & Sons, Inc., was seeking an alliance with an established general construction company in order to meet the specifications for certain subcontracts awarded by Combustion Engineering.
Petitioner was interested in Simkin's proposals and favored a permanent association of some sort to extend beyond the atomic energy project. After numerous discussions between petitioner and Simkin, during which the scope of the arrangement was of primary concern, the two jointly submitted a bid on the atomic energy project. When that bid was accepted, a new corporation, Associated General Builders, Inc. (herein referred to as Builders), was immediately formed to begin construction. The initial capital contributions to Builders were made by Simkin and two other members of his family. No formal arrangement was entered into between Builders and the two corporations controlled by petitioner, but Builders purchased some of their assets and borrowed others for limited periods of time after which they were returned. Out of a maximum of 125 employees of petitioner's corporations, 7 to 10 key employees were employed by Builders or Simkin.
In May 1958 an agreement was entered into by Builders, Charles Simkin & Sons, Inc., and petitioner which provided, inter alia:
WHEREAS COMBUSTION ENGINEERING, INC., a corporation of the State of Delaware, hereinafter called ‘COMBUSTION’, did on the 15th day of July, 1955, enter into a contract with the United States of America, acting through the United States Atomic Energy Commission, identified as Contract #AT (30-3)-198; and
WHEREAS SIMKIN has received a sub-contract from COMBUSTION whereunder SIMKIN is to perform certain work in connection with the performance of the aforementioned contract with the United States of America; and
WHEREAS BUILDERS and SIMKIN have entered into a subcontract whereunder BUILDERS has agreed to perform work under the aforementioned subcontract which SIMKIN has entered into with COMBUSTION; and
WHEREAS BUILDERS desires to engage PUTCHAT and PUTCHAT desires to work for BUILDERS,
2. BUILDERS hereby engages PUTCHAT to work for BUILDERS and PUTCHAT hereby agrees to work for BUILDERS upon the following terms and conditions:
(a) BUILDERS agrees to employ and PUTCHAT agrees to be employed as ‘Vice President in Charge of Construction’ (if there be any legal impediment in PUTCHAT being designated a Vice President he shall be denominated as Superintendent in Charge of Construction) for the period of time necessary to complete the work required to be done by BUILDERS under its said contract with SIMKIN and by SIMKIN under its said contract with COMBUSTION upon the aforementioned Atomic Energy project.
(b) PUTCHAT agrees to devote all of his time, for not less than five (5) days per week, and his best efforts to and for the benefit of SIMKIN and BUILDERS (except as mentioned in provision 2(c) below), and by way of inclusion but not by way of limitation to perform the following services:
(i) To be over-all project manager and to be subject to the direction and control of SIMKIN and to be considered to be employed also by SIMKIN as project manager without any additional compensation except as shall be paid by BUILDERS as hereinafter stated.
(ii) To coordinate all trades, including the mechanical trades of plumbing, heating, and process piping.
(iii) To act in the best interest, according to his best judgment and discretion in good faith, of SIMKIN as well as BUILDERS.
(iv) To do all purchasing involved in the general construction part of the contract, SIMKIN and BUILDERS to be responsible for payment for all purchases.
(v) To be in charge of all job drawings, processing of all paper work involved in general construction, and to be in charge of all records involved in general construction; BUILDERS and SIMKIN to supply all the necessary clerical help, equipment, office space and other things necessary or proper to carry on this work, as well as for the purchasing involved in provision 2(b)(iv) above.
(vi) Not to engage in any work for any other person, firm or corporation during the lifetime of this agreement than BUILDERS and SIMKIN (subject to exceptions not here relevant).
3. (a) During the period of time necessary to complete the work required to be done by BUILDERS under its said contract with SIMKIN and by SIMKIN under its said contract with COMBUSTION upon the aforementioned Atomic Energy project, and for a period of sixty (60) days thereafter, SIMKIN and BUILDERS shall make all reasonable efforts to submit legitimate bids and get more contracts and jobs, whether together or separately, and this contract and employment shall continue upon all the terms, covenants and conditions, including but not by way of limitation, all provisions of compensation, including profits mentioned, also during said period of sixty (60) days, and whether or not there is any additional work to be done during said period of sixty (60) days (salary and other compensation to be apportioned during the last week of the sixty (60) day period), and
(b) if either SIMKIN or BUILDERS or both enters into any other contract or contracts or takes on any additional job or jobs during said Atomic Energy project or the sixty (60) days thereafter, this contract and employment shall continue upon all the terms, -covenants and conditions, including but not by way of limitation, all provisions of compensation including profits mentioned, during the time necessary to complete said additional job or jobs.
4. PUTCHAT shall be entitled to and BUILDERS agrees to pay him the following compensation:
(a) The sum of Three Hundred Dollars ($300.00) per week.
(b) PUTCHAT shall be paid in addition thereto a living allowance in the amount of Fifty Dollars ($50.00) per week.
(c) PUTCHAT shall receive in addition to all the foregoing transportation (the mode or modes of transportation, such as by plane, train, bus or otherwise, to be at the option of PUTCHAT) of PUTCHAT to and from the place of work to his home in Trenton.
(d) PUTCHAT is also to be provided for the purposes of the job or jobs with a station wagon or car and all operating expenses therefor to go to and from the job site or sites.
(e) In addition to all the foregoing PUTCHAT shall receive twenty per cent (20%) of such net profits, determined as hereinafter stated as shall be made by BUILDERS upon its aforesaid contract with SIMKIN, and upon any other contract or contracts entered into upon which job or jobs PUTCHAT shall be employed, payable upon completion of each job and only if PUTCHAT shall remain until completion of the job. In determining net profits there shall be charged off from the total income and revenue of the particular job the actual cost of: labor employed on the job, material used on the job, bonds and insurance premiums, reasonable upkeep and necessary repairs of equipment for the job, freight necessary to transport any equipment or materials to the job, proper overhead charges in connection with the performance of the work of the particular job, but no depreciation shall be charged, and no salaries shall be charged for any services of Theodore T. Simkin, Samuel Simkin or Milton Simkin or for any persons not actively engaged in the performance of the particular contract or the work.
(f) In addition to all the foregoing, and as further consideration and compensation, BUILDERS hereby grants to PUTCHAT an option to acquire forty (40) shares of the common stock of BUILDERS upon the following terms and conditions:
(i) That PUTCHAT abides by all of the terms and conditions as hereinabove set forth upon his part to be performed.
(ii) That the option shall be effective, or the period during which PUTCHAT may exercise the option shall commence, only upon the termination of the aforesaid project for which COMBUSTION has made the aforesaid contract, and said option shall continue to remain in existence for a period of two (2) years after the termination of said project or until April 1, 1961, whichever is sooner, provided PUTCHAT shall be an employee of BUILDERS and provided all other terms and conditions hereof shall be complied with.
(iii) The price to be paid by PUTCHAT shall be Ten Thousand Dollars ($10,000.00) for the aforementioned forty (40) shares of common stock.
(iv) BUILDERS represents and warrants to PUTCHAT that there is and will not be any other class of stock of BUILDERS, and that the aforesaid common stock shall not have its voting rights or rights to dividends or any other rights therein changed prior to the time PUTCHAT shall exercise said option and become the owner of said forty (40) shares of stock, provided, however, that if there shall be a reorganization of BUILDERS it is agreed and understood that for the aforesaid Ten Thousand Dollars ($10,000.00) consideration PUTCHAT shall be entitled to receive so many shares of stock as shall constitute a twenty per cent (20%) interest in BUILDERS, and provided, however, that PUTCHAT shall have the same corresponding, co-relative and proportionate voting rights, rights to dividends and all other rights as he would have had prior to the reorganization, and without any reduction or diminution in any of such rights.
(v) This option is not assignable or transferrable and shall terminate in any event upon the death of PUTCHAT.
(ix) PUTCHAT shall have no rights as a stockholder with respect to the stock covered by this option until after the purchase price shall have been paid in full, at which time a certificate for such stock shall be issued by BUILDERS to him.
(xii) If PUTCHAT shall cease to be employed for any reason whatever by BUILDERS, this option shall terminate immediately.
Petitioner began performance under the agreement on the atomic energy project and cooperated with Simkin in submitting joint bids for other construction projects. By late 1958, however, friction began to develop between petitioner and Simkin. Petitioner felt that certain subcontracts were not awarded to Builders by Charles Simkin & Sons, Inc., in violation of the working arrangement between the companies and that he was denied access to certain records relating to the atomic energy project. After Simkin indicated to petitioner that he was no longer willing to continue operating under the agreement, petitioner filed on March 20, 1959, a suit in equity in the Superior Court of New Jersey seeking to enjoin Charles Simkin & Sons, Inc., from subcontracting any of the general construction work on the atomic energy project covered under certain prebid agreements to anyone other than Builders, from preventing petitioner from being employed as vice president in charge of construction and project manager of such existing work or of jobs contracted for during the atomic energy project and 60 days thereafter, from interfering with petitioner's rights to 20 percent of net profits of completed work, from employing anyone else to perform the duties of petitioner under the agreement, from commingling funds of the general construction and mechanical trades portions of the jobs, from denying petitioner access to the books and records of both corporations, and, affirmatively to require Charles Simkin & Sons, Inc., to make reasonable efforts to submit legitimate bids on more contracts and to pay damages to petitioner.
A temporary restraining order was obtained by petitioner on March 20, 1959, but was dissolved 6 days later. On April 11, 1959, prior to the completion of the atomic energy project, petitioner was discharged by Builders by way of a telegram sent by Simkin which stated:
Due to your neglect of duties and obligations your constant disregard of instructions breaches of your employment duties and obligations and your insubordination and your refusal to appear today although instructed to appear to go over the accounts and figures on the combustion job which instruction was the second one you refused having failed to show up last Saturday as well as today for the same purpose your employment is terminated.
After further litigation of the controversy on appeal, during which another restraining order was issued and then dissolved, petitioner executed on May 28, 1959, a general release of the obligations of the other parties to the contract in consideration for a payment to him of $75,000. On the same day all suits concerning the agreement in question were dismissed. At that time work continued in progress on the atomic energy project, and petitioner had no accrued right to a percentage of the profits.
On their Federal income tax return for 1959, petitioners reported the $75,000 as the gross sales price of ‘forty shares of Associated General Builders, Inc.’ and reported a long-term capital gain of $58,433.36, after subtracting $16,566.64 in legal fees incurred in the litigation. In the statutory notice of deficiency respondent determined that petitioner received $58,433.36 of ordinary income.
OPINION
Petitioners contend that by way of settlement of a lawsuit they received $75,000 in exchange for the release of certain capital assets consisting of the right to acquire stock and the right to earn uncertain future profits. That portion of the amount in excess of costs incurred in litigation, they argue, constitutes capital gain. Respondent characterizes the $75,000 as consideration for the cancellation of an employment contract which is taxable as ordinary income and contends that no option under the agreement ever existed. In the alternative, respondent contends that, if an option under the agreement did exist, the surrender of the option right did not constitute a ‘sale or exchange.’
The legal principles applicable to this controversy depend entirely upon a single, essentially factual determination, i.e., the nature of the option granted to petitioner under the agreement. We think the record is clear that the option to purchase Builders stock at a bargain price constituted compensation for services relating to subcontract work on the atomic energy project rendered by petitioner to Builders. The following factors support this conclusion: (1) Without the services of petitioner whose corporations were experienced in general construction, Charles Simkin & Sons, Inc., could not have qualified for subcontracts on the atomic energy project; (2) $300 per week and 20 percent of net profits alone were not adequate compensation for the services to be performed by petitioner under his agreement with Builders and Charles Simkin & Sons, Inc.;
(3) the option was to become effective only after the satisfactory completion of petitioner's duties with respect to the atomic energy project; (4) the option was nontransferable and would have expired upon petitioner's death; and (5) the option was characterized as compensation in the agreement.
The following testimony was given at trial by petitioner in response to questions propounded by counsel for respondent:
Q. How long had you been working for Associated Builders?
A. Since April of 1958.
Q. What were you getting paid?
A. $300 a week.
Q. Did you feel that adequate compensation for your services?
A. No.
Q. You felt that the 20 percent of the profits was certainly—
A. No, my big interest was in the stock equity.
Q. Would 20 percent of the profits satisfy you with respect to the compensation; in other words, Clause 4-F, what we are talking about now?
A. No, not completely.
Q. You wanted more compensation than that?
A. I wanted what my contract gave me.
Q. What more compensation did you want?
A. The equity interest.
Q. You wanted that given to you as additional compensation?
A. That's right.
We are not persuaded by petitioner's assertions that the corporations controlled by him and Charles Simkin & Sons, Inc., became joint venturers or that he was a founder and incorporator of Builders, contributing to it the assets of his controlled corporations. It was Simkin who was the prime mover behind the Builders concept, and he needed petitioner as an employee to make it work. The few assets of petitioner's controlled corporations utilized by Builders were either purchased or borrowed and then returned; only a relatively small number of employees became employees of Builders. Petitioner has failed to establish that any consideration provided for in the agreement was attributable to his contribution to Builders of his proprietary interests in the controlled corporations.
This factual determination effectively distinguishes this case from the cases upon which the petitioner principally relies, viz, Turzillo v. Commissioner, 346 F.2d 884 (C.A. 6, 1965), and Dorman v. United States, 296 F.2d 27 (C.A. 9, 1961).
The concept of ‘gross income’ 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.’ Commissioner v. Smith, 324 U.S. 177, 181 (1945). It follows that, absent any specific statutory provision to the contrary,
the granting of a stock option as an incentive
See the discussion infra relating to subsequently enacted secs. 421 through 424, I.R.C. 1954.
at a bargain price results in ordinary income to the employee to the extent of the gain realized. Commissioner v. LoBue, 351 U.S. 243 (1956).
Simkin testified that, by granting an option to petitioner, ‘we thought we would give him an inducement to do a good job for us.’
As stated in Spangler v. Commissioner, 323 F.2d 913, 916 (C.A. 9, 1963), affirming a Memorandum Opinion of this Court:
In determining whether receipts are taxable as ordinary income or return of capital it is immaterial whether taxpayer effected collection amicably or by resolving a dispute through compromise or litigation. It is the nature of the underlying claim that controls and not the manner of collection.
Petitioner makes no argument that he constructively received the shares of stock of Builders, and we find no justification for so holding. See Albert C. Becken, Jr., 5 T.C. 498, 503 (1945).
Petitioner's suit in equity was primarily for the protection of his contract rights to be employed as project manager, to receive 20 percent of net profits of completed work, and to exercise the stock option. We believe these rights were essentially compensatory in nature, and any consideration for their release should stand upon the same footing. Albert C. Becken, Jr., 5 T.C. 498 (1945); W. W. Sutton, 35 B.T.A. 348 (1937). See also Carter's Estate v. Commissioner, 298 F.2d 192 (C.A. 8, 1962), affirming 35 T.C. 326 (1960); Mathey v. Commissioner, 177 F.2d. 259 (C.A. 1, 1949), affirming 10 T.C. 1099 (1948).
Section 421, I.R.C. 1954, provides that no income will result upon the transfer of stock to an employee pursuant to his exercise of a qualified stock option (sec. 422), of an option granted under an employee stock purchase plan (sec. 423), or of a restricted stock option (sec. 424). Petitioner never exercised or attempted to exercise the option granted to him by the agreement, nor did he ever receive any Builders stock.4 The provisions of section 421 are, therefore, inapplicable to the instant case, rendering operative the provisions of section 1.421-6, Income Tax Regs., which provide as to scope of coverage, ‘When an option is granted for any reason connected with the employment of an employee, this section applies, if section 421 does not apply.’
The option held by petitioner was not actively traded on an established market, nor could its fair market value be measured with reasonable accuracy. The release executed by petitioner constituted an arm's-length ‘transfer’ of his option rights. See Commissioner v. Ferrer, 304 F.2d 125 (C.A. 2, 1962). Section 1.421-6(d)(3), Income Tax Regs., provides:
(d) Options without a readily ascertainable fair market value. If there is granted an option to which this section applies, and if the option does not have a readily ascertainable fair market value at the time it is granted, the employee in connection with whose employment the option is granted is considered to realize compensation includible in gross income under section 61 at the time and in the amount determined in accordance with the following rules of this paragraph:
(3) If the option is not exercised by the person to whom it was granted, but is transferred in an arm's length transaction, the employee realizes compensation in the amount of the gain resulting from such transfer of the option, and such compensation is includible in his gross income in accordance with his method of accounting.
Predicated upon our determination that the granting of the option to petitioner was ‘connected with his employment,‘ the foregoing regulation, the validity of which petitioners do not question, is, on its face, dispositive of the issue presented. Accordingly, we hold that the net income of $58,433.36 received by petitioner is taxable as ordinary income.
Decision will be entered for the respondent.