Brown v. United States

• Decision Date: 19 May 1970
• Docket Number: No. 23774.,23774.
• Citation: 427 F.2d 57
• Parties: Dorothy E. BROWN and Donald Lee Brown and United States National Bank of Oregon, etc., Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

427 F.2d 57 (1970)

Dorothy E. BROWN and Donald Lee Brown and United States National Bank of Oregon, etc., Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 23774.

United States Court of Appeals, Ninth Circuit.

May 19, 1970.

Stephen B. Hill (argued) of Mautz, Souther, Spaulding, Kinsey & Williamson, Portland, Or., for appellants.

Gilbert Andrews (argued), Johnnie M. Walters, Ass't. Gen., Lee A. Jackson, E. O. C. Ord, John M. Kirk, Tax Division, Dept. of Justice, Washington, D. C.; Sidney I. Lezak, U. S. Atty., Portland, Or., for appellee.

Before BARNES, ELY, and HUFSTEDLER, Circuit Judges.

HUFSTEDLER, Circuit Judge:

The residuary legatees of Clay Brown, deceased, appeal from a judgment of the district court denying their claim to a partial refund of income taxes for 1956.¹ At issue is the tax treatment of two blocks of stock that the decedent acquired pursuant to a stock option plan under the then applicable section 421 of the Internal Revenue Code (26 U.S.C. § 421).²

On October 28, 1954, Mr. Brown was elected president of M and M Woodworking Company ("M & M"), and shortly thereafter became a director. As a part of the resolution naming him president, Mr. Brown was granted a stock option for 10,000 shares of M & M stock of which 2,000 shares would be available for purchase on November 1, 1954, and the remainder in four blocks of 2,000 shares each on October 31, 1956 through 1959. The option price was $9.90 per share. Mr. Brown bought the first block of stock for that price on December 23, 1954.

On May 26, 1955, the board of directors revised the option plan, making the second block of 2,000 shares available for purchase on November 1, 1955, rather than on October 31, 1956. Mr. Brown exercised his option for the second block of shares on November 15, 1955, at $9.90 per share. On May 24, 1956, he expressly waived any rights to acquire further shares under his option.

On May 3, 1956, following negotiations between the management of M & M and that of Simpson Redwood Company ("Simpson"), M & M's board of directors approved a plan whereby Simpson would purchase all of M & M's assets, M & M would be liquidated, and its shareholders would be paid $35 per share. M & M's stockholders approved the plan at their annual meeting on June 21, 1956. Pursuant to that plan, Simpson deposited $50,536,186.61, the full purchase price of M & M's assets, to the account of M & M on August 17, 1956, and M & M concurrently put the money into an irrevocable escrow for distribution to its shareholders. The escrow agreement provided that distribution to each shareholder would be made only upon his surrender of his stock certificates. Over 96 percent of M & M's stockholders surrendered their certificates and received their distributions from the escrow on August 17, 1956. Mr. Brown did not yield his certificates and receive payment therefor until December 12, 1956. M & M was thereafter dissolved.

In their 1956 joint income tax return, Mr. and Mrs. Brown reported their acquisition of the 4,000 shares under a restricted stock option and their disposition of the shares in 1956, two years after receipt of the option. Asserting the benefits of section 421 of the Code, the taxpayers reported receipt in 1956 of ordinary income in the sum of $6,880, representing the difference between the option price and the fair market value of the stock at the time the option was exercised³ and the realization in the same year of long-term capital gain in the sum of $92,520, the difference between the fair market value of the stock at the time the option was exercised and the sale price. The taxpayers did not disclose in their return the revision of the stock option plan that was adopted by M & M on May 26, 1955.

The Internal Revenue Service disallowed capital gains treatment in respect of all gain realized from the disposition of both blocks of stock on the ground that the requisite two-year holding period was not met,⁴ because a disposition within the meaning of section 421 occurred on August 17, 1956, the date the purchase money had been placed in the irrevocable escrow.

The Browns paid the deficiency assessment, a claim was filed on their behalf, and, after the claim for refund was rejected, this action was brought.

The district court decided that: (1) a disqualifying disposition occurred on August 17, 1956, because Mr. Brown had constructively received his share of the liquidation distribution on that date; (2) the May 1955 revision of the option was a "modification" of the plan, disqualifying the second block of shares from section 421 benefits, even if a disqualifying disposition had not occurred on August 17, 1956; and (3) taxpayers were estopped from asserting that the second block of shares had been acquired pursuant to a non-restricted stock option.

On appeal, the taxpayers do not challenge the second ground of the decision below.

We hold that a disqualifying disposition did not occur within the two-year holding period because the disposition was not made by the voluntary, affirmative act of Mr. Brown, as required by section 421, and that the taxpayers are not estopped from asserting the consequences of the modification of the stock option plan.

1. No disqualifying disposition

Were section 421 drawn simply to require "a disposition" of shares as the event upon which disqualification turned, we might agree with the Government that "a disposition" occurred when M & M reached agreement with Simpson for a sale and complete liquidation of M & M, and we would then have to decide whether or not the date of such disposition was the date upon which the liquidating payment was placed in escrow, or some other time. But the statute was not thus written.

The disqualifying event is not payment, actually or constructively received. The section 421 disposition is not just any disposition. The statute says not once, but repeatedly, that the disqualifying event is a "disposition of such share * * * made by him the holder of the option within 2 years from the date of the granting of the option." (Emphasis added.) We construe the terms "disposition * * * made by him" as manifesting Congress' intent that some affirmative, voluntary act of the option holder-taxpayer is required to constitute a disqualifying disposition. That Congress intended to focus upon the voluntary act of the individual executive is evidenced by the history of section 421. The statute was designed to give tax benefits to key corporate executives for the purpose, according to its proponents, of increasing corporate productiveness and thus stimulating the nation's economy. (S.Rep.No.2375, 81st Cong., 2d Sess., 1950 U.S.Code Cong. & Service, 3114-15; see H.R.Rep.No.749, 88th Cong., 1st Sess. (1963), 1964 U.S. Code Cong. & Ad.News, pp. 1313, 1375.) The incentive rationale is obviously no longer seved when the executive has chosen to dispose of his stock.⁵

The Government suggests that Mr. Brown took such affirmative action because (1) as President of M & M he negotiated the liquidation agreement on M & M's behalf, and (2) as a stockholder, he voted for the liquidation plan.

Nothing in the record supports even an inference that M & M or Simpson was acting as Mr. Brown's agent, or that either was subject to his control. Mr. Brown participated in the negotiations for sale in his fiduciary capacity, not in his capacity as a stockholder, and his actions as a fiduciary under these circumstances cannot be converted into actions on his individual behalf. (Cf. May Rogers (1935) 31 B.T.A. 994, 1004, aff'd (2d Cir. 1939) 107 F.2d 394; Rev.Rul. 67-405, 1967-2 Cum.Bul. 293).

The record does not support the district court's finding that Mr. Brown voted as a stockholder for the liquidation plan; the court's findings is clearly erroneous.⁶

It is unnecessary for us to decide whether or not Mr. Brown's act in surrendering his share certificates would have been an affirmative act constituting a disposition by him, because the act was not done before the expiration of the two-year holding period.

We hold that the involuntary exchange of Mr. Brown's stock pursuant to the liquidation plan and the irrevocable deposit of the liquidation payment to the escrow did not constitute a disqualifying disposition made by Mr. Brown, and we therefore hold that the district court erred in concluding that the first block of stock was disqualified from section 421 benefits.

2. Effect of "modification"

Our reversal of the district court's decision on the disposition issue requires our considering the alternative positions of the Government and of appellants in respect of the second block of 2000 shares.

The pretrial order embodied the Government's contention that, even if the first block of stock had not been sold within two years of the date of the granting of the option, the second block had been thus disqualified because it was purchased pursuant to a "modification" of the plan adopted by M & M in May 1955. The district court found that the 1955 revision constituted a "modification" as defined in section 421(e) (2) of the Code⁷ and in Treasury Regulation section 1.421-4(c) (1) (1958).⁸

Appellants contended that the 1955 revision of the stock option plan was merely a "clarification" of the plan, and not a "modification." They do not now contest the district court's contrary holding. Rather, they urge that the necessary result of that holding is that the second block of stock was acquired under a non-restricted stock option plan. The "modified" plan could not have been a "restricted stock option," as that term is defined in section 421(d) (1), because the option price ($9.90) was less than 85 percent of the fair market value of the stock at the time the option was granted in May 1955 ($16). Therefore, appellants say, these tax consequences must follow: The difference between the option price and the fair market value of the stock at the time the nonrestricted stock option was granted...