Frank v. Comm'r of Internal Revenue

• Decision Date: 26 January 1970
• Docket Number: Docket No. 4436-66.
• Citation: 54 T.C. 75
• Parties: M. P. FRANK AND BEATRICE FRANK, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

54 T.C. 75

M. P. FRANK AND BEATRICE FRANK, PETITIONERS
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 4436-66.

United States Tax Court

Filed January 26, 1970.

[54 T.C. 76]

Marvin E. Klitsner and William J. Willis, for the petitioners.

Sheldon Chertow, for the respondent.

Petitioner received certain nonstatutory options to acquire the stock of two corporations for which he had rendered services as an organizer, promoter, officer, and director. Held:

1. Petitioner was an employee of both corporations, and the options at issue were granted for reasons connected with such employment, and therefore, the rules contained in sec. 1.421-6, Income Tax Regs., are applicable to the instant case.

2. The options at issue did not have a readily ascertainable value at the time of their grant. Consequently, date of grant does not constitute the appropriate taxable event herein.

3. Petitioner is taxable at the time of exercise upon the difference between the amount he paid for the stock at issue and the fair market value of such stock on the exercise date.

4. The fair market value of the stock at issue on the date of exercise was $18.50 per adjusted share.

STERRETT, Judge:

The Commissioner determined a deficiency in the petitioner's income tax for the calendar year 1960 in the amount of $644,187.86.

The issues presented for our decision are as follows:

(1) Whether the rules contained in section 1.421-6, Income Tax Regs., governing the taxation of nonstatutory stock options, are applicable to the instant case.

(2) Whether the options at issue had a readily ascertainable fair market value at the time of the grant, and were therefore taxable to petitioner in the year of grant as compensation income under section 61(a) of the Internal Revenue Code of 1954.¹

(3) If grant does not constitute the appropriate taxable event, whether petitioner realized compensation income in the year of exercise within the meaning of section 61(a) to the extent that the fair market value of the stock petitioner received upon exercise of the options exceeded the amount that he paid for such stock.

(4) If exercise is determined to be the appropriate taxable event, what was the fair market value of the stock at issue on the date of exercise.

FINDINGS OF FACT

Some of the facts have been stipulated by the parties. The stipulated facts and the exhibits attached thereto are incorporated herein by this reference. A summary of the pertinent facts is set forth below.

At the time of filing their petition herein, M. P. Frank (hereinafter referred to as petitioner) and Beatrice Frank were husband and wife residing in Mequon, Wis. They filed their joint Federal income tax

[54 T.C. 77]

return for the calendar year 1960 with the district director of internal revenue at Milwaukee, Wis.

From 1952 through the year in issue and beyond, petitioner was a partner in a Milwaukee, Wis., law firm. His law practice consisted primarily of real estate law.

Petitioner Max H. Karl and Spiros W. Kallas organized a Wisconsin insurance corporation known as Mortgage Guaranty Insurance Corp. (hereinafter referred to as MGIC). On September 1, 1956, 10 weeks prior to MGIC's incorporation, the incorporating group unanimously adopted a resolution providing that MGIC would issue 1,000 shares of no-par common stock for $525 per share. It was also resolved that the $525 per share price would be allocated as follows: $400 to capital, $100 to capital surplus, and $25 for promotional and/or organizational expense. The resolution of the MGIC incorporating group dated September 1, 1956, further stated in pertinent part:

RESOLVED: That M. P. Frank, Max H. Karl and Spiros W. Kallas shall be empowered to sell the capital stock of the corporation for the price above designated, and that in consideration of their efforts in such sale and in the promotion and organization of this corporation, they shall be given compensation in accordance with the following proposed option agreement, which is hereby ratified by the incorporators:

FOR VALUABLE CONSIDERATION, it is hereby agreed by and between M. P. FRANK, of Whitefish Bay, Wisconsin, MAX H. KARL of Whitefish Bay, Wisconsin, and SPIROS W. KALLAS of Wauwatosa, Wisconsin, hereinafter called Promoters, and the incorporators of MORTGAGE GUARANTY INSURANCE CORPORATION, hereinafter called the Company, that in consideration of the Promoters expending their time and effort in the organization of the Company and the sale of its capital stock, they shall be paid the sum of $25.00 per share of such stock as is sold by them in accordance with the subscription agreement of the Company; and at any time prior to December 31, 1959, each of the Promoters shall have the option to purchase 100 shares of common stock without par value for the consideration of $500.00 per share, and such aggregate of 300 shares shall be reserved for them during such option period.

Petitioner did not participate in the promotion and sale of MGIC stock after the initial capital of $200,000 was subscribed.

On November 14, 1956, the original articles of incorporations of MGIC were filed in the office of the commissioner of insurance of the State of Wisconsin, who issued a certificate of incorporation on November 21, 1956. The principal business purpose of MGIC was insuring mortgage lenders against credit losses on residential first-mortgage loans.

In the 1930's, when the insuring of lenders against mortgage loans was a function of private insurance, the insurers operating at the time suffered severe losses and failed. When private insurance companies

[54 T.C. 78]

withdrew from the mortgage loan insurance field in the 1930's, Federal programs were adopted in the national interest to fill the continuing need for this insurance, principally the insurance activities of the Federal Housing Administration (FHA) which began in 1934 and the mortgage loan guaranty activities of the Veterans' Administration (VA) which began in 1944. These agencies remained the only general available source of mortgage loan insurance until MGIC entered the field in 1957. Accordingly, there was little or no experience of record of private companies to serve as a guide with which to estimate the risks involved.

Petitioner Max H. Karl and Spiros W. Kallas were also the organizers and promoters of a second Wisconsin corporation, Guaranty Insurance Agency, Inc. (hereinafter referred to as GIAI). Articles of incorporation for GIAI were filed with the secretary of state for the State of Wisconsin on February 15, 1957. The authorized capital of GIAI was 1,000 shares of no-par common stock, and the original price per share was $25. The principal business purpose of GIAI was the selling of insurance issued by MGIC and the financing of the payment of commissions due agents.

On January 9, 1957, petitioner was elected to the MGIC board of directors, and on the same day he was chosen to be the first MGIC secretary-treasurer. On May 6, 1957, petitioner was elected to serve on the GIAI board of directors, and on May 23, 1957, he became the first GIAI president.

In his capacity as secretary-treasurer and director of MGIC, petitioner attended and participated in at least 16 MGIC board meetings and five MGIC shareholder meetings held during the years 1957, 1958, and 1959. Petitioner's signature and the designation ‘Secretary’ appears at the end of the corporate minutes for each of these 21 meetings. On February 18, 1957, the MGIC board of directors authorized the president of MGIC and petitioner in his capacity as secretary thereof to borrow $200,000 from American State Bank, Milwaukee, Wis. At a MGIC board meeting held on March 29, 1957, petitioner presented a plan concerning the insurance of mortgages secured by a bond issue, and the board authorized him to proceed with further negotiations relating to this plan. On May 6, 1957, petitioner submitted a report of contacts with lending institutions in Madison, Wis., to the MGIC board. In a meeting held on January 8, 1958, the MGIC board conferred general management authority, including the hiring of personnel, on a three-man committee consisting of Max H. Karl, Spiros W. Kallas, and petitioner. Petitioner was authorized to sign checks and make deposits to various MGIC bank accounts.

[54 T.C. 79]

In his capacity as president and director of GIAI, petitioner attended and chaired at least six GIAI board meetings and at least one GIAI shareholders meeting held during the years 1957 through 1959. On January 8, 1958, the GIAI board unanimously agreed that the management of GIAI would be vested in a three-man board composed of petitioner (president), Spiros W. Kallas (vice president), and Mary Jane Johnston (secretary-treasurer). Petitioner was authorized to sign checks and make deposits to the GIAI account with North Shore State Bank of Shorewood, Wisc.

On July 1, 1959, petitioner resigned from his position as director of MGIC and director and president of GIAI. He also resigned from the office of treasurer of MGIC on September 27, 1960. At the insistence of his business associates, petitioner continued to hold the office of secretary until 1965.

Petitioner did not directly receive cash remuneration for any services as an organizer, promoter, officer, or director of MGIC and GIAI, except to the extent of his share of the $25 per share promotional fee and except to the extent that the options at issue may be found to constitute compensation.

In March 1957 the MGIC shareholders authorized an increase in capitalization from $500,000 to $1 million by raising the number of authorized shares from 1,000 shares (no-par value) to 10,000 shares ($100 par value). The board of directors resolved that the new issue price would be $125 ($100 to stated capital and $25 to capital surplus), and that the old shareholders could convert on the basis of four new shares for each original share.

On May 6, 1957, the first meeting of the incorporators and subscribers of GIAI was held. Commencing on May 7, 1957, shares...