Gresham v. Comm'r of Internal Revenue

Decision Date16 August 1982
Docket NumberDocket No. 14686-79.
Citation79 T.C. 322
PartiesLOUIS B. GRESHAM and MARGARET S. GRESHAM, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Sec. 57(a)(6), I.R.C. 1954, includes as a tax preference item the difference between the fair market value and the option price of stock issued upon the exercise of a qualified stock option. Held: Where the option shares are subject to the restrictions of the Securities Act of 1933 as amended and an investment letter, the fair market value is the discounted value which would be realized in a private placement. Sec. 1.57-1(f)(3), Income Tax Regs., which directs that restrictions which lapse should be ignored in determining fair market value, is invalid. Stanley P. Weiner, for the petitioners.

Alan M. Jacobson, for the respondent.

WHITAKER, Judge:

Respondent determined deficiencies in petitioners' income taxes as follows:

+-----------------------+
                ¦Year 1  ¦Deficiency   ¦
                +---------+-------------¦
                ¦1975     ¦$13,234.59   ¦
                +---------+-------------¦
                ¦1976     ¦17,916.67    ¦
                +-----------------------+
                

The sole issue for decision is the fair market value for purposes of the minimum tax, section 57(a)(6),2 of shares of stock acquired by petitioner Louis B. Gresham pursuant to several exercises of a qualified stock option.

FINDINGS OF FACT

The facts are fully stipulated and are found accordingly.

Louis B. Gresham (petitioner) and Margaret S. Gresham are husband and wife. They filed joint Federal income tax returns for the years 1975 and 1976. Mrs. Gresham is a petitioner only by reason of having filed joint income tax returns with her husband. At the time the petition was filed, petitioners resided in Shawnee Mission, Kans.

During the years in question, petitioner was chief executive officer of General Energy Corp. (GEC). GEC common stock was then traded on the over-the-counter market. Effective January 1, 1973, GEC adopted a stock option plan meeting the requirements of section 422. Pursuant thereto, petitioner received a stock option for 50,000 shares of stock. The option price was $2.50 per share. As a condition to the issuance of stock pursuant to the exercise of the option, petitioner was required to execute an “investment letter” in order for the transaction to be exempt from the registration requirements of the Securities Act of 1933, as amended, 15 U.S.C. sec. 77d(2).

In general, under the rulings of the Securities and Exchange Commission (SEC), the effect of the required investment letter was to prohibit petitioner for a period of 2 years from selling the shares except in a private placement, unless a registration statement was in effect with respect to the shares. No such registration statement was in effect on the dates of issuance of the option shares. In any such private placement, the SEC would require the purchaser to execute a similar investment letter. Certificates for the option stock were required to bear an appropriate legend, and a stop transfer order was placed against the share with GEC's transfer agent.

Petitioner exercised the option to the extent of 5,000 shares in December 1974. During 1975, petitioner purchased in two separate exercises a total of 25,000 shares, and in 1976, petitioner purchased the remaining 20,000 shares of stock. Upon each exercise of the option, petitioner executed the required investment letter.

For purposes of the minimum tax calculation on petitioner's 1974,3 1975, and the 1976 returns, petitioner determined the bid prices for the GEC common stock traded on the over-the-counter market on the dates of exercise of the option and then discounted the total value of each block of shares purchased by 331;3 percent, reporting the discounted value as the fair market value of the option stock so acquired. The amount of tax preference income in each year was determined by deducting from the discounted value of the option stock petitioner's cost for the stock.4

In determining the deficiencies for these 2 years, respondent valued the option stock at the mean of the bid and asked prices in the over-the-counter market on the dates of exercise of the option, without taking into account the effect of the investment letter restrictions applicable to the stock. In so doing, respondent applied section 1.57-1(f)(3), Income Tax Regs.,5 which adopts the principles of section 83(a)(1) to compute fair market value for purposes of the minimum tax. Section 83(a)(1) specifies that restrictions shall not be taken into account in valuing stock unless they are nonlapse restrictions. The restrictions in this case, which are required under the Securities Act of 1933, as amended, and the rules of the SEC, are considered to be ones which will lapse. See sec. 1.83-3(h), Income Tax Regs.

In this case, the parties have stipulated that if the Court holds that section 1.57-1(f)(3), Income Tax Regs., is valid and applicable, petitioner will concede the deficiencies as asserted in the statutory notice, including the increased deficiency for 1975 asserted in respondent's amendment to the answer. On the other hand, the parties have stipulated that if we should decide that the regulation is not valid or does not apply, the fair market value of the stock is to be determined by applying a discount of 331;3 percent to the mean of the bid and asked prices on the over-the-counter market.6 Application of this discount will reflect the price at which the shares could have been sold in a private placement with the purchaser executing a similar investment letter.

Pursuant to the stipulation, we find that the mean of the bid and asked prices in the over-the-counter market of GEC common stock on the several dates on which petitioner exercised the option in 1974, 1975, and 1976 were as follows: 7

We find that on the respective dates of the transfer of stock to petitioners upon the exercise of this option, the only method by which petitioners could have sold the stock was through a private placement at a price equivalent to 662;3 percent of the mean of the bid and asked prices in the over-the-counter market on those dates. We further find that the fair market value of the option stock on the respective dates of acquisition was such discounted value.

OPINION

Section 56 imposes a minimum tax upon the sum of the items of tax preferences with adjustments not here material. The tax preferences are listed in section 57. Of these, only section 57(a)(6), reading as follows, is applicable here:

(6) STOCK OPTIONS .—-With respect to the transfer of a share of stock pursuant to the exercise of a qualified stock option (as defined in section 422(b)) or a restricted stock option (as defined in section 424(b)), the amount by which the fair market value of the share at the time of exercise exceeds the option price. [Emphasis supplied.]

The stock in question was transferred to petitioner upon the exercise of his qualified stock option; thus, we are called upon to determine the amount of this tax preference, that is, the amount, if any, by which the fair market value of the shares exceeded the option price on each date. There is no dispute as to the option price so our inquiry is simply as to the “fair market value” of the shares on each date.

The Code does not define the term “fair market value.” However, for many years the universally accepted definition of this term has been the willing buyer, willing seller test under which fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973). Normally, the fair market value of shares of stock which are listed or traded on a stock exchange or the over-the-counter market is the mean between the highest and lowest quoted selling prices on the day in question, but there are many exceptions to this rule, such as when there is a restriction on the sale of the stock. Kolom v. Commissioner, 71 T.C. 235 (1978), affd. 644 F.2d 1282 (9th Cir. 1981); Frizzelle Farms, Inc. v. Commissioner, 61 T.C. 737 (1974).8 On the dates in question, there was an over-the-counter market for GEC shares which would fix the fair market value of shares which would or could trade in that market. It is respondent's position that this over-the-counter fair market value should be used for the stock in issue here, but respondent ignores the fact, which we have found in this case, that there were significant restrictions on the sale of the shares of the option stock, as reflected by the investment letters. These restrictions precluded trading these shares of stock on the issue dates on the over-the-counter market; thus, that market cannot establish fair market value.

On the authority of section 1.57-1(f)(3), Income Tax Regs., respondent urges that we ignore the restrictions and accept the artificial concept of fair market value which is mandated by Congress in section 83(a),9 but nowhere appears in sections 56 and 57. We disagree. For the reasons expressed herein, we hold that section 1.57-1(f)(3), Income Tax Regs., is inconsistent with the plain meaning of the statute.

This Court considered this regulation in Kolom v. Commissioner, supra, but in a slightly different context. There, we determined, for purposes of the minimum tax, the fair market value of option stock the disposition of which was subject to section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. sec. 78p(b). Section 16(b) requires that a corporate insider who sells his option stock upon the date of issuance, or at any time within 6 months thereafter, for a profit (that is, for an amount in excess of his option price), must return that profit to the issuing corporation, his employer. Although we recognized that section 16(b) might affect the value of the stock to an insider such as the petitioner in Kolom, we held that this section does not...

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