McDonald v. C.I.R.

Decision Date28 June 1985
Docket NumberNo. 83-4588,83-4588
Parties-5318, 85-2 USTC P 9494 Jackie L. and Janet G. McDONALD, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
CourtU.S. Court of Appeals — Fifth Circuit

Glenn L. Archer, Asst. Atty. Gen., Gary R. Allen, Kenneth L. Greene, Tax Div., U.S. Dept. of Justice, Fred Goldberg, Chief Counsel, John Menzel, IRS, Henry G. Salamy, Chief Branch, No. 4, Tax Litigation Div., Michael L. Paup, Chief Appellate Section, Dept. of Justice, Washington, D.C., for respondent-appellant.

David G. Glickman, Richard A. Freling, Dallas, Tex., for petitioner-appellees.

Appeal from the Decision of the United States Tax Court.

Before RUBIN, POLITZ, and GARWOOD, Circuit Judges.

GARWOOD, Circuit Judge:

This is an appeal by the Commissioner of Internal Revenue from a judgment of the United States Tax Court holding invalid Treasury Regulation section 1.57-1(f)(3), which makes the standard of "fair market value ... determined without regard to any [lapse] restriction" contained in Internal Revenue Code ("Code") section 83 applicable, for purposes of the minimum tax imposed on items of tax preference, to valuation under Code former section 57(a)(6) (1969) of stock acquired by exercise of a Code section 422 qualified stock option. We conclude that, absent a clear indication in the language of section 57(a)(6) or in its legislative history that Congress intended otherwise, the settled meaning of the term "fair market value" should not be thus disturbed, and that, by applying section 83 rules to section 57(a)(6), the Commissioner exceeded his statutory authority. Accordingly, we affirm.

FACTS AND PROCEEDINGS BELOW

The parties stipulated to facts which we here summarize. Appellees Jackie L. McDonald and Janet G. McDonald, husband and wife, reside in Dallas, Texas; it is their 1972 tax return which is the subject of controversy here.

At all times pertinent, appellee Jackie McDonald ("McDonald") was an employee of Centex Corporation ("Centex"). On December 3, 1968, Centex adopted a qualified stock option plan meeting the then requirements of Code ("IRC") section 422. 1 On February 3, 1969, pursuant to this plan, McDonald was granted an option to purchase 3,500 shares of Centex common stock at an option price of $19 per share. 2 On September 2, 1969, also pursuant to the plan, McDonald was granted a second option, to purchase an additional 2,000 shares at an option price of $28.50 per share, presumably the then market price of Centex stock. Centex common stock split several times during 1971 and 1972. As a result, McDonald became entitled to purchase up to four times the originally designated number of option shares at an exercise price per share of one-fourth that quoted in the original option agreements. On September 25, 1972, McDonald exercised a portion of both options: under the first, he purchased 7,000 shares at a price of $4.75 per share (total: $33,250); under the second, he purchased 4,000 shares at $7.125 per share (total: $28,500). On September 25, 1972, Centex common stock sold on the New York Stock Exchange for $25.75 per share.

The shares purchased by McDonald by his exercise of these qualified stock options were not registered with the Securities and Exchange Commission ("SEC"). McDonald was required to execute an "investment letter" when he exercised the options, which, under SEC rules and decisions, limited transferability of the acquired shares within an initial two-year holding period. 3 As a result of these transferability restrictions, the fair market value of this "lettered" Centex stock on the September 25, 1972 date of option exercise was $18.025 per share.

For calendar year 1972, appellees paid a section 56(a) minimum tax in connection with the exercise of these stock options as provided by section 57(a)(6), which listed as an item of tax preference, in case of acquisition during the tax year "of a share of stock pursuant to the exercise of a [section 422] qualified stock option ... the amount by which the fair market value of the share at the time of exercise exceeds the option price." Appellees calculated the tax preference amounts on the option purchases to be $136,525, this being the excess of $198,275 (the aggregate value of the stock purchased under both options, valued at $18.025 per share) over the total purchase price of $61,750.

In 1978, the Internal Revenue Service ("IRS") sent appellees a statutory notice of deficiency, which the parties have stipulated was timely, alleging underpayment of the minimum tax on these option purchases. The IRS valued the stock for purposes of section 57(a)(6) at the $25.75 per share New York Stock Exchange price effective on the date of exercise, not at the then $18.025 per share value used by appellees. The latter value took into account, as the IRS valuation did not, the effect of the "lettered stock" transferability restrictions on the stock's fair market value. The IRS arrived at its valuation by applying Treasury Regulation ("Reg.") section 1.57-1(f)(3), 26 C.F.R. Sec. 1.57-1(f)(3) (1978), which provides that, for purposes of section 57(a)(6), the fair market value of such qualified option stock must be determined without regard to restrictions other than those which by their own terms do not lapse ("nonlapse restrictions"). 4 This valuation standard and the language embodying it were borrowed from section 83 and applied by this regulation to the section 57(a)(6) computation, for purposes of the section 56 minimum tax, of the item of tax preference arising from the exercise of a qualified stock option. 5

Appellees petitioned the Tax Court for a redetermination of the deficiencies asserted by the Commissioner. That court characterized the case as containing a "sole issue for decision ... whether certain Federal securities law restrictions imposed on the transfer of common stock received by an employee upon the exercise of a qualified stock option should be considered in determining the fair market value of the stock for purposes of the minimum tax computation." McDonald v. Commissioner, No. 1983-197 (T.C. April 11, 1983), at 6. The Tax Court ruled in favor of the McDonalds. It felt itself bound by its prior decision in Gresham v. Commissioner, 79 T.C. 322 (1982), aff'd, 752 F.2d 518 (10th Cir.1985), 6 which held Reg. section 1.57-1(f)(3) invalid, and specified that, for minimum tax purposes, similar lapsing restrictions on the transferability of stock acquired by exercise of a qualified stock option may not be wholly disregarded in determining the stock's fair market value when so acquired. The Commissioner appeals to this Court.

THE LEGAL FRAMEWORK
The Minimum Tax

Section 56 of the Internal Revenue Code was enacted as a part of the Tax Reform Act of 1969. As enacted and as in effect in 1972, 7 it imposed a so-called minimum tax on certain "items of tax preference," as listed in IRC section 57. Section 56 levied a tax, additional to all other taxes, in an amount equal to ten percent of the excess of "the sum of the items of tax preference" listed in section 57 over the sum of $30,000 plus the taxpayer's regular income tax liability (subject to certain adjustments) apart from the section 56 tax itself. 8 Section 57(a) as relevant here provided that, for purposes of section 56, "the items of tax preference are," and listed several different items, including:

"(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 added.) 9

The term "fair market value" is not defined in either section 56 or section 57. In fact, it is not defined anywhere in the Code. However, Reg. section 1.57-1(f)(3), at issue here, provides, for purposes of section 57(a)(6):

"(3) Fair market value. In accordance with the principles of section 83(a)(1), the fair market value of a share of stock received pursuant to the exercise of a qualified or restricted stock option is to be determined without regard to restrictions (other than nonlapse restrictions within the meaning of Sec. 1.83-3(h)). Notwithstanding any valuation date given in section 83(a)(1), for purposes of this section, fair market value is determined as of the date the option is exercised." (Emphasis added.)

Section 83 of the Code, referred to in Reg. section 1.57-1(f)(3), was enacted as part of the Tax Reform Act of 1969, as were sections 56 and 57. Section 83 is not directed particularly to the exercise of compensatory options, stock or otherwise, but is generally applicable to all transfers of property "in connection with the performance of services ... to any person other than the person for whom such services are performed." 10 It provides that with respect to such a transfer there "shall be included in the gross income of the person who performed such services" the amount by which any payment for the transferred property is exceeded by

"the fair market value of such property (determined without regard to any restriction other than a restriction which by its own terms will never lapse) ...." 11 (Emphasis added.)

By the terms of its subsection (e), section 83 "shall not apply to--(1) a transaction to which section 421 applies." 12 Section 421, as below noted, provides, inter alia, for nonrecognition of income on transfer of stock pursuant to exercise of a qualified stock option meeting the requirements of section 422(a). It is conceded here that section 421 is applicable to the transfer of the Centex stock to McDonald.

Employee Stock Options

Even before there were particular statutory provisions expressly dealing with the taxation of employee stock options, it was recognized that the typical employee stock option, with its lack of transferability and other...

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