Michaelsen v. New York State Tax Com'n

• Decision Date: 08 July 1986
• Citation: 67 N.Y.2d 579,496 N.E.2d 674,505 N.Y.S.2d 585
• Parties: , 496 N.E.2d 674 In the Matter of James A. MICHAELSEN et al., Respondents, v. NEW YORK STATE TAX COMMISSION, Appellant.
• Court: New York Court of Appeals Court of Appeals

Page 585

505 N.Y.S.2d 585

67 N.Y.2d 579, 496 N.E.2d 674

In the Matter of James A. MICHAELSEN et al., Respondents, v. NEW YORK STATE TAX COMMISSION, Appellant.

Court of Appeals of New York.

July 8, 1986.

Robert Abrams, Atty. Gen. (Wayne L. Benjamin, Robert Hermann and Peter H. Schiff, Albany, of counsel), for appellant.

Arnold Y. Kapiloff, New York City, for respondents.

OPINION OF THE COURT

SIMONS, Judge.

In this article 78 proceeding challenging a State income tax assessment, the issue presented is the proper treatment to be afforded to a nonresident who exercises stock options granted to him as a form of compensation by his New York employer and who later disposes of the stock acquired pursuant to those options. We agree with the position now taken by the Tax Commission that the taxable gain is the difference between the option price and fair market value of the stock on the date the option is exercised, and that gain derived from the subsequent sale of such stock is not income derived from New York sources and thus not taxable.

In 1968, petitioner, ¹ James Michaelsen, a senior executive working for Avon Products, Inc. in New York City was granted certain stock options in Avon capital stock pursuant to a qualified employee stock option plan (see, Internal Revenue Code § 422; 26 U.S.C. § 422). He exercised the options by purchasing 3,000 shares of stock on March 13, 1972 and an additional 3,000 shares on February 22, 1973. In 1973, while a resident of Connecticut, he sold all the shares. He reported a gain of $179,761 for 1973 Federal income tax purposes but he did not report any part of that sum on his nonresident New York State income tax return for that year. Respondent Tax Commission audited petitioner's return and assessed addition personal income tax liability in the amount of $19,017.12. Following a hearing, the Tax Commission determined that the stock was connected with petitioner's employment and ruled that both the gain derived from the exercise of the option and the gain derived from the subsequent sale of the stock were taxable in New York under Tax Law § 632(b)(1)(B).

Petitioner then commenced this article 78 proceeding to annul the Commission's determination, contending that the gain from the sale of the Avon stock was not derived from New York sources. Special Term dismissed the petition, holding that "there was no evidence indicating that the options through which the stock was acquired were issued other than as a form of compensation to petitioner James Michaelsen for either past services or incentive for future services to his employer" (122 Misc.2d 824, 826, 471 N.Y.S.2d 789). The Appellate Division held that the Tax Commission had improperly calculated the gain attributable to New York sources. It therefore remitted the matter to respondent Commission directing it to recompute the tax on the value of the stock options by " 'subtract[ing] the aggregate exercise price of each issue of options from the aggregate fair market value of the shares of stock on the date that the options became exercisable' " (107 A.D.2d 389, 391, 486 N.Y.S.2d 479, quoting its decision in Matter of Donahue v. Chu, 104 A.D.2d 523, 525, 479 N.Y.S.2d 889). We granted the Commission leave to appeal.

The Tax Commission's determination and the confirmation by Special Term attributed both the gain realized from the exercise of the option and the gain realized on the subsequent sale of the stock acquired by exercising the options to compensation for New York State income tax purposes. The Appellate Division holding allowed New York State to tax only the difference between the fair market value of the stock when the options become exercisable and the option price. That formula normally will result in no New York State tax consequences since qualified stock options are usually exercisable when granted and under Internal Revenue Code § 422(b)(4) the option price, with a limited exception, must equal the fair market value of the stock when the option is granted.

Tax Law § 632(a)(1) provides that the New York adjusted gross income of a nonresident individual shall include all income entering into a taxpayer's Federal adjusted gross income, provided that it is "derived from or connected with New York sources". Section 632(b)(1)(B) provides that income attributable to a "business, trade, profession or occupation carried on in this state" shall be considered income derived from or connected with a New York source. Section 632(b)(2) provides that "[i]ncome from intangible personal property, including * * * gains from the disposition of intangible personal property, shall constitute income derived from New York sources only to the extent that such income is from property employed in a business, trade, profession, or occupation carried on in this state".

Because New York income tax law evinces a strong intent to conform to Federal authority wherever possible (Matter of Hunt v. State Tax Commn., 65 N.Y.2d 13, 16, 489 N.Y.S.2d 451, 478 N.E.2d 967; Matter of Friedsam v. State Tax Commn., 64 N.Y.2d 76, 79-80, 484 N.Y.S.2d 807, 473 N.E.2d 1181), it is necessary for background purposes to review the Federal income tax consequences to petitioner in this case. For Federal income tax purposes, in addition to the tax on any gain that petitioner may have realized from the sale of the stock--the fair market value of the stock when sold less the fair market value of the stock on the date the option was exercised--there is also a tax imposed to reflect the compensation the employee received by virtue of having the ability to purchase the stock at less than its fair market value by exercising the option. This principle was firmly established by the Supreme Court in Commissioner v. LoBue, 351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142 and petitioner concedes the point.

The more difficult question is how the compensation derived from a stock option is valued. If an option, by virtue of its transferability, has a readily ascertainable fair market value when it is granted, it will be valued at the time it is received by the employee (Internal Revenue Code § 83[a]; Treas. Reg. [26 CRF] § 1.83-7[a] ). An option granted, as here, pursuant to a qualified employee stock option plan is not transferable, however (Internal Revenue Code § 422[b][6] ), and cannot have a readily ascertainable fair market value when it is granted (Treas. Reg. [26 CFR] § 1.83-7[b][1], [2] ). Gain derived from these latt options is realized when the option is exercised; the option is valued by subtracting the option price from the fair market value of the stock when the option is exercised (Treas. Reg. [26 CFR] § 1.83-7[a] ). This gain is characterized by...