Pagel, Inc. v. Comm'r of Internal Revenue

• Court: U.S. Tax Court
• Writing for the Court: WELLS
• Citation: Pagel, Inc. v. Comm'r of Internal Revenue, 91 T.C. 200, 91 T.C. No. 18 (T.C. 1988)
• Decision Date: 08 August 1988
• Docket Number: Docket No. 34122-85
• Parties: PAGEL, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

91 T.C. 200

91 T.C. No. 18

PAGEL, INC., Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 34122-85

United States Tax Court

Filed August 8, 1988

In connection with serving as an underwriter in a stock offering, P received cash and a Warrant to purchase stock. P could not transfer or exercise the Warrant until at least 13 months after the date of receipt, and there was no active trading of such warrants on any established market. P later sold the Warrant to its sole shareholder. HELD: Section 83 is properly at issue. HELD FURTHER: Under the provisions of sec. 1.83-7, Income Tax Regs., P must recognize ordinary income from the Warrant upon P's sale of the Warrant, not upon P's receipt. HELD FURTHER: No abuse of discretion for sec. 1.83-7, Income Tax Regs. to be effective retroactively. HELD FURTHER: Sec. 1.83-7, Income Tax Regs., is a valid regulation. John W. Lundquist, for the petitioner.

Gail K. Gibson and James K. Harris, for the respondent.

WELLS, JUDGE:

Respondent determined a deficiency in petitioner's Federal income tax for the year ending March 31, 1982, in the amount of $195,782.54. After concessions, the remaining issue is whether petitioner realized capital gain ordinary income upon the sale by petitioner to its sole shareholder of a warrant to purchase stock in another corporation.

PRELIMINARY MATTER

When the instant case was reached for trial, the parties had settled all but two of the items raised in the notice of deficiency. Trial then proceeded with respect to the issues involving those two items — the characterization and timing of the income attributable to a warrant for the purchase of stock in Immuno Nuclear Corporation and a warrant for the purchase of stock in FilmTec Corporation. The parties then filed simultaneous briefs and simultaneous reply briefs. In his reply brief, respondent stated that he ‘concedes the portion of the tax deficiency arising from the FilmTec warrant for purposes of this litigation. Respondent makes this concession without waiving its right to pursue the conceded portion through appropriate tax assessment procedures for the [year ending March 31, 1985].‘

Although respondent's reply brief proffered to concede a significant portion of the deficiency for the year before us (ending March 31, 1982), petitioner filed a supplemental reply brief requesting the Court to render a decision on the merits and not to accept respondent's concession. ¹ Petitioner, however, has cited no authority to support a rejection of respondent's proffered concession. Petitioner objects to respondent's offer of concession on the following grounds:

Respondent's shifting positions are prejudicial to the Petitioner. Petitioner has fully liquidated and is in the process of dissolving itself. It has retained only enough assets to pay any judgment in the pending Tax Court matter. It will not have sufficient assets to defend and pay a large judgment based upon the value of the warrant at the time of exercise.

The acceptance or rejection of a proffered concession is a matter within the discretion of the Court, and we should exercise our discretion in accordance with the ‘interest of justice.‘ See Jones v. Commissioner, 79 T.C. 668, 673 (1982); McGowan v. Commissioner, 67 T.C. 599, 607 (1976). Petitioner has not suggested how the interest of justice would compel us to reject respondent's offer of concession, and we can conceive of no injustice in allowing petitioner to prevail as to the portion of the deficiency relating to the FilmTec warrant. We therefore accept respondent's concession on that issue and shall proceed to our decision on the final item — the Immuno Nuclear Corporation warrant.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by this reference.

During all relevant periods, petitioner was a corporation having its principal place of business in Minneapolis, Minnesota. Petitioner is a stock brokerage firm which provided the services usually offered by such firms to their clients. Petitioner's sole shareholder is Jack W. Pagel.

In September 1977 petitioner served as underwriter for a stock offering by Immuno Nuclear Corporation (‘Immuno‘). In the stock offering, 235,000 Immuno shares were sold at $1.50 per share, thus generating total proceeds of $352,500. Of that amount, Immuno received $310,200 and petitioner received $42,300 as commissions for the underwriting.

In connection with the underwriting, petitioner also received a warrant for the purchase of Immuno stock (the ‘Warrant‘). Petitioner paid Immuno a total of $10 for the Warrant. Petitioner acquired the Warrant pursuant to a clause in an Underwriting Agreement between Immuno and petitioner which provided that Immuno would sell to petitioner for $10 a warrant for (1) 17,000 Immuno shares, provided that petitioner sold at least 170,000 Immuno shares in the underwriting, or (2) 23,500 shares, in the event that petitioner sold all 235,000 shares made available in the offering.

The Warrant provided that petitioner had the right to purchase 23,500 shares of Immuno common stock during the period beginning thirteen months after October 5, 1977, the date of the Warrant, and ending October 4, 1982, at the following prices per share:

If purchased after October 4, 1978 ² and on or before October 4, 1979 at $1.605;

If purchased thereafter and on or before October 4, 1980 at $1.710;

If purchased thereafter and on or before October 4, 1981 at $1.815;

If purchased thereafter until expiration at $1.920.

Petitioner's right under the Warrant to purchase the Immuno stock was not conditioned upon the future performance of any services by petitioner. Petitioner, however, could not assign, transfer, hypothecate, sell, or otherwise dispose of the Warrant during the first thirteen months after October 5, 1977.

When petitioner received the warrant, there was no active trading of Immuno warrants on any established market. Petitioner held the Warrant in a segregated investment account from the time it acquired the Warrant (October 1977) until October 1981. On October 2, 1981, petitioner sold the Warrant to its sole shareholder, Mr. Pagel, for $314,900. On its Federal corporate income tax return for the year ending March 31, 1982, petitioner reported the sale of the Warrant as a capital gain in the amount of $314,890 (proceeds of $314,900 and basis of $10).

In the notice of deficiency, respondent recharacterized the gain from the sale of the Warrant as ordinary income, based upon the following explanations:

1i. Schedule D (Capital Gains and Losses)

Since you were the underwriter for Immuno and were afforded the right to purchase their stock warrants at a bargain purchase price, your sale of these stock warrants should be reported as ordinary income. Therefore, we have not allowed capital gain treatment for the $314,890 gain resulting from the sale of these stock warrants.

1j. Underwriting Income

3 Ordinary income was increased * * * to reflect the sale of stock warrants of [Immuno] * * *. You were the underwriters * * *, and were afforded the right to purchase their stock warrants [sic] at a bargain purchase price. Therefore, you should recognize ordinary income at the time of exercise or transfer of the option in the amount of the difference between the fair market value and the exercise price.

OPINION

The issue is whether petitioner's gain from the sale of the Warrant to Mr. Pagel is taxable as ordinary income or as capital gain. Respondent asserts that section 83 ³ governs the resolution of this case. He argues that, under section 83 and section 1.83-7, Income Tax Regs.,$314,890 ($314,900 proceeds from petitioner's sale of the Warrant to Mr. Pagel, less $10 cost) is taxable as ordinary income in petitioner's 1982 tax year as compensation received by virtue of the underwriting services provided to Immuno by petitioner in 1977.

Petitioner contends that respondent did not raise the applicability of section 83 until after the completion of trial and, therefore, ‘All references to section 83 should be stricken on account of the Respondent's failure to raise the issue.‘ Petitioner also makes the following alternate arguments to support the proposition that section 83 does not cause the gain from the sale of the Warrant to be taxable as ordinary income: (1) there was no compensatory element in petitioner's receipt of the Warrant; (2) any compensation element should be determined only at petitioner's receipt of the Warrant, not at the sale of the Warrant, because the Warrant was transferrable and had a readily ascertainable fair market value; and (3) section 1.83-7, Income Tax Regs., is either inapplicable to the Warrant or is an invalid regulation.

SECTION 83 REGULATIONS DISCUSSED AND APPLIED TO THE WARRANT

We shall begin our analysis with an exegesis of the general provisions of section 83. We then shall examine those provisions in conjunction with the facts of the instant case so that we may decide whether respondent adequately notified petitioner of the issue of the applicability of section 83. Section 83(a) generally provides that where property is transferred in connection with the performance of past, present, or future services, the excess of the fair market value of the property over the amount paid for the property is includable as compensation in the gross income of the taxpayer who performed the services. Bagley v. Commissioner, 85 T.C. 663, 669 (1985), affd. per curiam 806 F.2d 169 (8th Cir. 1986). Section 83 does not apply only to employees of the transferor of the property; rather, it is applicable to any person other than the one for whom the services were performed, including independent contractors of the transferor. Cohn v. Commissioner, 73 T.C. 443, 446 (1979). ⁴ Thus, even though petitioner's relationship to Immuno was that of an independent contractor rather than an employee, section 83 may apply to the...