Rank v. United States

• Decision Date: 04 May 1965
• Docket Number: No. 21257.,21257.
• Citation: 345 F.2d 337
• Parties: Raymond A. RANK et al., Appellants, v. UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

345 F.2d 337 (1965)

Raymond A. RANK et al., Appellants, v. UNITED STATES of America, Appellee.

No. 21257.

United States Court of Appeals Fifth Circuit.

May 4, 1965.

William P. Fonville, Dallas, Tex., James F. Hoge, Jr., Fort Worth, Tex., for appellants.

Myron C. Brown, Atty., Dept. of Justice, Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, Washington, D. C., H. Barefoot Sanders, U. S. Atty., Dallas, Tex., David O. Walter, Michael I. Smith, Attys., Dept. of Justice, Washington D. C., for appellee.

Before TUTTLE, Chief Judge, and BROWN and GEWIN, Circuit Judges.

JOHN R. BROWN, Circuit Judge:

This case presents the question whether the gain received by the Taxpayer-Optionee on the assignment back to the Employer-Optioner of the unexercised option granted as a compensatory restricted stock option is taxable as capital gain when a transfer of the underlying stock at such time would have been a disqualifying disposition subjecting the proceeds to treatment as ordinary income. In rejecting the Taxpayer's appeal, we agree with the District Court that the gain is ordinary income.

The facts are neither complex nor conflicting. And the case comes to us, as it did below, on stipulated facts which we repeat or paraphrase.

The Taxpayer¹ was an employee of Southern,² the optionor. Southern's business was the production and sale of oil, natural gas, and gas distillates. In December 1950, Southern acquired Danciger Oil and Refining Company and substantially all of the personnel of Danciger. Danciger was a much larger company than Southern, with substantially larger reserves. It was vital to Southern that most of the former Danciger personnel remain with Southern. However, Danciger personnel had been allowed to deal in oil and gas leases and royalties outside the scope of their employment, and this practice was forbidden by Southern. In order to give the Danciger personnel a proprietary interest in Southern, and to induce them to remain with Southern a restricted stock option plan was made available to the former Danciger employees, as well as to Southern employees who had not participated in an earlier qualified restricted stock option plan of Southern.³

The stock option plan was approved by the stockholders of Southern on May 7, 1952. Under the plan 125,000 shares of the company's Unissued common stock were made available to employees of the company under provisions which qualified as restricted stock options under § 130A of the Internal Revenue Code of 1939.⁴

Restricted stock options under the plan were issued on May 8, 1952 to Taxpayer.⁵ The option price was the fair market value of the common stock of Southern on that date ($532.50). None of the Taxpayers exercised his option.

During the summer of 1956 the Board of Directors of Southern authorized negotiations with Sinclair Oil and Gas Company for the sale of its properties. The sale was made. On July 23, 1956, Southern announced the sale of its assets to Sinclair and its intention to comply with § 337 of the Internal Revenue Code of 1954. On August 10, 1956, a plan of complete liquidation was adopted by the Board of Directors of Southern. On October 11, 1956, at a special meeting of its stockholders, a plan of complete liquidation of Southern was approved.

On October 11, 1956, there were options outstanding covering 98,960 shares under the restricted stock option plan.⁶ These outstanding stock options represented a problem to Southern, in that in order to qualify for the tax treatment of gains on complete liquidation of a corporation, under § 337 all of the assets of the corporation, less assets retained to meet claims, had to be distributed within one year from the date of the adoption of the plan of liquidation. The existence of these outstanding stock options represented a potential barrier to such complete liquidation within a one-year period. For the purpose of eliminating the options and avoiding thereby possible litigation which would have prevented or delayed the orderly liquidation of Southern within the one-year period, the Board of Directors of Southern authorized the acquisition by Southern of optionees' rights under the outstanding restricted stock options at a price of $11.25 per share.⁷

The holders of all of the outstanding options accepted this offer, and their options were sold to Southern by contracts dated October 25, 1956.⁸

The liquidation was consummated, the options acquired by Southern, and the agreed consideration paid by it.⁹

Thereafter the Revenue Service determined that the gain was taxable as ordinary income, not capital gains. After timely claim by each of the Taxpayers, the denial thereof, and payment of the disputed taxes, this refund suit was timely filed.

The District Judge on these stipulated facts, and one possible excursion into fact finding on his own,¹⁰ held that the Commissioner's determination was correct, and that the gains received from the sale of these options should be treated as ordinary income in the years in which received.

At the outset, it bears emphasis that had the stock been issued at this time and then sold — either to a third party or back to the corporation — the very same gains would clearly have been ordinary income since the stock would not have been held the requisite six months to qualify as a statutory restricted stock option.¹¹ In other words, extinguishing for a consideration the option with its carefully built-in statutory restrictions would, in practical effect, enable the parties to obtain the immediate income tax benefit free of the very conditions prescribed by Congress in this area of high controversy.¹² Of course we recognize that failure to satisfy the requirements of a statutory restricted stock option or the even more stringent contemporary qualified stock option¹³ does not necessarily condemn gain to the unfavored, unwanted, more expensive ordinary income category. There are option plans which either by chance, neglect, accident, or choice are non-restricted. Their utility and tax incidents are the subject of extensive, sometimes hopeful, sometimes despairing writings.¹⁴ But they are not for our decision now, and we readily leave these intriguing problems to another day.

We may do that because Taxpayer in seeking to justify capital gains treatment does not take the route of a non-restricted stock option. Rather, Taxpayer recognizes that this was in form a restricted stock option plan. The capital gains here sought are justified, not on the ground of compliance with that plan, nor as authorized effective modifications of it,¹⁵ but because the stock was never acquired, the option was never exercised, and on the contrary the option was sold.

Taxpayer's theory, as near as we can grasp it, runs this way. Options are property¹⁶ and come within the definition of capital asset.¹⁷ Since Taxpayer was not a dealer in options and it is undisputed that these options were held for more than four years, the gain on sale qualifies for long term capital gain treatment.¹⁸ And contrary to the contention of the Government here and below and the holding of the trial court, Commissioner v. LoBue, 1956, 351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142,¹⁹ does not prevent capital gains treatment. This case, as did those following it,²⁰ held that it was the transfer of the stock to the employee for less than its full market value which conferred the benefit intended as compensation to the employee. Compensation, as such, must, of course, be taxed, but the compensation there involved was not in the grant of the option, but rather in the transfer of the stock pursuant to it. Upon a correct reading of such cases, the employer's intention to compensate was the purpose of transferring the stock. In no other way could the intention to compensate be made effective since the options themselves had no value.

Here, however — so the argument continues — no such purpose existed. The trial Court's finding that the stock options were compensation to the plaintiffs is unsupported, contradictory, and contrary to the stipulated facts. This is so because the Court also found the "options had no ascertainable market value at the time they were granted" (see note 10, supra), and it was stipulated by the parties that the purpose of the purchase of the options was to enable the Employer to eliminate the options and avoid these impediments to its liquidation within the required one-year period.²¹ Additionally, the Trial Court's finding is wholly unacceptable because if the options themselves were compensation, the initial stock option plan could not have qualified as the statutory restricted stock option which it was and was stipulated to be.

And finally, so the argument runs, had Taxpayer exercised the option and acquired the stock, the stock would have been a capital asset in his hands. Under § 1234, as it then existed, capital gains would be acccorded when received from the sale of the underlying option.²²

We think that in emphasizing the Employer's purpose as between compensating employees, on the one hand, and avoidance of impediments to a § 337 liquidation, on the other, Taxpayer confuses the time for determination of that purpose and the value of the option at any such moment. In other words, for the intention to compensate to be fulfilled, there must be value, so it is the time when demonstrable value exists that likewise measures intention. But the Court in LoBue did not begin even remotely to suggest that merely because the options, with their built-in restrictions, had no "ascertainable market value,"²³ the employer had no purpose to compensate the employees at the time the options were granted. On the contrary, in rejecting application of the normal rule that a mere "purchase of property * * * at a bargain price" gives "rise to no taxable gain in the year of purchase,"²³ the Court described the option plan as "an arrangement by which an employer transferred valuable property...