Rosenberg v. Commissioner , 20 T.C. 5 ( 1953 )

Abraham Rosenberg and Lois Rosenberg, Petitioners, v. Commissioner of Internal Revenue, Respondent

Rosenberg v. Commissioner

Docket No. 37719

United States Tax Court

20 T.C. 5; 1953 U.S. Tax Ct. LEXIS 201;

April 6, 1953, Promulgated

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Decision will be entered under Rule 50.

Held, the petitioner Abraham Rosenberg did not realize taxable income upon exercise of a stock option received from his employer prior to February 26, 1945, where it was found that the option was given to enable him to acquire a proprietary interest in the employer corporation and not with the intent to compensate him for services.

Joseph Walker, Esq., for the petitioners.

Robert Margolis, Esq., for the respondent.

Arundell, Judge.

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ARUNDELL

The respondent has determined a deficiency of $ 8,118.88 in the petitioners' income tax liability for the taxable year ended December 31, 1946. The petitioners contest the entire deficiency and allege as error the respondent's inclusion in 1946 taxable income of the difference between the option price at which the petitioners acquired shares of stock and their market value at the time the option was exercised and the stock was acquired. The respondent's disallowance of part of the medical expense deduction as a result of the increase in taxable income is also contested.

FINDINGS OF FACT.

The petitioners, Abraham Rosenberg and Lois Rosenberg, are husband and wife residing in Riverdale, New York. They filed a joint income tax return for the taxable year 1946 with the collector of internal revenue for the first district of New York.

For a period of about 14 years prior to 1938 the petitioner Abraham Rosenberg (hereinafter referred to as the petitioner) had been employed by a New York department store on a fixed salary basis. In 1938 his salary was $ 11,500 per annum.

In the spring of 1938, petitioner and George Farkas, president of Alexander's Department Stores, Inc. (hereinafter referred to as Alexander's), entered into negotiations regarding the employment of the petitioner by Alexander's. They discussed the compensation to be paid to petitioner and arrived at an agreement that he would be paid $ 12,000, plus a percentage of sales and increased profits over the base year. The employment contract was to run for a period of 5 years.

During the course of these negotiations, Farkas and the petitioner consulted with an attorney representing Alexander's who drafted an employment contract embodying the various discussions and agreements between the parties. Copies of the draft were forwarded to each of the parties in the latter part of June 1938.

Paragraph 2 of the draft provided that:

2. (a) As full compensation for all services to be rendered by you hereunder, including all services to be rendered by you as an officer of the Company, you shall be paid the following:

(1) A salary at the rate of $ 12,000 per annum, payable in approximately equal instalments at the end of each calendar week (commencing with the week ending August 6, 1938), during the term of your employment hereunder;

(2) A sum, with respect to any fiscal year of the Company (ending on any July 31) during the term of your employment hereunder in which the net income of the Company (determined as hereinafter provided) shall exceed the net income of the Company (so determined) for its fiscal year ending July 31, 1938, equal to 1% of such excess; and

(3) A sum, with respect to any fiscal year of the Company (ending on any July 31) during the term of your employment hereunder in which the net sales of the Company (determined as hereinafter provided) shall exceed the amount of the net sales of the Company (so determined) during its fiscal year ending July 31, 1938, equal to 1/10th of 1% of such excess.

The remainder of this paragraph related to the manner of computing and paying the sums referred to in subdivisions (2) and (3) and contained no reference to a stock option.

A few days after receiving the draft, the petitioner met with Farkas and made it known to him that he was willing to sign the draft but at the same time expressed a desire to own some shares of stock in Alexander's at some future date. Farkas agreed that this was desirable and stated that he would instruct his attorney to make provision therefor in a revised draft. The petitioner and Farkas did not discuss the stock option provision or the manner in which the shares were to be acquired. No mention was made of the number of shares to be purchased, the date of purchase, or the purchase price. The matter was left to the discretion of Farkas.

The revised draft contained some formal changes of no importance to this proceeding, and added the following stock option provision:

5. In order to induce you to enter into this agreement, the Company hereby grants to you an option, exercisable in the manner and subject to the provisions hereinafter stated, to purchase all or any part of 3,000 shares of the Common Stock, without par value, of the Company at the price of $ 5.40 per share.

The terms and conditions upon which such option is granted and may be exercised are as follows:

(a) Such option shall be exercisable at any time or from time to time during the period commencing on August 1, 1938 and ending on July 31, 1943, provided that you shall at the time be in the employ of the Company hereunder * * *

The quoted provision was a standard type of stock option clause which counsel for the employer inserted at the last moment in response to instructions to provide an opportunity for the petitioner to share some day in the ownership of the corporation. This provision is followed by extensive provisions pertaining to the stock option and relating specifically to such matters as adjustments to be made to the petitioner's stock option in the event of stock dividends on the common stock, reclassification of the shares of common stock, reorganization or recapitalization of Alexander's, a consolidation or merger, or a sale of all or substantially all of its assets in which Alexander's common stock was given in exchange, or distributions by Alexander's in stock, securities, or property (other than cash) upon the original stock or securities of the classes at the time subject to the option, or changes in the stock or securities of such class. Also, it was provided that:

5. (i) You have advised the Company that you will not purchase any of the shares of Common Stock of the Company or other stock or securities in the exercise of the option herein contemplated with a view to the distribution thereof to the public.

The agreement as thus drafted was signed by petitioner and Farkas on July 1, 1938. The petitioner was not represented by counsel.

At a time subsequent to the discussion of the acquisition of shares of stock in Alexander's and on or about July 1, 1938, the petitioner gave notice to his employer, a large New York department store, that he was resigning on July 31, 1938. On that date, the petitioner entered the employ of Alexander's.

The petitioner was employed as a buyer of shoes with his former employer. His duties with Alexander's consisted of various activities in the field of merchandising, advertising, and personnel. He continued in this employment until his resignation on April 30, 1946.

In an agreement dated February 12, 1944, petitioner and Alexander's agreed that "all terms and conditions of the July 1938 contract continue in effect, until and unless we state otherwise."

During 1943, the petitioner exercised the option contained in his employment contract and purchased 500 shares of the capital stock of Alexander's at $ 5.40 per share. Two hundred shares were purchased during the early part of the calendar year 1943, which was during the employer's fiscal year 1943 ended July 31, 1943; and 300 shares were purchased during the latter part of the calendar year 1943, which was during the employer's fiscal year 1944. In 1946 while still in the employ of Alexander's, he again exercised his option and purchased at $ 5.40 per share the remaining 2,500 shares of Alexander's capital stock he was privileged to purchase under his employment contract. The petitioner sold the 3,000 shares of stock to Farkas in 1947 at $ 11 per share, its then fair market value. The market value of the common stock in Alexander's was approximately $ 3 or $ 3.25 per share on July 31, 1938, and $ 11 per share in 1946 when the petitioner exercised the option and acquired 2,500 shares.

In its income tax returns for its fiscal years 1943 and 1944, Alexander's did not refer to the petitioner's exercise of the option in those years or claim a deduction therefor. In its income tax return for the fiscal year 1946, the year in which the petitioner exercised the option and purchased 2,500 shares, Alexander's reported the purchase and claimed a deduction for salaries and wages in an amount equal to the difference between the option price and the market value of the shares at the time of the exercise. This sum was recorded as salaries and wages expense on its books of account. In the withholding statement (Form W-2) submitted on behalf of the petitioner for 1946, Alexander's did not include this sum in petitioner's income or refer to the exercise of the option.

The stock option was given to the petitioner to enable him to acquire a proprietary interest in the employer corporation at some future time and was not given as compensation.

During the taxable year 1946, the petitioner paid $ 2,043.92 for medical expenses.

OPINION.

We have before us the factual question whether an option to purchase stock was given to the petitioner Abraham Rosenberg by his employer prior to February 26, 1945, as compensation to be received upon exercise, or was given instead to enable him to acquire a proprietary interest in the employer corporation. This question, which is primarily a question of intent, arises because of the well-established principle of law that upon exercise of such an option the difference between the option price and the market value at the time of the exercise and receipt of the stock constitutes taxable income to the employee at that time if the option was given as compensation, Commissioner v. Smith, 324 U.S. 177">324 U.S. 177, but not if it was given to assist him in acquiring a proprietary interest, Rossheim v. Commissioner, 92 F. 2d 247; Norman G. Nicolson, 13 T. C. 690; Delbert B. Geeseman, 38 B. T. A. 258.

The respondent contends that the option was given as compensation and, accordingly, he has added to the petitioner's taxable income the difference between the market value and the option price at which petitioner purchased 2,500 shares in the employer corporation in 1946. The limited question presented is whether or not the option to petitioner was given as compensation. At the outset, it is desirable to explain the Commissioner's position in this particular case. After the decision of the Supreme Court in Commissioner v. Smith, supra, dated February 26, 1945, Regulations 111, section 29.22 (a)-1 were amended by T. D. 5507, dated April 12, 1946, 1946-1 C. B. 18, to provide that:

If property is transferred by an employer to an employee for an amount less than its fair market value, regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fair market value is in the nature of compensation and shall be included in the gross income of the employee.

By its terms, however, the amended Regulations were not to apply to options granted prior to February 26, 1945, the date of the decision in the Smith case. The language of the Regulations on this point reads as follows:

In the case of property transferred by an employer to an employee pursuant to the exercise of an option granted to the employee before February 26, 1945, the provisions of these Regulations prior to the amendment by this Treasury Decision [No. 5507] shall apply.

In further elaboration of the amended Regulations, the Commissioner issued I. T. 3795, 1946-1 C. B. 15, in which it is stated that:

as respects an option granted to an employee prior to February 26, 1945, unless * * * within the purview of section 29.22 (a)-1 of Regulations 111 prior to the amendments made by Treasury Decision 5507 * * * the employee would otherwise clearly realize income by way of compensation through the exercise * * * of the option, this office will hold that the exercise * * * does not result in income to the employee by way of compensation * * *

We look for our answer to the question presented in the Regulations before their amendment by T. D. 5507 and in the several opinions of the courts in which the question was dealt with under the old Regulations. The pertinent part of Regulations 111, section 29.22 (a)-1, prior to amendment, provided that:

If property is transferred by a corporation to * * * an employee, for an amount substantially less than its fair market value, regardless of whether the transfer is in the guise of a sale or exchange, such * * * employee shall include in gross income the difference between the amount paid for the property and the amount of its fair market value to the extent that such difference is in the nature of (1) compensation for services rendered or to be rendered * * *

The cases in which this and other courts have resolved this question of fact are numerous and no useful purpose would be served by reviewing them here. Each case must be decided on its own peculiar facts, and facts which have been deemed significant under some circumstances may serve as guides but are not necessarily controlling. After carefully studying all the evidence, particularly the employment contract and the testimony of the petitioner, and weighing various factors, some of which were present in previous cases, we have found that the option was not given as compensation but instead was given to satisfy the petitioner's desire to acquire an interest in the corporation at some future time.

The evidence convinces us that the option was granted because the employer and the employee both believed that it was desirable that the employee be given immediate assurance that the stock of the employer corporation, which it seems was closely held by a family, could be purchased by him. The full compensation in the form of salary and a percentage of sales and profits had already been agreed to when at the last moment the parties considered the desirability of giving petitioner this opportunity and thereupon incorporated the option provision in the agreement. In view of the fact that when the petitioner acquired the option in 1938 to purchase at $ 5.40 per share, the market value was approximately $ 3 or $ 3.25 per share, it can hardly be said that the option was given with compensation in mind.

The terms and conditions of the employment agreement as originally drafted were not changed by the granting of this option. The full compensation in the form of salary and a percentage of sales and profits remained the same. We think it is also significant that the option did not replace a prior bonus agreement and, further, that the salary alone, aside from percentage of sales and profits, exceeded the salary petitioner received from his former employer.

It is also significant that the option price and the number of shares subject to the option were not dependent upon the effectiveness of petitioner's services, such as in increasing sales or profits. Furthermore, the purchase, pursuant to the option, required a substantial payment by the petitioner and the stock once acquired could be retained regardless of whether or not the petitioner remained in the employ of the corporation.

The respondent stresses the fact that the employment contract refers to the option as being given "In order to induce you to enter into this agreement." However, as has been previously held, such language is not conclusive, Herbert G. Springford, 41 B. T. A. 1001, and Gordon M. Evans, 38 B. T. A. 1406, and the reasonableness of this view is apparent here. Not only was this phrase part of a standard type of stock option clause which the attorney for the employer inserted at the last moment in response to instructions to provide an opportunity for the petitioner to share some day in the ownership of the corporation but, in addition, it has little meaning in view of the previous paragraph which deals with the more important matter of salary and percentage of sales and profits. This paragraph provides: "As full compensation for all services to be rendered by you hereunder * * * you shall be paid the following: * * *." The remainder of the paragraph relates to the salary and percentage of sales and profits and nowhere in that paragraph is the option referred to as compensation or even mentioned.

We have also taken into account the fact that the employer claimed a deduction for salary and wages in its fiscal year 1946 incident to the exercise of the option in that year although it did not seek a like deduction in its fiscal years 1943 and 1944 when petitioner exercised his option during those years. However, we think it is clear that petitioner cannot be bound by the action his employer decided to take in connection with the exercise of the stock option. Delbert B. Geeseman, supra, Estate of Lauson Stone, 19 T.C. 872">19 T. C. 872.

Two witnesses were called to explain the differences in treatment upon the exercise of the option during the several years but we find nothing in their testimony which we regard as helpful in resolving the question we are called upon to decide.

After a careful consideration of the entire record, we have concluded that the stock option was not given with a view toward compensation but instead was given for the purpose of enabling the petitioner to acquire a proprietary interest in the employer corporation at some future time. Therefore, the petitioner did not realize taxable income upon the exercise of the option in 1946.

From our determination of this issue, it follows that the respondent cannot be sustained in his disallowance of part of the medical expense deduction claimed for the taxable year 1946.

Decision will be entered under Rule 50.