Opinion
Docket No. 5399-65.
1967-11-2
DONALD H. KUNSMAN AND LEE N. KUNSMAN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
David E. Crabtree, for the petitioners. B. David Freundlich, for the respondent.
David E. Crabtree, for the petitioners. B. David Freundlich, for the respondent.
Held, the surrender of restricted stock options by petitioner, who was was a key employee of RCA, resulted in gain taxable as ordinary income. Held, further, the damage to petitioner's swimming pool caused by a storm in 1959 gave rise to no casualty loss deduction in a subsequent year (1962) simply because that was the year in which the pool was replaced.
MULRONEY, Judge:
Respondent has determined a deficiency in petitioners' 1962 income tax in the amount of $19,167.57.
The issues in the case are (1) whether a certain amount received by petitioner from his corporate employer in 1962 with respect to his surrendering his options to purchase employer's stock is taxable as ordinary income, and (2) whether petitioner suffered a deductible casualty loss in 1962 with respect to his swimming pool at his home.
FINDINGS OF FACT
Some of the facts have been stipulated and they are found accordingly.
Petitioners, husband and wife, reside in Cherry Hill, N.J. They filed their joint income tax return for 1962 with the district director of internal revenue at Camden, N.J. Donald H. Kunsman will be referred to as petitioner.
Findings With Respect to Stock Option Issue
Petitioner commenced working for Radio Corporation of America (hereinafter called RCA) in September 1949. By January 1, 1960, he had become vice president and general manager of the Electronic Data Processing Division of RCA at a salary of $52,000 a year, exclusive of certain fringe benefits, including rights under a stock option plan.
RCA's stock option plan, adopted in 1957 and amended in 1960, provided, in part, as follows:
1. Purposes of the Plan.
To advance the interests of the Corporation and its subsidiaries by assuring continuance of the services of key employees and by attracting other able executives.
2. Administration.
The Plan shall be administered by a Committee consisting of not less than five directors of the Corporation to be appointed by and serve during the pleasure of the Board of Directors. None of the Committee shall be eligible to participate in the Plan either while members of the Committee or at any time thereafter. The Committee shall determine which employees of the Corporation and its subsidiaries shall be granted options to purchase stock under the Plan. The Committee shall have full power to construe and interpret the Plan.
The Committee shall report to the Board of Directors the names of those granted options, and the terms and conditions of each option granted.
3. Stock Subject to Option.
The shares to be issued upon exercise of options granted or to be granted under the Plan shall be shares of RCA Common Stock which may be either authorized but unissued shares or shares purchased by the Corporation. The aggregate amount of stock to be optioned under the Plan shall not exceed 600,000 shares, plus shares which have or may become available pursuant to the following paragraph.
In the event there is any change in the Common Stock of the Corporation as the result of stock split-ups, or stock dividends, or combinations or exchanges of shares, or otherwise, the number of shares available for option and the shares subject to any option shall be equitably adjusted by the Committee.
4. Terms and Conditions of Options.
All options granted under this Plan are intended to be restricted stock options under the Internal Revenue Code and shall be issued upon such terms and conditions as the Committee, in its discretion, may from time to time determine, subject to the following provisions:
(a) Option Price. The option price per share with respect to each option shall be not less than the fair market value of the stock on the date the option is granted.
(b) Exercise of Option. Full payment for shares acquired shall be made in cash at or prior to the time that an option, or any part thereof, is exercised.
In connection with the exercise of any option, option shall be required to give satisfactory assurance that the shares are being purchased for investment and not with a view to distribution.
(c) Continuation of Employment. Each participant, in consideration of the granting of the option, shall agree in writing to remain in the employ of the Corporation, or a subsidiary corporation, for a period of not less than five years or the term of the option, whichever is greater.
(d) Termination of Employment. Each option, to the extent that it shall not have been exercised, shall terminate when the employment of the participant by the Corporation or a subsidiary terminates, unless the employment terminates because of voluntary resignation with the consent of the Board of Directors or because of death or incapacity. If the employment terminates because of voluntary resignation with the consent of the Board of Directors or because of incapacity, the option shall terminate upon the expiration of three months after the employment terminates. If the employment terminates because of death the option shall terminate upon expiration of one year after the date of death. If any unexercised option terminates for any reason, the shares covered thereby may be optioned to other employees and such shares shall not be considered in computing the aggregate amount of shares to be optioned under the Plan.
(e) Options Non-Assignable. Each option and all rights thereunder shall be non-assignable and non-transferable, except by will or the laws of descent and distribution.
(f) Incentive Plan Awards. In determining which employees shall be granted options and the number of shares for which an option or options shall be granted, the Committee shall take into account the amount of any awards received by employees under the RCA Incentive Plan.
The fifth and last paragraph of the above option plan made provision for its becoming effective on approval of the board of directors and ratification of the stockholders.
Pursuant to the aforementioned stock option plan, RCA transferred to petitioner, in recognition of petitioner's services rendered to RCA, stock options on the following dates at the indicated price per share and for the indicated number of shares, as shown by the letter agreements:
+-------------------------------------+ ¦ ¦Number ¦Price per ¦ +-------------+-----------+-----------¦ ¦Date ¦of shares ¦share ¦ +-------------+-----------+-----------¦ ¦Oct. 31, 1957¦2,000 ¦$28.875 ¦ +-------------+-----------+-----------¦ ¦Feb. 6, 1959 ¦1,000 ¦44.125 ¦ +-------------+-----------+-----------¦ ¦Jan. 8, 1960 ¦1,000 ¦66.375 ¦ +-------------+-----------+-----------¦ ¦Apr. 18, 1961¦2,000 ¦59.625 ¦ +-------------------------------------+
Each option so issued to petitioner qualified as a restricted stock option within the meaning of section 424(b) of the Internal Revenue Code of 1954.
The letter agreements of October 31, 1957, February 6, 1959, January 8, 1960, and April 18, 1961, are identical except for the number of shares and the price per share. Each letter agreement, or option, was granted in consideration of petitioner's agreement to remain in RCA's employ for 10 years, and was subject, inter alia, to the following conditions:
On Oct. 26, 1961, the date that petitioner accepted the termination agreement, petitioner was not eligible to obtain the 416 shares.
All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated. 2. By Pub. L. 89-809 sec. 210(a), Code sec. 1234(c) was redesignated sec. 1234(d) effective Jan. 25, 1965. Since the year involved here is 1962 we will use the nonapplication statute designation of 1234(c) as it appeared prior to 1965, though subsec. (c)(2) is identical with sec. 1234(d)(2) in the Code after Jan. 25, 1965.
a. The option period was 10 years and during each of the first 5 years no more than 20 percent of the total number of shares could be purchased; but this restriction was ,noncomulative. If less than 20 percent were purchased in any 1 year the difference could be made up in any later year.
b. The option was nonassignable and to the extent it was not exercised it terminated upon termination of petitioner's employment with RCA, except in the case of death or incapacity or voluntary resignation with the consent of RCA's board of directors, circumstances which do not apply in this case.
c. All shares purchased were to be acquired for investment and not with a view to distribution.
d. Stock dividends declared during the option period were reflected by an increase in the number of shares covered by the option, with a corresponding reduction in the price per share.
Subsequent stock dividends resulted in the change in the number of shares obtainable by petitioner under the aforementioned option agreements and in the price per share so that by the time petitioner terminated his employment with RCA on October 31, 1961, the number of shares, the eligibility of petitioner to obtain said shares by the exercise of his options, and the price per share were as follows:
+--------------------------------------------------------+ ¦ ¦ ¦Number of ¦ ¦ +---------------------+---------+--------------+---------¦ ¦ ¦Number ¦shares ¦Price per¦ +---------------------+---------+--------------+---------¦ ¦Option agreement date¦of shares¦petitioner was¦share ¦ +---------------------+---------+--------------+---------¦ ¦ ¦ ¦eligible to ¦ ¦ +---------------------+---------+--------------+---------¦ ¦ ¦ ¦obtain ¦ ¦ +---------------------+---------+--------------+---------¦ ¦Oct. 31, 1957 ¦2,080 ¦1 416 ¦$27.765 ¦ +---------------------+---------+--------------+---------¦ ¦Feb. 6, 1959 ¦1,040 ¦624 ¦42.429 ¦ +---------------------+---------+--------------+---------¦ ¦Jan. 8, 1960 ¦1,020 ¦408 ¦65.074 ¦ +---------------------+---------+--------------+---------¦ ¦Apr. 18, 1961 ¦2,000 ¦400 ¦59.625 ¦ +--------------------------------------------------------+
Petitioner exercised his options and purchased RCA stock as follows:
+-------------------------------------------------------+ ¦ ¦Number ¦Price per¦Date of ¦ +---------------------+---------+---------+-------------¦ ¦Option agreement date¦of shares¦share ¦purchase ¦ +---------------------+---------+---------+-------------¦ ¦ ¦purchased¦ ¦ ¦ +---------------------+---------+---------+-------------¦ ¦Oct. 31, 1957 ¦1,000 ¦$27.765 ¦Jan. 9, 1961 ¦ +---------------------+---------+---------+-------------¦ ¦Oct. 31, 1957 ¦664 ¦27.765 ¦July 19, 1961¦ +---------------------+---------+---------+-------------¦ ¦Feb. 6, 1959 ¦0 ¦0 ¦ ¦ +---------------------+---------+---------+-------------¦ ¦Jan. 8, 1960 ¦0 ¦0 ¦ ¦ +---------------------+---------+---------+-------------¦ ¦Apr. 18, 1961 ¦0 ¦0 ¦ ¦ +-------------------------------------------------------+
The fair market value of each share of RCA common stock on October 31, 1961 was $53.44.
Petitioner resigned as vice president and general manager and terminated his employment with RCA effective October 31, 1961.
Because of certain events and circumstances in connection with his employment that were not to petitioner's liking, he resigned and terminated his employment with RCA effective October 31, 1961, pursuant to the following letter termination agreement:
RADIO CORPORATION OF AMERICA
RCA Building
30 Rockefeller Plaza
New York 20, N.Y.
JOHN L. Burns
President
OCTOBER 18, 1961
MR. D. H. KUNSMAN
117 Ambler Road
Colwick, Merchantville 8, N.J.
DEAR MR. KUNSMAN:
You have advised us that you wish to terminate your service as an employee of RCA on October 31, 1961 and to be released from your obligations under the option agreements of October 31, 1957, February 6, 1959, January 8, 1960, and April 18, 1961 between us.
In return for your release of RCA from any obligations it might have under the above-mentioned agreements and of any other claim you might have arising out of or connected with your employment, we agree to release you from your obligations under such agreements and to pay to you the sum of $67,700 on January 15, 1962.
Very truly yours,
RADIO CORPORATION OF AMERICA By (S) John L. Burns
Accepted:
(S) D. H. KUNSMAN
Date: Oct. 26, 1961
Pursuant to the aforementioned termination agreement, petitioner received the sum of $67,700 from RCA on or about January 15, 1962. Of the said amount of $67,700, $40,439.10 was received by petitioner with respect to the options to purchase RCA stock.
Petitioner reported said sum of $67,700 on his 1962 joint income tax return in the following manner:
+---------------------------------------------------------+ ¦(a) Balance due under RCA incentive plan ¦$20,022.54¦ +----------------------------------------------+----------¦ ¦(b) Severance pay ¦7,238.36 ¦ +----------------------------------------------+----------¦ ¦(c) Surrender of options to purchase RCA stock¦40,439.10 ¦ +----------------------------------------------+----------¦ ¦ ¦67,700.00 ¦ +---------------------------------------------------------+
Petitioner reported items (a) and (b) as ordinary income and item (c) as long-term capital gain.
In his notice of deficiency respondent determined the $40,439.10 was ordinary income.
Findings With Respect to Casualty Loss Issue
Petitioner purchased his home in Cherry Hill, N.J., in 1956 for the sum of $40,500. At that time the home was equipped with a prefabricated Fiberglas swimming pool measuring 36 feet long, 12 feet wide at the ends, and 18 feet wide in the center. In June of 1959 the pool was damaged by a tree blown over in a sudden wind. The tree penetrated the fence surrounding the pool and tore a 5-inch hole in the bottom of the pool at the 6-foot end.
The water drained out of the pool through this hole in the bottom. In July of 1959 petitioner attempted to fix the damage to the pool by applying layers of an acrylic liquid type of substance over the hole and allowing the layers to solidify. This repair job and the repair job to the fence cost $220 and in his 1959 income tax return petitioner took a deduction of $220 described as ‘Casualty Damage to Fence and Swimming Pool By Sudden Wind, June 1959, per Pictures Attached.’
The repair job was not effective in that the pool continued to lose water at a substantial rate. During the balance of 1959 and in 1960 petitioner did not attempt further repairs but used the pool by replenishing the water. In the spring of 1961 when the water was draining out at the rate of 3 or 4 inches a day, petitioner again attempted a repair job much like the first repair job. But this patching was again unsuccessful and in the summer of 1961 petitioner decided the pool was a total loss and had to be replaced.
In the spring of 1961 petitioner had the prefabricated Fiberglas pool removed and an all-concrete pool installed at a cost of $5,411.95. On his 1961 income tax return petitioner took a casualty loss deduction in the amount of $5,411.95 and explained, in a separate statement, that it was for the same casualty loss and the expenditure was necessary because the repair attempts were ineffective and the pool had to be entirely replaced to restore the property to its original value.
Respondent disallowed the 1962 casualty loss of $5,411.95 explaining ‘it has been determined that this loss occurred in the year 1959 and is properly deductible in that year, and not 1962.’
OPINION
It is admitted that the petitioner realized gain in the amount of $40,439.10 when he was paid that sum for the surrender of his stock options in 1962. It is admitted that these options were issued to petitioner as compensation for services rendered RCA. It is respondent's position that the income received was in the nature of compensation and taxable at ordinary rates. Petitioner contends this realized gain is to be taxed at capital gains rates due to the provisions of section 1234(a), which provides as follows:
SEC. 1234. OPTIONS TO BUY OR SELL.
(a) TREATMENT OF GAIN OR LOSS.— Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, a privilege or option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as the property to which the option or privilege relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).
Employee stock options have been the subject of special legislation (see secs. 421-425) and numerous court decisions. This case does not demand an excursion into the general legislative and judicial history of employee stock options. Petitioner relies entirely upon the above-quoted section and he makes no argument at all that the said gain was not taxable as ordinary income if the quoted section was not applicable.
It is respondent's position that this section has no application due to section 1234(c)(2)
which, in the year in question, provided as follows:
(c) NON-APPLICATION OF SECTION.— This section shall not apply to
(2) In the case of gain attributable to the sale or exchange of a privilege or option, any income derived in connection with such privilege or option which, without regard to this section, is treated as other than gain from the sale or exchange of a capital asset:
There is no doubt that compensation for services is taxed as ordinary income even though it be in the form of compensatory stock option. Commissioner v. LoBue, 351 U.S. 243 (1956); Commissioner v. Smith, 324 U.S. 177; Jack I. LeVant, 45 T.C. 185, affirmed and modified on another point 376 F.2d 434.
Petitioner argues on brief that the above nonapplication section ‘is not altogether clear.’ Petitioner sees certain language in the legislative history of the section and a Treasury regulation that leads him to the conclusion that the gain realized on the surrender of a compensatory employee stock option is to be considered compensation if the parties intended the amount paid for the surrender of the options to be compensation. He also contends this intention must be manifested at the time of the payment and surrender of the options.
Petitioner points to the report of the House Ways and Means Committee which states with respect to this nonapplication statute:
Under this exception, for example, to the extent that gain on the sale or exchange of an option to purchase stock is in the nature of compensation to an employee, such gain is not to be treated as capital gain merely because the stock, if acquired, would be a capital asset in his hands. (H. Rept. No. 775, 85th Cong., 1st Sess. (1957), 195803 C.B. 899.)
The language of the Senate Finance Committee report is identical. S. Rept. No. 1983, 85th Cong., 2d Sess. (1958), 1958-3 C.B. 922, 1128.
Petitioner also points to section 1.1234-1(e)(1), Income Tax Regs., which provides, in part, as follows:
(e) Other exceptions. Section 1234 does not apply to gain resulting from the sale or exchange of an option
(1) To the extent that the gain is in the nature of compensation (see sections 61 and 421, and the regulations thereunder, relating to employee stock options);
Petitioner suggests that the foregoing shows the nonapplicability provision is not to be invoked in all cases of a sale or surrender of a restricted stock option; and therefore it will only apply in an employee stock option case where the facts show the employer paid the money for the surrender of the options as compensation for services. His argument on brief is:
Whether a payment represents compensation to the recipient is governed by the intention of the parties to the transaction. The evidence in this case shows that the elements of the lump-sum payment made to petitioner in 1962 were separately and clearly identified by RCA's personnel vice-president. Specific amounts were earmarked for severance pay and incentive plan accumulations, both compensatory items. These amounts were all the petitioner was entitled to and all that RCA could legally pay him for services rendered as a corporate officer. An equally specific amount was allocated to the surrender of petitioner's stock options, which petitioner was under no legal obligation to surrender or release to RCA.
Petitioner testified that he received the full value for his options in the sense that the $40,439.10 he received that was attributable to surrender of his options represented the option price deducted from the market price of RCA stock on the day of the calculation.
Petitioner's argument seems to be that under section 1234(a) the gain is to be considered as attributable to the underlying stock and therefore capital gain because there is no evidence of a compensatory motive at the time he was paid $40,439.10 for the surrender of his option agreements.
There is no merit in petitioner's argument. Each stock option was issued to petitioner as compensation. There is no evidence that they had any readily ascertainable market value on the date of issuance and therefore under applicable regulations the time to report income attributable to such options was postponed until the options were transferred. Secs. 1.421-6(c)(1) and 1.421-6(d), Income Tax Regs. Since the very purpose of the options when issued was compensatory, then what he realized when he surrendered the options was compensation or ordinary income.
Petitioner is making the same argument that was presented in Rank v. United States, 345 F.2d 337, and Dugan v. United States, 234 F.Supp. 7, and in both of those cases the issue was determined against the employee taxpayers. In both of the cited cases, the restricted stock options which the employers had granted were surrendered to the employers and it was held the consideration received was compensation and taxable as ordinary income. In both of the cited cases it was held section 1234 would not provide for capital gains treatment because it would be inapplicable under section 1234(c)(2) because the gain in question being compensatory would, without regard to section 1234, be ‘treated as other than gain from the sale or exchange of a capital asset.’
In Rank v. United States, supra, the opinion points out that the legislative history of section 1234(c)(2) eliminates all doubt about the section making section 1234 inapplicable when gain is realized on the surrender of compensatory stock options.
The Senate report in connection with section 1234(c)(2) of the Code is precisely in point:
(2) It is made clear that the section does not apply to gains on the sale of an option in any case in which income derived in connection with the option would be treated, without regard to this section, as ordinary income. As a result, the section will not apply to gain from the sale of an employee stock option which is in the nature of compensation to the employee. * * * (S. Rept. No. 1983, 85th Cong., 2d Sess. (1958), 1958-3 C.B. 999)
Also in Rank, the following pertinent statement is precisely in point here to answer petitioner's argument of lack of showing of compensatory motive at the time of surrender of the options:
Since it was the purpose to compensate at the time the options were granted, it matters not what the motive was for putting an end to those options.
We hold for respondent on the issue presented. The $40,439.10 was taxable as ordinary income and not as capital gains.
The second issue involves the casualty loss deduction. Sections 165(a) and 165(c)(3) provide for a deduction for any uninsured loss sustained ‘during the taxable year * * * of property not connected with a trade or business, if such losses arise from * * * storm * * * .’
Petitioner's pool was damaged in a 1959 storm that blew a tree over and into the pool tearing a hole in the bottom of the pool. Petitioner took a casualty loss in that year's income tax return of $220, representing repairs to the hole in the pool. The repairs were not effective and petitioner testified that in 1961 he decided the pool would have to be replaced. In the spring of 1962, it was replaced and petitioner took a casualty loss in his 1962 return in the sum of $5,411.95, representing the sum he expended for removing the Fiberglas pool and installing a new concrete pool. Petitioner had the burden of showing he sustained a casualty loss in 1962. He is not relieved of that burden because of the wording in the statutory notice to the effect that the Commissioner determined ‘this loss occurred in the year 1959 and is properly deductible in that year, and not 1962 when the damaged property was replaced.’ However, as will later appear, the question of who has the burden is immaterial.
In general, casualty losses are deductible in the year the loss is sustained. Secs. 1.165-1(d)(1) and 1.165-7(a)(1), Income Tax Regs. But this is not necessarily the year of the casualty. In Rose Licht, 37 B.T.A. 1096, the fire occurred in 1931 but it was held the loss did not occur until 1933, the year taxpayer settled with insurers. Also in United States v. Barrett, 202 F.2d 804, trees were damaged by a freeze in December of 1943 and January of 1944. The taxpayer attempted to revive the trees during 1944 and 1945 but was unsuccessful and it was held the ‘loss' occurred in the spring of 1946 when it became apparent that the trees could not be saved. To much the same effect, see Nourse v. Birmingham, 73 F.Supp. 70 (S.D. Iowa), and Oregon Mesabi Corporation, 39 B.T.A. 1033.
We do not feel the facts here bring petitioner within the doctrine of any of the cases where the deduction has been permitted in a year after the year of the casualty. These are cases where the loss or the full extent of the loss was not or by its very nature could not be known until a subsequent year. But even in the cited cases there is no suggestion that the taking of the deduction could be postponed to a year beyond the year when the full extent of the loss was known. Here, under petitioner's own testimony, he knew the pool was a complete loss in 1961. Without indicating agreement with petitioner's contentions as to the amount of loss (see Helvering v. Ownes, 205 U.S. 468, (1939) or that he was entitled to take a casualty deduction in any year other than 1959, it is enough to say we hold he could not take the deduction for the 1959 casualty in a subsequent year (1962) merely because that happened to be the year he replaced the pool with a new one. He testified he knew the pool was a total loss in 1961. If the taking of the deduction for the 1959 casualty can be postponed at all to subsequent years, it cannot be postponed beyond 1961, the year that he says he knew the pool was a total loss. The 1962 replacement did not establish the loss. In view of the fact that petitioner did take a casualty loss in 1959 and under his theory it was in the wrong amount he could have filed an amended return for 1959 when he knew the full extent of the damages in 1961. See Jane U. Elliott, 40 T.C. 304, 311.
We hold petitioner failed in his burden of proving he suffered a casualty loss in 1962. In fact, even if it be thought because of the wording in the deficiency notice that respondent had the burden to show petitioner did not suffer the casualty loss in 1962 we would hold respondent met the burden for the record shows conclusively that 1962 was not the proper year for taking any loss deduction resulting from the 1959 storm.
Decision will be entered for the respondent.