Opinion
October 5, 1967. —
October 31, 1967.
APPEAL from an order and a judgment of the circuit court for Milwaukee county: JOHN A. DECKER, Circuit Judge. Affirmed.
For the appellant the cause was argued by E. Weston Wood, assistant attorney general, with whom on the brief was Bronson C. La Follette, attorney general.
For the respondent there was a brief by Thomas J. Donnelly, Jr., Samuel J. Recht, and John A. Hazelwood, attorneys, and Brady, Tyrrell, Cotter Cutler of counsel, all of Milwaukee, and oral argument by Mr. Recht.
Clarence Uecke, hereinafter referred to as taxpayer, was a resident of Wisconsin during 1959 and 1960 and employed by the Outboard Marine Corporation, hereinafter referred to as Outboard, as industrial relations director. Taxpayer has been employed by Outboard for thirty-six years.
On February 20, 1956, taxpayer entered into a written stock option agreement with Outboard. The agreement provided in part as follows:
"Outboard has established an Executive Option Plan pursuant to which present or future officers and executives of Outboard and its subsidiaries, who are mainly responsible for its growth, development and success, may be granted options to purchase shares of its common stock in order to secure to Outboard the advantages of the incentive and sense of proprietorship inherent in stock ownership by such persons. . . ." (Emphasis added.)
The agreement also provided:
"(c) This option may be exercised only by delivery to Outboard of a written notice by Employee stating the number of shares in respect to which the option is exercised, together with cash or a certified check for the full amount of the option price of such shares of Stock, and a written representation in such form as may be prescribed by Outboard, that the Stock is being acquired with the intention of holding the same for investment and not with a view to distribution. . . ." (Emphasis added.)
Shares subject to options under this agreement were not required to be registered with the Securities and Exchange Commission. Taxpayer acquired 1,600 shares during 1959 and an additional 100 shares on January 25, 1960, all at the option price of $13.27 per share. One thousand of these shares were acquired in the name of the taxpayer and his wife as joint owners. These 1,700 shares are what produce this controversy. At the acquisition times, the quoted price of the stock on the New York Stock Exchange ranged from $31 to $35 per share.
In January of 1960, Outboard stockholders authorized an amendment of the stock option agreement so as to require an investment certification covering only 60 percent of the shares acquired by an optionee under the plan. Because the stock option agreement, as so amended, contemplated, for the first time, the possible sale of 40 percent of option stock by the employees, it was necessary that the stock subject to the plan be registered with the Securities and Exchange Commission. This was accomplished and amendments to the stock option agreements were executed.
In January of 1961, taxpayer took advantage of the provisions of the amended agreement and sold approximately 40 percent of the shares of stock he had acquired. The sale price was $24 per share. He reported the difference between the sale price and the option price as taxable income on his Wisconsin income tax for the year 1961.
The appellant, Wisconsin Department of Taxation, hereinafter referred to as department, made an additional income tax assessment against taxpayer for the years 1959 and 1960 claiming that taxpayer received taxable income in those two years at the time he exercised the options to purchase the shares of stock. The amount of this additional income was measured, by the department, as the difference between the option price and the price quoted for shares of the company's stock traded on the New York Stock Exchange on the days the options were exercised. The Wisconsin board of tax appeals affirmed the assessment.
The circuit court reversed the Wisconsin board of tax appeals and remanded the matter to the board. In doing so, the court determined that the findings of fact and conclusions of law as determined by the board were incorrect, in that in determining the value of the stock the board had not considered the effect of the restrictions on the disposition of the stock.
The real issue is whether the terms of the option agreement effectively restricted the sale of the stock and hence the value thereof.
The position of the department is demonstrated by the following statements contained in a communication from the counsel for the department dated November 1, 1962:
"1. For Wisconsin income tax purposes there is no statutory distinction between `restricted stock options' and other stock options to employes. Accordingly, the Wisconsin income tax treatment of all stock options to employes must be governed by the same basic considerations, regardless of the fact that for federal income tax purposes `restricted stock options' are specially treated under Section 421 of the Internal Revenue Code. . . .
"4. Ordinarily a compensation payment comes into existence at the time an option given to an employe is exercised or sold. . . . If the option is exercised by the employe, he receives compensation equal to the difference between the market value of the stock and the price paid therefor on the date he receives the stock."
Our attention has not been directed to any statute, case, ruling or other published policy in Wisconsin concerning Wisconsin income taxation of employee stock options prior to 1962.
Effective for the year 1963, Wisconsin adopted provisions substantially identical to the restricted stock option provisions of the Federal Internal Revenue Code. The provisions are found in sec. 71.032, Stats. 1963. The Federal Revenue Act of 1964 amended the provisions relating to restricted stock options and in 1965 Wisconsin law was again amended to substantially follow the federal act. Included in the 1965 amendment was the repeal of sec. 71.032 which was adopted in 1963.
The Wisconsin statute applicable to the matter presently before us is sec. 71.03, Stats. 1959, which provides in part:
"Gross income; inclusions, exclusions. (1) INCLUSIONS. The term `gross income,' as used in this chapter, shall include:
"(a) All wages, salaries or fees derived from services, . . .
"(1) And all other gains, profits or income of any kind derived from any source whatever except such as hereinafter exempted."
This court, on several occasions, has directed its attention to the meaning of the term "income" as used in Wisconsin income tax laws.
In Lawrence v. Tax Commission (1933), 213 Wis. 273, 276, 251 N.W. 242, this court indicated:
"Of course the idea of the income tax law is to tax income, and income is cash or its equivalent. It must be money or that which is convertible into money."
Also, more recently in Department of Taxation v. Siegman (1964), 24 Wis.2d 92, 96, 128 N.W.2d 658, the meaning of the term "income" was again considered.
"What does the term `income' mean as it is used in sec. 71.03 (1), Stats.?
"This court has held that `income' as used in the constitution is to be interpreted in accordance with its common, ordinary meaning as understood in everyday life. `It must be gain or profit and it must be money or something equivalent thereto.'
"In everyday usage, the phrase `taxable income' is not coextensive with the notion of economic gain or increment. To be deemed income, for the purpose of sec. 71.03 (1), Stats., an economic gain must be utilized by the taxpayer to satisfy some need before such increment is taxable. In short the income in the sense of economic gain must be `realized' before it can be taxed."
In Siegman, supra, the court then discussed "realization" and alluded to several federal cases, including Helvering v. Horst (1940), 311 U.S. 112, 61 Sup. Ct. 144, 85 L.Ed. 75, and at page 99 stated:
"Analytically then, any economic gain or increment is income, constitutionally and within the meaning of the Federal Code. However, the receipt is not taxable until `realized,' that is to say, utilized for some benefit, material or otherwise by the taxpayer. As Horst suggests, the realization requirement is a matter of administrative convenience. The cost of conducting annual valuations of the appreciation on stock holdings, for example, would exceed the revenue recovered. The critical issue surrounding realization problems is not whether a receipt shall be taxed, but when it shall be taxed."
The pivotal question in the matter before us is whether the restriction placed upon the transferability of the stock in 1959 and 1960 was sufficiently effective to inhibit realization of a gain so as to render the actual value of the stock indeterminable at the time the options were exercised.
We conclude that the restrictions placed upon the transferability of the stock were sufficiently effective so as to inhibit the realization of any gain at the time the options were exercised and in doing so consider the following factors to be controlling in the case presently before us:
(a) The purpose of the executive option plan was to grant a proprietary interest in the corporation.
(b) The requirement of a written representation that employee intended to hold the stock for investment purposes, rather than for distribution.
(c) The employees' representation of "investment intent" brought the stock option plan within the provisions in the Securities Act of 1933 which exempt from the registration requirements "transactions by an issuer not involving any public offering." ( 15 USCA sec. 77d (1)). Sale of the unregistered Outboard stock without qualifying under this exemption would have exposed both the company and the employee to both civil and criminal sanctions under the Securities Act.
(d) The general knowledge of the employees, as evidenced by testimony, recognizing the fact that they were not free to sell the stock as long as they worked for Outboard and that if they did sell such stock they "might as well look for another job."
(e) An individual notice to each employee, before he became eligible to exercise his respective option, which served as a reminder of the purpose of the option plan.
(f) A managerial attitude, as evidenced by the testimony of Mr. Robert Wallace, secretary of Outboard, which revealed that dismissal would be the most practical form of discipline for violation of the option scheme.
(g) The fact that from the inception of the plan there was only one instance in which an employee sold a portion of the option stock in violation of the restriction in the agreement. This involved 100 shares of stock. The employee was severely reprimanded but no further action was taken because Outboard was satisfied that the employee had misunderstood the investment restriction.
(h) The fact that the effective restriction was eventually modified by the 1960 amendment and compliance had with the regulations of the Securities and Exchange Commission.
The impracticability of endeavoring to measure, for income tax purposes, an employee's economic benefit in exercising stock purchase options is readily apparent in reviewing the history of MacDonald v. Commissioner of Internal Revenue (7th Cir. 1956), 230 F.2d 534. In MacDonald, the taxpayer acquired stock in his employer's corporation pursuant to an option, and orally agreed not to sell the stock during the term of his employment. At the time the treasury regulations did not provide, as they now do, that a restriction on sale postpones the realization of income until the restrictions lapse. The commissioner argued that because the taxpayer could quit his job and sell the stock, there was no legal restriction on transfer and therefore the income should be realized in the year of the exercise of the option. The court of appeals indicated that that reasoning "borders on the absurd." The court remanded the case to the tax court to determine the effect of the potential job loss on the stock's value. Obviously the tax court could not measure the value of the taxpayer's job in connection with his stock and so held, MacDonald (1956), 16 T. C. M. 208. However, the court of appeals again reversed and remanded in 1957. Commissioner of Internal Revenue v. MacDonald (7th Cir. 1957), 248 F.2d 552.
Subsequent to MacDonald, supra, Treas. Reg. sec. 1.421-6 (d) (2) (i) was enacted, which provides:
"If the option is exercised by the person to whom it was granted but, at the time an unconditional right to receive the property subject to the option is acquired by such person, such property is subject to a restriction which has a significant effect on its value, the employee realizes compensation at the time such restriction lapses or at the time the property is sold or exchanged, in an arm's length transaction, whichever occurs earlier. . . ."
The final contention of the department is that should the court determine there were effective restrictions, and we have so determined, that the 1960 amendment removed the restrictions as to 40 percent of the shares of stock involved. The record discloses that the department has never made an assessment against the taxpayer on this basis and, therefore, this contention is not properly before this court on appeal. Callaway v. Evanson (1956), 272 Wis. 251, 75 N.W.2d 456; Sohns v. Jensen (1960), 11 Wis.2d 449, 105 N.W.2d 818.
By the Court. — Order and judgment affirmed.
The following memorandum was filed December 22, 1967.
In its brief in support of its motion for rehearing, the state contends the mandate is inconsistent with the opinion filed. However, the state is in error in assuming that the affirmance of the order of the trial court remanding the matter to the Wisconsin tax appeals commission requires the commission to determine the value of the stock. It was our intention that upon remand the commission would enter findings, conclusions and an order consistent with our opinion that no assessment was proper at the time the options were exercised.
Motion denied without costs.