Gresham v. Commissioner , 79 T.C. 322 ( 1982 )

Whitaker, Judge:

Respondent determined deficiencies in petitioners’ income taxes as follows:

Year¹ Deficiency

1975 .$13,234.59

1976 . 17,916.67

The sole issue for decision is the fair market value for purposes of the minimum tax, section 57(a)(6),² of shares of stock acquired by petitioner Louis B. Gresham pursuant to several exercises of a qualified stock option.

FINDINGS OF FACT

The facts are fully stipulated and are found accordingly.

Louis B. Gresham (petitioner) and Margaret S. Gresham are husband and wife. They filed joint Federal income tax returns for the years 1975 and 1976. Mrs. Gresham is a petitioner only by reason of having filed joint income tax returns with her husband. At the time the petition was filed, petitioners resided in Shawnee Mission, Kans.

During the years in question, petitioner was chief executive officer of General Energy Corp. (GEC). GEC common stock was then traded on the over-the-counter market. Effective January 1, 1973, GEC adopted a stock option plan meeting the requirements of section 422. Pursuant thereto, petitioner received a stock option for 50,000 shares of stock. The option price was $2.50 per share. As a condition to the issuance of stock pursuant to the exercise of the option, petitioner was required to execute an "investment letter” in order for the transaction to be exempt from the registration requirements of the Securities Act of 1933, as amended, 15 U.S.C. sec. 77d(2).

In general, under the rulings of the Securities and Exchange Commission (SEC), the effect of the required investment letter was to prohibit petitioner for a period of 2 years from selling the shares except in a private placement, unless a registration statement was in effect with respect to the shares. No such registration statement was in effect on the dates of issuance of the option shares. In any such private placement, the SEC would require the purchaser to execute a similar investment letter. Certificates for the option stock were required to bear an appropriate legend, and a stop transfer order was placed against the share with GEC’s transfer agent.

Petitioner exercised the option to the extent of 5,000 shares in December 1974. During 1975, petitioner purchased in two separate exercises a total of 25,000 shares, and in 1976, petitioner purchased the remaining 20,000 shares of stock. Upon each exercise of the option, petitioner executed the required investment letter.

For purposes of the minimum tax calculation on petitioner’s 1974,³ 1975, and the 1976 returns, petitioner determined the bid prices for the GEC common stock traded on the over-the-counter market on the dates of exercise of the option and then discounted the total value of each block of shares purchased by 33% percent, reporting the discounted value as the fair market value of the option stock so acquired. The amount of tax preference income in each year was determined by deducting from the discounted value of the option stock petitioner’s cost for the stock.⁴

In determining the deficiencies for these 2 years, respondent valued the option stock at the mean of the bid and asked prices in the over-the-counter market on the dates of exercise of the option, without taking into account the effect of the investment letter restrictions applicable to the stock. In so doing, respondent applied section 1.57 — 1(f)(3), Income Tax Regs.,⁵ which adopts the principles of section 83(a)(1) to compute fair market value for purposes of the minimum tax. Section 83(a)(1) specifies that restrictions shall not be taken into account in valuing stock unless they are nonlapse restrictions. The restrictions in this case, which are required under the Securities Act of 1933, as amended, and the rules of the SEC, are considered to be ones which will lapse. See sec. 1.83-3(h), Income Tax Regs.

In this case, the parties have stipulated that if the Court holds that section 1.57-l(f)(3), Income Tax Regs., is valid and applicable, petitioner will concede the deficiencies as asserted in the statutory notice, including the increased deficiency for 1975 asserted in respondent’s amendment to the answer. On the other hand, the parties have stipulated that if we should decide that the regulation is not valid or does not apply, the fair market value of the stock is to be determined by applying a discount of 33 % percent to the mean of the bid and asked prices on the over-the-counter market.⁶ Application of this discount will reflect the price at which the shares could have been sold in a private placement with the purchaser executing a similar investment letter.

Pursuant to the stipulation, we find that the mean of the bid and asked prices in the' over-the-counter market of GEC common stock on the several dates on which petitioner exercised the option in 1974, 1975, and 1976 were as follows:⁷

Date Mean price

Dec. 11, 1974 . $10.9375

Feb. 10, 1975 . 15.3125

July 28, 1975 . 13.6875

Feb. 5, 1976 . 10.750

We find that on the respective dates of the transfer of stock to petitioners upon the exercise of this option, the only method by which petitioners could have sold the stock was through a private placement at a price equivalent to 66% percent of the mean of the bid and asked prices in the over-the-counter market on those dates. We further find that the fair market value of the option stock on the respective dates of acquisition was such discounted value.

OPINION

Section 56 imposes a minimum tax upon the sum of the items of tax preferences with adjustments not here material. The tax preferences are listed in section 57. Of these, only section 57(a)(6), reading as follows, is applicable here:

(6) Stock options. — With respect to the transfer of a share of stock pursuant to the exercise of a qualified stock option (as defined in section 422(b)) or a restricted stock option (as defined in section 424(b)), the amount by which the fair market value of the share at the time of exercise exceeds the option price. [Emphasis supplied.]

The stock in question was transferred to petitioner upon the exercise of his qualified stock option; thus, we are called upon to determine the amount of this tax preference, that is, the amount, if any, by which the fair market value of the shares exceeded the option price on each date. There is no dispute as to the option price so our inquiry is simply as to the "fair market value” of the shares on each date.

The Code does not define the term "fair market value.” However, for many years the universally accepted definition of this term has been the willing buyer, willing seller test under which fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973). Normally, the fair market value of shares of stock which are listed or traded on a stock exchange or the over-the-counter market is the mean between the highest and lowest quoted selling prices on the day in question, but there are many exceptions to this rule, such as when there is a restriction on the sale of the stock. Kolom v. Commissioner, 71 T.C. 235 (1978), affd. 644 F.2d 1282 (9th Cir. 1981); Frizzelle Farms, Inc. v. Commissioner, 61 T.C. 737 (1974).⁸ On the dates in question, there was an over-the-counter market for GEC shares which would fix the fair market value of shares which would or could trade in that market. It is respondent’s position that this over-the-counter fair market value should be used for the stock in issue here, but respondent ignores the fact, which we have found in this case, that there were significant restrictions on the sale of the shares of the option stock, as reflected by the investment letters. These restrictions precluded trading these shares of stock on the issue dates on the over-the-counter market; thus, that market cannot establish fair market value.

On the authority of section 1.57-l(f)(3), Income Tax Regs., respondent urges that we ignore the restrictions and accept the artificial concept of fair market value which is mandated by Congress in section 83(a),⁹ but nowhere appears in sections 56 and 57. We disagree. For the reasons expressed herein, we hold that section 1.57-l(f)(3), Income Tax Regs., is inconsistent with the plain meaning of the statute.

This Court considered this regulation in Kolom v. Commissioner, supra, but in a slightly different context. There, we determined, for purposes of the minimum tax, the fair market value of option stock the disposition of which was subject to section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. sec. 78p(b). Section 16(b) requires that a corporate insider who sells his option stock upon the date of issuance, or at any time within 6 months thereafter, for a profit (that is, for an amount in excess of his option price), must return that profit to the issuing corporation, his employer. Although we recognized that section 16(b) might affect the value of the stock to an insider such as the petitioner in Kolom, we held that this section does not affect the fair market value of the stock for purposes of sections 56 and 57(a)(6). Section 16(b) does not preclude sale in the particular market; it merely captures the insider profit if realized within 6 months.

Here, in contrast, the effect of the restriction was to make a private placement sale the only market for the stock on the dates in question. Moreover, because the purchaser of such stock was required to execute an investment letter restricting his ability to dispose of the stock, the restriction significantly reduced the value of the stock in that market. See LeVant v. Commissioner, 45 T.C. 185, 203-205 (1965), revd. and remanded 376 F.2d 434 (7th Cir. 1967). The parties have stipulated that the stock’s fair market value in the private placement market was 66% percent of the mean of the bid and asked prices on the over-the-counter market for stock not bearing this restriction. Thus, Kolom is factually distinguishable from this case.

In Kolom, we carefully avoided deciding on the validity of section 1.57-l(f)(3), Income Tax Regs., as applied to situations where the fair market value under the willing seller, willing buyer test was not the same as the fair market value which respondent determined by application of the regulations.¹⁰ See 71 T.C. at 243. Here, by contrast, we find that application of the regulation does change the criteria for determining fair market value since fair market value under the regulation is the mean of the over-the-counter bid and asked prices for similar stock not subject to restrictions, while fair market value under the willing buyer, willing seller test is only 66% percent of such amount.

Because neither Kolom nor any other case has addressed the overall validity of the regulation, we must now determine whether or not there is any reasonable basis upon which to ignore the apparently plain meaning of section 57(a)(6) and to apply, instead, the artificial criteria of section 83(a)(1) to the determination of fair market value as the regulation directs.

Respondent would have us treat section 83 and sections 56 and 57 in tandem, both reflecting congressional action in 1969 to close existing loopholes and to more equitably apportion the tax burden. However, the fact that both sections were added to the Code in 1969 and were designed to achieve somewhat comparable objectives does not necessarily imply that they must be construed alike. Comparison of these two provisions of the 1969 Act demonstrates that Congress intended different results in the two sections.¹¹ It is patently clear that Congress had before it the question of the effect of restrictions on sales of property received as compensation for services. In section 83, Congress unequivocally modified the concept of fair market value, whereas, in section 56(a)(6), the modifying language was omitted. We fail to find the necessary ambiguity to allow us to ignore statutory language. Accordingly, we hold that regulation 1.57 — l(fl)(3) is inconsistent with the statute and is therefore invalid.

Respondent points to language in Kolom in which we recognized (note 12) that Congress intended by section 56 to require payment of tax on "economic income.” Respondent argues that in this case the difference between the stock’s value on the over-the-counter market and petitioner’s cost is economic income because were it not for the deferral of section 421, petitioner would have been required to pay tax on such difference. However, respondent loses sight of the fact that these shares of stock could not have traded on the over-the-counter market irrespective of section 421. The option stock received by petitioner was not exactly like shares of GEC stock which he could have purchased on the open market. The option stock had a unique aspect, a limitation on marketability attached to the particular shares and plainly spelled out on the certificates. The willing buyer, willing seller here would be dealing in a property which had its own inherent peculiarities. The economic value of these shares of stock on the dates of issuance to the willing buyer as well as to the willing seller was that price at which these shares of stock could trade in the private placement market only.

Respondent calls to our attention the case of Harrison v. United States, 475 F. Supp. 408 (E.D. Pa. 1979), affd. per order 620 F.2d 288 (3d Cir. 1980), in which the U.S. District Court found this regulation to be reasonable and consistent with the legislative purpose. We respectfully disagree. That court noted that this regulation was initially proposed in December 1970 and remained in the same proposed form until adopted in 1978, and that during that period section 57 was amended by Congress on several occasions. The District Court interpreted this as tantamount to congressional approval of respondent’s regulation. There is, however, no evidence that Congress ever focused on this particular regulation, which is not unusual since it remained in proposed form during that 8-year period. Until 1978, respondent’s interpretation was uncertain.¹² This fact situation does not rise to the status of congressional adoption of a departmental construction. See, e.g., Lykes v. United States, 343 U.S. 118 (1952).¹³

The other court which has examined section 1.57-1 (f)(3), Income Tax Regs., avoided the validity issue, as we did in Kolom v. Commissioner, supra. The U.S. District Court for the Northern District of Iowa in Thomsen v. United States, an unreported case (N.D. Iowa 1981, 47 AFTR 2d 81-93, 81-1 USTC par. 9253), held that the section 16(b) requirement does not affect market value.

We conclude that section 1.57 — 1(f)(3), Income Tax Regs., is contrary to the unambiguous language of section 57(a)(6). The section 57(a)(6) fair market value criterion requires that restrictions applicable to shares of option stock in the hands of both the willing seller and the willing buyer must be taken into account in determining fair market value. We hold for petitioner.

Decision will be entered under Rule 155.

Reviewed by the Court.

1 The year 1974 is also involved. See note 8 below.

2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended.

3 Petitioner paid no minimum tax for 1974 as a result of the carryovers allowed by sec. 56(c), as then in effect.

4 Inadvertently, in determining the value for this purpose of the option stock acquired in 1976, the discount was applied twice.

5 Sec. 1.57-1(0(3), Income Tax Regs., provides:

(3) Fair market value. In accordance with the principles of section 83(a)(1), the fair market value of a share of stock received pursuant to the exercise of a qualified or restricted stock option is to be determined without regard to restrictions (other than nonlapse restrictions within the meaning of § 1.83-3(h)). Notwithstanding any valuation date given in section 83(aXl), for purposes of this section, fair market value is determined as of the date the option is exercised.

6 The parties are also in agreement that an adjustment would have to be made in that case to take into account the use by petitioner of a double discount for the year 1976. Other adjustments to the deficiencies will follow automatically from the Court’s decision.

7 In computing the minimum tax for 1975, respondent reduced the tax carryover from 1974 as a result of revaluing the option stock acquired in 1974 at the mean of the over-the-counter market rather than at the discounted value used by petitioner.

8 See also United States v. Cartwright, 411 U.S. 546 (1973); sec. 20.2031-2(b), Estate Tax Regs.

9 Sec. 83(a) reads as follows:

(a) General Rule. — If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of—

(1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over

(2) the amount (if any) paid for such property,

shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arm’s-length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture.

10 Hinton v. Commissioner, T.C. Memo. 1982-221, is not to the contrary. There we again determined the fair market value of option stock held by an insider subject to sec. 16(b), Securities Exchange Act of 1934, 15 U.S.C. sec. 78p(b). In a brief reference to Kolom v. Commissioner, 71 T.C. 235 (1978), we summarized our treatment of the regulation in that case by stating that we upheld its validity, without intending in any way to change our clear reservation of the validity issue as expressed in Kolom.

11 In his dissent to the denial of the writ of certiorari in Kolom v. Commissioner, 454 U.S. 1011 (1981), Justice Powell noted the dissimilarity in the language of these two 1969 Act provisions:

"It is this policy of encouraging employee stock ownership that explains why the language of §57 and §83 differs. Both sections were enacted as part of the Tax Reform Act of 1969. Yet §57, imposing minimum tax on the transfer of qualified stock, uses only the words 'fair market value’ whereas §83, seeking to end tax avoidance through the use of non-qualifying stock and spurious restrictions, modifies that phrase with a parenthetical indicating that restrictions that lapse are to be ignored. Congress’s failure to include any similar qualification in §57 strongly suggests that it intended to use 'fair market value’ in its traditional and well-established sense. Any other understanding of the term would defeat the purpose §§57, 421 and 422 were designed to serve. [454 U.S. 1011, 1016 (1981), 81-2 USTC par. 9741, at 88,487.] ”

12 The preamble to T.D. 7564, 1978-2 C.B. 19, reflects that consideration was given to comments received on this part of the proposed regulation urging that restrictions should be taken into account.

13 It is interesting to note that Congress has become aware of court decisions such as Kolom v. Commissioner, supra, and as a part of the Economic Recovery Tax Act of 1981, 95 Stat. 172, 260, has amended sec. 83(c) to provide that, with respect to the sec. 16(b) situation, the taxpayer’s ownership of shares of stock would be deemed to be subject to a substantial risk of forfeiture and not transferable, hence not taxable, until after expiration of the 6-month period.