DocketNumber： Docket No. 46330
Judges： Rice
Filed Date： 11/10/1954
Status： Precedential
Modified Date： 11/14/2024
*46
Petitioner Harold E. MacDonald terminated his employment as vice president of one corporation and accepted a similar position with another corporation although this resulted in the forfeiture of substantially all of $ 53,500 in deferred compensation credited to him by his former employer. He also accepted a base salary, which, during his first and second years of employment, was substantially less than that which he was currently earning. The decisive factor in inducing petitioner to make these financial sacrifices was a stock option granted to him by his new employer-corporation which permitted him to acquire 10,000 shares of the corporation's stock at a price intended to be, and which was, much lower than the market price of such stock. There was a vague oral understanding that petitioner would not sell his stock while in the employ of the company, but no binding agreement was ever entered into; and other officers subject to a similar "understanding" had sold their stock and remained in the company's employ.
1.
2.
*228 This proceeding involves a deficiency in income tax determined against Harold E. MacDonald and Marian B. MacDonald in the amount of $ 116,438.30 for the taxable year 1949.
The sole issue to be decided is whether petitioner Harold E. MacDonald realized additional income in the amount of $ 168,000 when he exercised an option to purchase stock from his employer-corporation for less than the market value of such stock.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found, and are incorporated herein by this reference.
Petitioners are husband and wife, residing in Glencoe, Illinois. They filed a joint Federal income tax return for the taxable year 1949, on the cash basis, with the*48 collector of internal revenue for the first district of Illinois.
Harold E. MacDonald (hereinafter referred to as petitioner) was vice president and a director of Schenley Distillers Corporation from 1944 to 1948. In April or May 1947, he was approached by a personnel placement executive on behalf of Household Finance Corporation (hereinafter referred to as Household) regarding his possible employment by Household. Household was interested in employing an executive of demonstrated ability who, within a short period of time, would be able to assume the duties of president of Household. *229 Petitioner met with Byrd E. Henderson, then the president of Household, and discussed the possible terms of such employment. It was "pretty much" agreed that if petitioner was hired, Household would pay him an annual cash salary of $ 50,000 for the first year of employment, $ 60,000 for the second year, and $ 75,000 for the third year. Petitioner was also informed, at this first meeting, that it was Household's policy that its key executives acquire a proprietary interest in the company.
Petitioner was at that time, and had been since June 1, 1944, receiving a base compensation of $ 50,000*49 a year from Schenley. (From December 1, 1947, through July 15, 1948, his base compensation at Schenley was at the rate of $ 70,000 per year.) Petitioner was also entitled to the benefits of Schenley's pension plan. In addition, pursuant to Schenley's Key Group Extra Compensation Plan, he was entitled to the following bonus credits and payments:
| Deferred | |||
| Year | Credit | Amount paid | compensation |
| 1946 | $ 31,250 | $ 5,000 | $ 26,250 |
| 1947 | 32,250 | 5,000 | 27,250 |
Petitioner pointed out to Henderson that leaving Schenley's employ would result in an immediate financial sacrifice since he would forfeit practically all of the foregoing deferred compensation as well as his rights under Schenley's pension plan.
Petitioner was unwilling to enter the employ of Household solely on the salary basis previously discussed. He wanted some additional inducement to make this change of employment. He stated that he was interested in seeing an "estate building up" for himself; and during additional meetings and discussions with Henderson, they discussed an "insurance type of thing" and "the possibility of acquiring stock through a bargain purchase."
On August 6, 1947, Henderson wrote to*50 petitioner informing him that he had told the members of the executive committee and some of the directors "that just as soon as it is believed that the arrangement with you will be successful, we are to arrange some sort of a stock deal with you that will enable you to acquire substantial holdings in Household at a reduced price and that if some arrangements could be made to accelerate your participation in the pension plan that that, too, be done." However, petitioner replied that "it seems to me quite doubtful that you would be able to effect the pension and stock purchase plan," and accordingly he had decided not to accept the position.
Negotiations were resumed sometime in 1948; and on May 5, 1948, Henderson sent the following letter to petitioner:
*230 Dear Mr. MacDonald:
Confirming recent conversations, I will outline informally below the offer which has been made to you. For brevity I will use the following terms: "company" means Household Finance Corporation. "stock" means the company's common stock. "market value" means the last sale price on the New York Stock Exchange. "adjusted book value" means the book value of the stock after adding back all reserves and*51 the call premium on the preferred stock, that being the formula by which the company has always fixed the price of employee stock offerings.
The purpose of this offer is to induce you to accept employment as an executive. The offer is conditioned on your accepting such employment and becomes operative only if and when you have done so.
Subject to the foregoing, and to the conditions set forth below, the company or a subsidiary will:
1. sell you up to 10,000 shares of stock at a price between (a) the market value at the time of purchase, and (b) the adjusted book value on May 31, 1948, less the amount of any cash dividends paid on an equivalent number of shares after May 31, 1948 and up to the date of purchase (after reducing such dividends by the federal income taxes you would have paid on them (at your top bracket rate) if you had received them); and
2. lend you (or extend you credit for) the full purchase price and also any federal income taxes for which you become immediately liable at the time of the purchase (or as of that time, after final determination of the liability) by reason of the purchase.
The price and number of shares within the above price range are to be fixed*52 by mutual agreement between you and the company, represented by Mr. F. B. Hubachek and myself. If we are unable to agree within two months from date on the price and number of shares covering this stock purchase, then you shall be empowered to refer the matter to arbitration, and the decision of the arbiter shall be final and conclusive. It is agreed that the arbiter shall be Mr. A. D. Bruce of Evanston, Illinois. If Mr. Bruce is unable or refuses to serve, then Mr. L. L. Footh of Evanston, Illinois shall resolve the dispute as the agreed arbiter; and, if Mr. Footh is unable or refuses to serve, then Mr. J. A. Martin of Evanston shall act as the agreed arbiter. If none of the foregoing are able or willing to serve, then we shall select an arbiter; and if we are unable to agree upon an arbiter, then the American Arbitration Association shall be requested to supply an arbiter. The rules of the American Arbitration Association shall govern the conduct and procedure of the arbitration if any question as to the same arises. In any event, if we are unable to agree on the price and number of shares covering the stock purchase on or before December 1, 1949, then this matter must be *53 referred to arbitration as above provided.
In determining the price and number of shares, the arbiter shall pay due regard to all the facts presented to him and shall determine and fix the specific price and number of shares on a basis which is fair and equitable in his judgment, both to the company and to you, in terms of giving you a reasonable proprietary interest in the company, commensurate with your status as a policy making executive.
The adjusted book value on May 31, 1948, is now estimated to be approximately $ 21.10; that figure will be definitely agreed on when you enter the company's employ.
At the company's election, it or a subsidiary will either sell you the stock on credit or will lend you the money with which to buy it, in either case on the following terms:
*231 You will give your promissory note, without interest, for the full amount of funds loaned or credit extended and will pledge all the purchased stock as collateral security for the full performance of the note for its entire life. The principal will be payable in installments consisting of the amount of all cash dividends paid on the stock after deducting federal income taxes imposed thereon at your top*54 bracket rates; these installments to continue until the unpaid balance comes due at the end of the fifteenth year. You to have the option of paying additional amounts on the note at any time. The note to contain the customary provisions for proceeding against the pledged stock, and all other standard commercial provisions, including an agreement to pledge stock dividends and other produce of the pledged security to prevent "dilution", etc.
If, as covered above, you incur federal income taxes because of and at the time of such purchase, the company or a subsidiary will lend you the amount of such income taxes and that amount will be added to the above described note, subject to all the terms thereof.
Very truly yours,
S/ B. E. Henderson.
The arbiters referred to in the above option agreement were selected to protect petitioner's interests. They were known to officials of Household as businessmen of character and integrity, and were friends of petitioner.
On June 1, 1948, Henderson tendered petitioner a formal offer of employment at a base salary of $ 50,000 for the first year, $ 60,000 for the second year, and $ 75,000 for the third year. The letter offering this employment confirmed*55 the option agreement of May 5, 1948. This employment contract was terminable by petitioner on 3 months' notice and by Household on 6 months' notice, which notices could be given at any time during the first year of employment. Petitioner accepted this offer of employment effective June 15, 1948; and, on June 17, 1948, he became executive vice president and a member of the board of directors of Household and its executive committee. He remained in this office until March 1951 when he became president of Household and Henderson became chairman of its board of directors.
Upon leaving Schenley, petitioner forfeited practically all the deferred compensation credited to him as well as his rights under its pension plan. From the inception of his employment at Household in June 1948 through 1952, he received the following salary and percentage bonus compensation:
| Percentage | |||
| Year | Base salary | Base salary | bonus actually |
| actually paid | paid | ||
| 1948 | $ 50,000 | $ 27,083.29 | $ 4,604.16 |
| 1949 | 60,000 | 55,416.67 | 11,083.33 |
| 1950 | 75,000 | 68,125.00 | 13,625.00 |
| 1951 | 87,000 | 85,000.00 | 17,000.00 |
| 1952 | 100,000 | 97,833.30 | 19,566.70 |
*232 The bonus received by petitioner *56 in the years 1948 to 1952, inclusive, was determined on a percentage basis and was paid because his status with the company placed him in a certain category of employees, composed of some 150 or 200 people, all of whom received the same percentage. Petitioner also became entitled to pension benefits at Household, after he had been there 3 years, which were substantially equivalent to those which he had previously had under the Schenley pension plan.
On October 4, 1949, petitioner exercised the stock option previously granted to him, and this was acknowledged by Household, as follows:
Dear Mr. MacDonald:
On May 5, 1948, this Company offered to sell you up to 10,000 shares of its common stock on certain terms and conditions, as an inducement to enter its employ. On June 14, 1948, you accepted employment by this Company and its offer to sell you stock became operative. The Company, through the undersigned, and you have agreed on a sale of 10,000 shares pursuant to the said offer at $ 18.70 per share, the purchase price to be lent to you by Household Consumer Discount Company, a wholly-owned subsidiary of this Company, against your promissory note.
This letter and its enclosures constitutes*57 a final and binding sale to you of 10,000 shares of Household Finance Corporation common stock for $ 187,000 pursuant to the said offer of May 5, 1948.
On behalf of Household Finance Corporation, we deliver to you herewith, and you hereby acknowledge receipt of, certificates for 10,000 shares of the said stock and a stock power executed by the Company, selling and transferring to you the said shares. The undersigned have instructed the Treasurer of the Company to deliver to you on request a check for $ 500 for the stamp taxes.
You have delivered to the undersigned, acting on behalf of the payee and Household Finance Corporation, and we hereby acknowledge receipt of, your promissory note, executed by you in the amount of $ 187,000 payable to Household Consumer Discount Company, the said note constituting payment for the said shares.
This transaction has been authorized and approved by Household Finance Corporation by an appropriate resolution of the Executive Committee of the Board of Directors of that Company.
Concurrently with the exercise of this stock option, petitioner executed his promissory note representing the purchase price of the said 10,000 common shares. This note was*58 secured by the 10,000 shares and provided that all dividends on said shares, less petitioner's applicable Federal income tax thereon calculated at the highest applicable bracket rates, should be applied to the payment of the principal of the note. No interest was payable on the principal of the note during its 15-year term. At the end of such term, the unpaid principal became payable, and, if not paid, interest at the rate of 4 per cent was thereafter to be charged. Up to October 29, 1953, a total of $ 23,000 had been applied against the principal of said promissory note.
The common stock of Household has been continuously listed on the New York Stock Exchange since some time prior to 1948. The fair market value of its common shares on certain dates of importance *233 herein, before the allowance of any amount on account of the effect of section 16 (b) of the Securities Exchange Act of 1934, was as follows:
| May 5, 1948 (date of option) | 30 7/8 |
| June 1, 1948 (date of employment agreement) No sales | (bid 30 3/4; |
| ask 31 1/8) | |
| June 14, 1948 (date of acceptance of employment | |
| agreement) | 30 7/8 |
| June 15, 1948 (date of commencement of employment) | 30 |
| Oct. 4, 1949 (date of exercise of option) | 33 3/4 |
*59 Petitioner was aware of Household's policy that its top executives acquire and maintain an investment in the equity shares of the corporation. There was an oral understanding that he would not sell the stock acquired pursuant to this option, but he at no time signed any agreement to that effect. Executives and directors of Household had in the past sold their holdings of the corporation's stock in personal emergencies. They had also transferred them by gift to their children and grandchildren. Petitioner had not sold any of the shares acquired pursuant to the instant option up to the time of the hearing herein.
Petitioner did not consider his right to acquire 10,000 shares of Household stock at a price substantially below its market value as a gift, but regarded it as an inducement to accept employment with Household.
On July 9, 1948, Household filed a Form 8-K report with the Securities and Exchange Commission in which it was stated that the consideration for the granting of the stock option to petitioner was the "Acceptance of employment by Mr. MacDonald."
In proxy statements contained in the notices of the annual meetings of stockholders of Household, dated February 17, 1949, *60 and February 17, 1950, it was stated that the purpose of the stock option granted to petitioner was to "induce" and to "encourage" him "to accept employment with the Company." A similar statement was made by Household in its annual report for the year ending December 31, 1949.
Household did not take a deduction on its income tax returns for 1948, 1949, or any other year, for compensation of petitioner by reason of the spread between the $ 18.70 per share price of the 10,000 shares sold to petitioner and the fair market value of such shares on either the date the option became effective or the date it was exercised. Household reported a capital gain on its return for 1949 measured by the spread between its cost for the 10,000 shares of treasury stock sold to petitioner and the $ 18.70 per share price which he paid. However, Household has filed "protective" claims for refund of any overpayments in tax which it may have made due to a failure to deduct amounts which this Court may find to have been paid to petitioner as compensation.
*234 Respondent determined that petitioner received ordinary income in the amount of $ 168,000 upon the exercise of the option, such amount being *61 determined by the difference between the option price ($ 18.70) and the asserted fair market value of the stock at the time the option was exercised ($ 35.50).
The option to purchase 10,000 shares of Household stock at a price substantially less than their current market value was granted to petitioner as compensation.
OPINION.
The issue herein is one of fact, , on appeal (C. A. 3, Oct. 8, 1954); namely, whether the stock option granted to petitioner was intended to compensate him or to enable him to acquire a proprietary interest in his new employer. Respondent has determined that the excess of the market price over the option price on the date of exercise was intended as compensation for petitioner and, consequently, is taxable as ordinary income. , rehearing denied . Petitioner contends that the option was meant solely to enable him to acquire a proprietary interest in the corporation and that he derived no taxable income upon exercising it.
The determination of such intent is a question of fact and*62 dependent upon the precise facts of the case at hand. "Each case must be decided upon its own peculiar facts, and facts which have been deemed significant under some circumstances may serve as guides, but are not necessarily controlling." . In the instant case, as in so many cases of this nature, "both elements are present and decision is impossible if the absence of one or the other is essential thereto." . After careful consideration of the entire record in the instant case, with particular attention to the various negotiations which culminated in the option agreement and employment contract granted to petitioner, to the correspondence between petitioner and the then president of the company, and to the various statements issued by the company regarding petitioner's employment and the stock option granted to him, we have concluded that the option price was determined with the intent that it compensate petitioner. We recognize that there may have been a fixed intent that petitioner acquire and hold his stock as a permanent investment in the*63 corporation. Nevertheless, we think it clear that the option price was established with the intent that he acquire such stock at a price substantially lower than its market price as a reward for services to be rendered.
Petitioner and his prospective employer had agreed at the very start of their negotiations on what his base salary would be for the *235 first 3 years; yet, a final agreement was not reached until over a year later. Understandably, petitioner wanted something in addition to this base salary in order to offset the forfeiture of substantially all of the $ 53,500 in deferred compensation credited to him at Schenley and a reduction in salary at the rate of $ 20,000 and $ 10,000 during his first and second years of employment at Household, respectively. Since petitioner was informed at the very first meeting with Henderson that it was Household's policy that its executives acquire a stock interest in the company, the granting of a stock option, alone, could not have been the factor which was the subject of these prolonged negotiations. We are convinced that the decisive element was the bargain nature of the stock option and that it was the assurance that there *64 would be a substantial spread between the option price and the market price which persuaded petitioner to accept his job with Household. Although the option price was not fixed at the time of employment, petitioner knew that it would be substantially below the market price. When it was subsequently fixed at $ 18.70, it appears probable, from the limited evidence before us, that the market price was somewhere between $ 30 and $ 33.75. When exercised, the market value was $ 33.75, providing a total spread of $ 150,500 on the 10,000 shares purchased.
We recognize that petitioner wanted to acquire a proprietary interest and build up an "estate" for his family. This aim was satisfied by the very generous credit terms on which Household permitted him to purchase his stock. It appears clear, however, that the price of the stock was determined to satisfy certain compensatory aspects of the negotiations. The bargain nature of the option was the factor which compensated petitioner for the financial sacrifice involved in leaving Schenley. This was the "inducement" which petitioner sought; and, as the term is used in the instant case, we are satisfied that it required the performance of*65 an act by petitioner which constituted the consideration for the option. Cf. This act was the acceptance of the position at Household, and upon so doing the option immediately became effective. It was thereafter exercisable regardless of whether petitioner remained at Household for any substantial length of time. The option thus conferred a benefit which was contingent on accepting employment, , affd. (C. A. 9, 1948); cf. ; and this benefit must be considered as compensation.
Although the record indicates that the option price was equivalent to the book value of the stock, this does not detract from our conclusion that the spread between the option price and the market value was granted to petitioner as compensation for joining the company. *236 The 10,000 shares of treasury stock sold to petitioner had a value on the market $ 150,500 in excess of the price which he paid, and this economic benefit was clearly conferred upon him with compensatory*66 intent. Nor is the failure of Household to take a deduction of this $ 150,500 as compensation determinative, cf. , affd. (C. A. 3, 1954);
Petitioner contends, in the alternative, that even if the gain arising out of the exercise of the option is found to be compensatory, the shares of stock had no value in his hands during the year in issue; and, consequently, the amount of compensation is not determinable. Petitioner relies upon two theories, neither of which we find to be meritorious. First, he argues that he could not sell his stock while he was employed by Household; and this, consequently, precludes a determination that it had a market*67 value during this period. However, no formal contract was ever entered into binding petitioner regarding the sale of his stock. From the viewpoint most favorable to petitioner, it would appear that there was an oral agreement, in extremely general terms, that he would not sell his shares unless compelled to by some emergency. This vague agreement could not effectively bind petitioner and prevent the sale of his shares. There was testimony that, in the past, various officers had sold stock in the company although subject to the same sort of oral "understanding." Moreover, had he wished to resign, the nature and purpose of the agreement would have permitted the immediate sale of his stock since such resignation would eliminate the need for his acquisition and retention of a proprietary interest in the company.
Petitioner also contends that restrictions contained in section 16 (b) of the Securities and Exchange Act of 1934 effectively prevented him from selling his stock within 6 months of the date of acquisition. Since such 6-month period would expire after the end of the taxable year before us, he argues that his stock had no ascertainable market value (under this theory) until*68 1950, a year which is not before us. Section 16 (b) is intended to eliminate "insiders" profits on transactions by the officers of a corporation in the stock of that corporation. It provides that any profit realized by an officer of a corporation arising out of the purchase and sale of the corporation's stock within a 6-month period shall be recoverable by the corporation.
*237 A situation similar to the instant one arose in (S. D., N. Y., 1950), affirmed per curiam (C. A. 2, 1950), wherein a corporation had granted stock warrants to various individuals to induce them to enter its employ in executive capacities. These warrants were sold within 6 months of their receipt. In a suit to determine the value of such warrants and the amount recoverable by the corporation under section 16 (b), it was held that these warrants constituted compensation to the employees to the extent of their market value at the time of issue. No amount was held to be recoverable by the corporation since the warrants had been sold for less than the market value on the date they were issued. *69 Similarly, in the instant case, petitioner could have sold the stock acquired pursuant to his option at any price up to $ 33.75 (its fair market value on the date of acquisition) without incurring any liability under section 16 (b). Consequently, this section of the Securities and Exchange Act of 1934 did not constitute a restraint on the sale of the stock at that price by petitioner during the year here involved. We, therefore, hold that the 10,000 shares of stock, when acquired by petitioner, had an ascertainable market value of $ 33.75 each, and that he is taxable on the excess of that amount over the amount paid.