Hann v. United States

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In the United States Court of Federal Claims
No. 15-20T F| LED
(Filed: August 16, 2017)
AUG 1 6 2017
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* U.S. COUF‘\T OF
GREGORY ALAN HANN ANI) ='= FEDERAL CLAW‘S
BARBARA CHILDS HANN, * Tax Refund Suit; 26 U.S.C. § 83; 26 C.F.R.
"' § 1.83-7; Nonqualified Stock ()ptions;
Plaintiffs, ”‘ Cashless Option Exercise; Initial Public
* Offering (IPO); Underwriters’
v. "‘ Commission; Capital Loss.
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THE UNITED STATES, *
Defendant. "‘
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Gregorv Hann and Barbara Childs Hann1 Virginia Beach, Virginia, pr_o Y.
David A. Hubbert, David l. Pinkus1 Marv M. Abate, and Jason S. Selmont, U.S.
Departrnent of Justice, Tax Division, Court of Federal Claims Section, P.O. Box 26 Ben Franklin
Station, Washington, D.C., 20044, for Defendant.
OPINION AND ORDER
WILLIAMS, Judge.
This matter comes before the Court on the parties’ cross-motions for summary judgment
Plaintiffs pr_o Y, Gregory Alan Hann and Barbara Childs Hann, seek a refund of income tax paid
for the 2011 tax year. Plaintiffs seek to recharacterize as an ordinary expense the Underwriters’
commission paid by Mr. Hann in connection with his participation in his employer’s initial public
offering As a matter of laW, the Underwriters’ commission in this case is properly characterized
as a capital expense because it Was paid to sell a capital asset - - the stock acquired by Mr. Hanu
in exercising his stock options to participate in the initial public offering.
As there is no genuine dispute of material fact, summary judgment is granted in favor of
Defendant.
?|Ill_? j].'-IEU |J|J[I|] lBHE BEILE
Bacltgroundl
During the relevant tax years, Mr. Hann Was Executive Vice President and Chief Financial
Officer (“CFO”) of Wesco Aircraft (“Wesco”). On January 29, 2009, While still a privately held
company Whose shares Were not sold on an established securities market, Wesco granted Mr. Hann
65,574 stock options as compensation2 Each option represented the right to acquire one share of
Wesco common stock (“option shares”). The initial exercise price Was $64.96 per share. On
October 28, 2009, some 10 months after the options Were granted, the stock option agreement Was
amended, and the exercise price decreased to $56.64 per share. When Wesco granted the options,
there Were no restrictions on their exercise beyond the vesting schedule.3 Once the options vested,
l\/lr. Hann had full legal rights to exercise the options and acquire the stock.
On June 7, 201 l, Wesco’s Executive Vice President and Chief Legal Officer, John Holland,
issued a confidential memorandum to Wesco employees regarding the proposed Initial Public
Offering (IPO) Wesco Was arranging on behalf of its primary shareholders, the Carlyle Group and
Wesco’s ChiefExecutive Office (“CEO”), Randy Snyder. Joint Ex. 4. The Holland memorandum
informed employee equity holders, including Mr. Hann, that Wesco Would provide them “an
opportunity to sell a portion of their eligible shares in the proposed offering alongside” the primary
shareholders I_c_i_. However, participating employee equity holders Were required to sell the same
proportion of their shares as the primary shareholders l_d. Therefore, participation required option
holders to “authoriz[e] the sale of [theirj eligible shares and the automatic exercise of [their] vested
and exercisable stock options . . .” to comply With the proportionality requirement I_d.
Because of a lock-up agreement4 the IPO Was the only opportunity for employee equity
holders to sell any Wesco shares Without Waiting until 180 days after the lPO. Ld The Holland
memorandum made explicit that the employee equity holders’ participation in the IPO vvas
1 This background is derived from the parties’ stipulation of facts and exhibits and the
exhibits attached to Defendant’s motion for summary judgment
2 The Wesco Holdings, Inc. Equity lncentive Plan Stock Option Agreement Grant Notice
granted Mr. Hann both nonqualified stock options (i.e. ordinary options) and incentive stock
options M Jt. Ex. 14. Mr. Hann exercised his nonqualified stock options in the transaction Jt.
Ex. 9.
3 Of the 65,574 options granted to Mr. Hann, 16,393 options vested on a time-based schedule
(i.e. after l\/lr. Hann Worked for a specified period), With one-third of the options vesting annually
on September 30 of 2009, 2010 and 2011. It. Ex. 14. The remaining 49,181 options vested on a
performance-based schedule §
4 Lock~up agreements bar existing shareholders from selling additional shares for a defined
period after the lPO. Lock~up agreements are “common, even essential, to the typical IPO”
because they assure potential buyers of the lPO’s securities, that additional shares owned by the
“pre-IPO shareholders of the issuer Will not enter the public market too soon after the offering.”
Lovvinger v. l\/lorgan Stanlev & Co. LLC, 841 F.3d 122, 131 (2d Cir. 20l6)(internal citations and
quotation marks omitted). “These assurances lead investors reasonably to expect an orderly market
free of the danger of large sales of pre-owned shares depressing the share price before the pricing
of the newly offered shares has settled in the market.” I_d.
“optional and voluntary.” l_d. Mr. Hann Was aware that his participation in the IPO Was optional
and that he could still exercise his options after the expiration of the 180-day “lock-up period.”
As Wesco’s Chief Financial Offlcer, Mr. Hann Was significantly involved in the lPO
process. Hann Dep.; Tr. 25. Wesco issued and filed With the Securities and Exchange Commission
the Prospectus for the proposed IPO on July 27, 2011. ln the Prospectus, Wesco represented that
the selling shareholders Were offering 21,000,000 shares of Wesco common stock in this offering
and that Wesco Would not receive any proceeds from the sale of the shares held by the selling
stockholders Def.’s Ex. 4. Wesco also represented:
0 the public offering of the price of the stock Would be $15 per share;
o the underwriting discounts and commissions Would be $0.8625 per share; and
» the proceeds to the selling shareholders Would be 314.1375 per share.
Li Wesco “agreed to`pay expenses incurred by the selling stockholders in connection With the
offering, other than the underwriting discounts and commission.” Ld
Mr. Hann elected to participate in the IPO. Wesco arranged for a “cashless exercise,”
Whereby participating option holders did not pay the exercise price out of pocket Rather, “the
exercise price Was deducted from the compensation the participant received from the Underwriters.
Holland 30(b)(6) Dep. 16.5 To achieve this cashless exercise and participate in the lPO, Mr. Hann
executed four documents prior to the July 28, 2011 lPO - - a Power of Attorney, an Exercise
Notice, a Custody Agreement, and a Lock-Up Agreement.
The Power of Attorney authorized Mr. Hann (acting as a Wesco executive, not in an
individual capacity) and a second Wesco executive (the “Attorneys”) to sell to the Underwriters
up to the “Maximum Nurnber of Optional Shares . . . represented by the Book-Entry credits placed
in escrow or the Exercise Notices deposited by [Mr. Hann] With the Custodian pursuant to the
Custody Agreernent . . . at a purchase price per share to be paid by the Underwriters, as determined
by negotiation . . . ” between Wesco and the representatives of the Underwriters. Joint Ex. 10.
The “Maximum Number of Optional Shares” Was 39,l67.63 (determined prior to a stock split),
roughly 60 percent of l\/Ir. Hann’s Shares of Common Stock Subject to Option. .loint Ex. 11.
The Exercise Notice notified Wesco that Mr. Hann exercised the vested portion of his
options “in connection With the Company’s anticipated initial public offering . . . contingent upon
the inclusion of the shares . . . in the offering contemplated . . . fin an amount to] be determined by
the Attorneys . . . .”6 Joint Ex. 9. The Exercise Notice directed that the “full amount of the exercise
price necessary to exercise [Mr. Hann’s] Vested Options and any applicable tax Withholding
obligations be deducted from the net proceeds [l\/lr. Hann Was} entitled to receive from the
5 “Holland 30(b)(6) Dep.” refers to John Holland’s Rule 30(b)(6) deposition on behalf of
Wesco Aircraft Holdings, Inc. rather than his individual depositionl
6 Mr. Hann exercised his nonqualified stock options in the transaction
subsequent sale of such Shares to certain Underwriters, as specified in the Custody Agreement.”
_lmd_.
The Custody Agreement directed that the IPO Custodian retain “Exercise Notices”
delivered by Mr. Hann and required Mr. Hann to concurrently execute an irrevocable power of
attorney authorizing the Attorneys to sell up to the number of shares of common stock represented
by his Exercise Notices and to enter an underwriting agreement in order to sell the shares on Mr.
Hann’s behalf Joint Ex. 11. Upon the closing date specified in the Underwriting Agreement, the
Custody Agreement directed the Custodian to (i) exercise the number of options subject to the
Exercise Notices to the extent necessary to provide the “Maximum Number of Shares” (i.e. the
number of shares necessary to meet the proportionality requirement) to the Underwriters, (ii)
transfer the option stock to the Underwriters, (iii) receive payment for the option stock from the
Underwriters, (iv) pay the exercise price from the amount received from the Underwriters, (v)
remit the balance to Mr. HannJ and (vi) furnish Mr. Hann a Foim 1099 reflecting the transaction
by January 31 of the following tax year. l_c_l_.
The “Lock~Up Agreement” restricted Wesco equity holders, like Mr. Hann, from (l)
offering, pledging, selling, contracting to sell, selling an option or contract to purchase, purchasing
an option or contract to sell, granting any option, right or warrant to purchase, lending, or otherwise
transferring or disposing of, directly or indirectly, any common stock they beneficially owned, or
(2) entering into any swap or other arrangement that transfers to another, in whole or in part, any
of the economic consequences of ownership of the Common Stock for 180 days after the lPO.
Joint Ex. 8.
The “cashless exercise” described by Mr. Holland took place in several distinct steps. First,
the primary shareholders, in conjunction with the Underwriters, determined the proportion of their
interest in Wesco they would sell and those shares’ market price. lmmediately prior to the lPO,
Wesco undertook a nine-way stock split. Joint Stip. ll 10. Each share was priced by the
Underwriters for public purchase at $15 per share. l_d. at ll 9. Corresponding with the stock split,
Mr. Hann’s options increased ninefold, from 65,574 to 356,558 options, and his option exercise
price Was reduced to one-ninth the existing price, from $56.64 per share to $6.29333 per share. id_.
at jljl 4-5, 8, 10.
On July 28, 20l1, immediately prior to the lPO, the participating shareholders, including
Mr, Hann, sold their shares to the lead Underwriters, Barclays Capital lnc. and Morgan Stanley &
Co., LLC (the c‘Underv\rriters”) for $14.1375 per share (a discount to their $15 fair market value).
ld; at 1111 ll, 14. Pursuant to the Custody Agreement, Mr. Hann’s Attorneys exercised 89,139
options on Mr. Hann’s behalf and immediately sold these 89,139 shares to the Underwriters, who
paid Mr. Hann $14.1375 per share. ici at 11 18; Joint Ex. 5. The Underwriters then sold these
shares to the public at 315 per share, taking a “commission” of 30.8625 per share (the
“Underwriters’ commission”). Joint Stip. 1111 14; Def.’s Ex. 4 (“The underwriting fee is the
difference between the initial price to the public and the amount the underwriters pay to the selling
stockholders for the shares.”). Mr. Hann did not take physical custody of any shares pursuant to
his participation in the lPO. Joint Stip. 11 14. However, as Mr. Holland acknowledged, to
participate in the IPO Mr. Hann needed to exercise his options and receive shares Holland Dep.
l9, 30.
All of the selling shareholders received from the Underwriters the net proceeds (the gross,
fair market price less the Underwriters’ commission) for their shares. Joint Stip. 11 14. F or the sale
of Mr. Hann’s 89,139 shares at $l$ per share, the gross proceeds were $1,337,085. The
Underwriters’ commission of $0.8625 per share for 89,139 shares amounted to $76,882.39. I_d. at
11 20. Therefore, the net proceeds from Mr. Hann’s sale of stock to the Underwriters, $1,260,202,
was deposited into Mr. Hann’s Morgan Stanley Smith Barney account Joint Exs. 5, 6.
Wesco issued Mr. Hann a W-2 for the 2011 tax year reporting ordinary income from the
IPO of $776,l03.56. Joint Ex. 7. This amount corresponds to the gross proceeds received in the
lPO, $1,337,085, less the option exercise price, $560,981.44. On April 15, 2012, Plaintiffs filed a
year 2011 tax return treating the $776,103.56 reported on the W-2 as ordinary income and the
$76,882.39 Undeiwriters’ commission as a short-term capital loss. Joint Ex. 1.
On April 19, 2012, Plaintiffs filed an amended individual income tax return (Forin 1040-
X) for tax year 2011, reporting the Underwriters’ commission as a reduction of gross income, and
requesting a $26,908 rehmd. Joint Ex. 2. Plaintiffs provided an explanation, stating:
ln June 2011, Wesco Aircraft had an initial public offering As part of this
transaction, taxpayer exercised certain nonqualified stock options. The difference
between the stock’s fair market value at time of exercise and the option price Was
included in taxpayer’s W-2 income. However, taxpayer was required to pay the
Underwriters’ commission as part of this overall transaction This $76,882 of
commission paid by the taxpayer is in fact part of his required cost to exercise the
option through the public offering As such, this amount should reduce taxpayer’s
W-2 income as reflected in this tax return.
Joint Ex. 2. On June 10, 20l4, the lnternal Revenue Service (“lRS”) disallowed Plaintiffs’ refund
claim for tax year 2011. Joint Stip. 11 23. Plaintiffs filed the instant action on January 8, 2015.
This Court held oral argument on the cross-motions for summary judgment on April l0, 201'/`, and
the parties filed supplemental briefs on May 10, 2017 and May 22, 20l7.
Discussion
Jurisdiction
The United States Court of Federal Claims is authorized to adjudicate tax refund claims
under the Tucker Act. 28 U.S.C. § 1491(a)(1) (“The United States Court of Federal Claims shall
have jurisdiction to render judgment upon any claim against the United States founded either upon
the Constitution, or any Act of Congress or any regulation of an executive department . . . in cases
not sounding in tort.”). Section 7422 of the lnternal Revenue Code governs the procedural
requirements for such cases. Wolens v. United States, 125 Fed. Cl. 422, 426 (2016). “Taxpayers
must first pay the assessed tax in full and file a tax refund claim with the IRS before bringing suit
in federal court.” Ld (citing 26 U.S.C. § 7422(a)). “lf the refund claim is denied, the taxpayer
generally must file suit within two years, and then may only raise the claims and arguments
previously presented to the IRS.”_ 1311 (internal citations omitted).
Here, the Plaintiffs fully paid the income tax for 20l1, properly filed a refund claim with
the IRS, and timely filed a suit in this Court.
Legal Standard for Summarv Judgment
in granting a motion for summary judgment a court must find that there is no “genuine
dispute as to any material fact and the movant is entitled to judgment as a matter of law.” RCFC
56(a). A genuine dispute is one which “may reasonably be resolved in favor of either paity.”
Anderson v. Libertv Lobbv, lnc., 477 U.S. 242, 250 (l986). A fact is material if it “rnight affect
the outcome of the suit . . . .” lj__. at 248. The moving party bears the burden of establishing the
absence of any genuine issue of material fact. Mingus Constructors, lnc. v. United States, 8l2
F.2d 1387, 1390 (Fed. Cir. 1987). Once the burden is met, the onus shifts to the non-movant to
point to sufficient evidence to show a dispute over a material fact that would allow a reasonable
finder of fact to rule in its favor. Liberty Lobby, 477 U.S. 256-57. When considering a motion
for summary judgment, the court draws all factual inferences in a light most favorable to the
nonmoving party. Matsushita Elec. lndus. Co.` Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587
(l986).
When opposing parties both move for summary judgment, “the court must evaluate each
party’s motion on its own merits, taking care in each instance to draw all reasonable inferences
against the party whose motion is under consideration.” Mingus, 812 F.2d at l39l. At the
summary judgment phase, the court may not weigh any evidence but only “determine whether
there is a genuine issue for trial.” Liberty Lobby, 477 U.S. at 249.
The Underwriters’ Commission Is Properlv Characterized as a Capital Loss
The parties stipulated to all material facts At issue is the proper tax treatment of the
Underwriters’ commission Plaintiffs argue that the Underwriters’ commission was properly
deductible from their 2011 ordinary income, entitling them to the 820,116 refund claimed on their
amended return.? J. Ex. 2. They posit four alternative theories. First, Plaintiffs argue the
transaction, in which Mr. Hann exercised his options and received cash, was a single-step
transaction Pls.’ Mot. 2-3. Second, Plaintiffs argue that Mr. Hann paid the Underwriters’
commission in order to exercise the options, entitling them to reduce the amount realized under
either 26 U.S.C. § 83 or 26 U.S.C. § 10l2. Compl. 1111 6-7, 12-13, 15; Pls.’ Mot. 3-4. Third,
Plaintiffs argue the Underwriters’ commission was an ordinary and necessary expenditure incurred
in a trade or business, deductible from gross income under 26 U.S.C. § 162. Compl. 11 8, 14; Pls.’
Mot. Fouith, Plaintiffs make a “substance over form” argument, asserting that because they paid
the Underwriters’ commission to generate ordinary income, the expense should be deductible from
ordinary income, and the form of the transaction should be disregarded Pls.’ Mot. 5 . Defendant
argues that the Underwriters’ commission was a cost incurred to sell the stock acquired by
exercising the options on the public market and is properly characterized as a capital loss under 26
U.S.C. § 1011. Def.’s Mot. 1-2.
Mr. Hann realized ordinary income upon receiving the options and was required to
recognize as ordinary income the fair market value of the option shares received less the exercise
price paid. In a separate taxable step, to participate in the IPO, Mr. Hann sold that stock to the
Underwriters, paid the Underwriters’ commission, and received the fair market value of his shares.
The Underwriters’ commission is properly treated as a reduction in the amount realized on Mr.
Hann’s sale of the stock to the Underwriters. Because the Underwriters’ commission reduced the
7 ln their complaint, Plaintiffs seek $26,908.
sale price to an amount below l\/lr. Hann’s basis in his shares, the difference is properly
characterized as a capital loss, which cannot offset ordinary income beyond $3,000 annually 26
U.S.C. § l2ll(b)(1) (2016).
Step (1): Mr. Hann Received Ordinarv Income When He Exercised His Options
An employee who receives nonqualified stock options as compensation for services
performed realizes ordinary income 26 U.S.C. § 83(a) (20l6); see also Comm’r v. LoBue, 351
U.S. 243, 247 (1956) (“When assets are transferred by an employer to an employee to secure better
services they are plainly compensation lt makes no difference that the compensation is paid in
stock [options] rather than in money.”). However, if the options lack a readily ascertainable fair
market value at grant, the employee does not immediately recognize income. 26 U.S.C. § 83(e)
(3). lnstead, the employee recognizes income upon exercising the option. 26 C.F.R. § 1.83-7(a).
When an employee exercises nonqualified stock options, the employee must include in his
gross income the difference between the option stock’s fair market value at exercise and the
“amount paid” to acquire the option stock. 26 U.S.C. § 83(a)(l). “[T]he term ‘arnount paid’ refers
to any amount paid for the grant of the option plus any amount paid as the exercise price of the
option.” 26 C,F.R. § l.83-3(g) (2014).
As part of his 2009 employee compensation, Mr. Hann received nonqualified Stock
options Mr. Hann did not pay any additional amount for the grant of the option. When Wesco
granted Mr. Hann these stock options, it was a privately held corporation, and its stock was not
sold on an established market and had no “readily ascertainable fair market value.” 26 C.F.R. §
1.83-7(b)(2), As the options lacked a readily ascertainable fair market value at grant, they were
not taxable upon receipt 26 U.S.C. § 83(e)(3). Plaintiffs were therefore not required to recognize
as income the fair market value of the stock options Mr. Hann received as compensation in 2009.
Instead, Plaintiffs deferred income recognition until Mr. Hann exercised the options 26 C.F.R. §
l.83-7(a).
To participate in the IPO, Mr, Hann placed an lrrevocable Exercise Notice in escrow and
authorized his Attomeys to exercise his options as required by the Underwriting Agreement. Mr.
Hann’s Attorneys exercised 89,139 options on his behalf, pursuant to the proportionality
requirement determined by the primary shareholders upon finalizing the lPO. As a result the
Attorneys received from Wesco 89,139 shares on Mr. Hann’s behalf that they immediately resold
to the Underwriters. Mr. Hann was the beneficial owner of these 89,139 shares the Attorneys
received Therefore, at the time of exercise, Plaintiffs were required to recognize as ordinary
income the difference between the option stock’s fair market value at exercise and the amount paid
to acquire the option stock. 26 C.F.R. § l.83-7(a); 26 U.S.C. § 83(a).
On the exercise date, the 89,139 Wesco shares’ fair market value was $15 per share, 8 or
31,337,085 total. The amount paid to acquire the option stock was the $6.29333 per share,9 or
$560,981.14 total. 26 C.F.R. § 1.83-3(g). Therefore, Plaintiffs were required to recognize as
ordinary income $8.70667 per share ($15 less $6.29333), or $776,103.88 total ~ the amount
reported by Wesco on Mr. Hann’s 2011 W-2. Joint Ex. 7. This was the first taxable step in Mr.
Hann’s IPO participation
Step (2): Mr. Hann Generated a Capital Loss Bv Selling His Wesco Shares to the
Underwriters
The tax consequences of a capital asset transaction govern the second taxable step in Mr.
Hann’s IPO participation A capital asset is any property not enumerated in 26 U.S.C. § l221(a).m
Stock in a corporation is a capital asset as it is not so enumerated 26 U.S.C. § l22l(a) (2016); see
also Ark. Best Corp. v. Comm’r, 485 U.S. 2l2, 217-18 (1988).
Unless otherwise provided in the Internal Revenue Code, a taxpayer recognizes all gain or
loss upon the disposition of property. 26 U.S.C. § 1001(c) (2016). The taxpayer must include in
gross income all gain recognized from the disposition of property. l_d. § 6l(a)(3) (2016).
Individual taxpayers may deduct from gross income any loss recognized in a transaction entered
into for profit Ld. at § 165(a)-(c) (2016). However, individual taxpayers may generally only
deduct a capital loss from gross income to the extent of capital gain recognized in that tax year.
id at §§ l65(i), 121 l(b). When capital losses exceed capital gains in a given year, an individual
taxpayer may further deduct a maximum of $3,000 in that tax year. l_d_l at 1211(b)(1). Any
remaining capital loss converts into capital loss carryover and carryback, which can offset capital
gain in past and future tax years. §§ id at §§ 172 and 1212(b).
8 The Underwriters determined this fair market price of the Wesco shares in the
simultaneously occurring IPO.
9 Per 26 C.f.R. § 1.83-3(g), this “amount paid” represents the $6.29333 per share exercise
price plus $0 paid for the option grant However, Mr. Hann did not pay the exercise price out of
pocket, the Underwriters paid it to Wesco on his behalf from l\/[r. Hann’s proceeds from the IPO.
10 Enumerated non-capital property includes (1) stock in trade properly included in the
taxpayer’s inventory or held by the taxpayer primarily for sale to customers in the ordinary course
of his trade or business and accounts or notes receivable acquired from the sale thereof; (2) trade
or business property depreciable by the taxpayer under 26 U.S.C. § 167 and real property used by
the taxpayer in a trade or business; (3) copyrights, literary, musical, or artistic compositions letters
or memorandaJ or similar property held by certain taxpayers; (4) accounts or notes receivable
acquired for services rendered in the ordinary course of trade or business; (5) U.S. Government
publications received from the government by certain taxpayers at a price other than that offered
to the public; (6) any commodities derivative financial instrument that fails to meet certain
requirements and is held by a commodities derivatives dealer', (7) certain hedging transactions;
and (8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the
taxpayer’s trade or business 26 U.S.C. § l221(a) (2016).
Mr. Hann acquired 89,139 Wesco shares when his Attomeys implemented the Exercise
Notice and Custody Agreement, pursuant to the Underwriting Agreement Mr. Hann is not in the
trade or business of selling securities, and Mr. Hann’s Wesco option shares were a capital asset
26 U.S.C. § 1221 (a). Contemporaneously with exercising Mr. Hann’s options 4 but in a separate,
taxable step 4 the Attorneys sold Mr. Hann’s 89,139 Wesco shares to the Underwriters on Mr.
Hann’s behalf Upon the disposition of l\/lr. Hann’s shares to the Underwriters, Plaintiffs realized
a capital loss to the extent their basis in the Wesco shares exceeded the amount realized on the
sale. I_d. at § 1001(a).
On the sale, Plaintiffs realized 815 per share in the fair market value of the option stock
paid by the Underwriters. However, because Mr. Hann paid the Underwriters’ commission as a
cost of participating in the IPO and selling his Wesco shares, Plaintiffs must reduce the amount
realized by the $0.8625 per share for the Underwriters’ commission to a net amount realized of
$l4.l375 per share, or $1,260,202.61. The Underwriters’ commission was incurred by all IPO
participants to sell the Wesco stock to the Underwriters, and was a capital expense Davis v.
Comm’r, 151 F.2d 441, 443 (8th Cir. 1945), cert denied, 327 U.S. 783 (1946) (Underwriters’
commissions paid by a principal shareholder pursuant to an IPO are a capital expense paid to sell
the stock). “lt has long been recognized as a general matter, that costs incurred in the acquisition
or disposition of a capital asset are to be treated as capital expenditures.” Woodward v. Comm’r,
397 U.S. 572, 575 (1970). As Plaintiffs’ basis in the shares exceeded the amount realized on the
sale to the Underwriters by $0.8625 per share, Plaintiffs realized a capital loss of $76,882.39, the
amount of the Underwriters’ commission 26 U.S.C. §§ 165, 1001. However, because Plaintiffs
lacked other capital gains in 20l1, they were permitted to recognize (i.e. deduct) a maximum of
$3,000 as a capital loss Ld. at § 1211(b)(1).
The Two Steps’ Simultaneous Execution Does Not Affect Their Separate Tax Treatment
Plaintiffs argue Mr. Hann engaged in a single-step transaction whereby he exercised his
options and received cash proceeds Plaintiffs argue that Mr. Hann never took possession of any
stock and his “paiticipation fin the IPO] as a non-qualified option holder did not allow him to
receive common st[o]ck upon exercise of the options.” Pls.’ Mot. l. Therefore, in Plaintiffs’ view,
the Underwriters’ commission should offset Plaintiffs’ ordinary income.
While Mr. Hann’s participation in the IPO did not entitle him to retain common stock upon
exercising his options, in order to participate in the IPO, Mr. Hann needed to acquire Wesco shares
via his options and then immediately resell the shares to the Underwriters. Holland Dep. 12-13,
15-17. Mr. Hann held legal - if not physical _ ownership of the shares when his Attorneys
exercised the options on his behalf. lqu at l9, 29-3 0. Only after Mr. Hann gained legal ownership
of the shares could his Attorneys sell those shares to the IPO Underwriters. The short duration of
Mr. Hann’s legal ownership of the Wesco shares did not alter the tax consequences of his
ownership and sale of the stock. The acquisition of Wesco stock pursuant to his stock options
followed by the immediate resale of the Wesco stock to the Underwriters was necessarily a two-
step transaction That Wesco agreed to accept payment of the exercise price directly from the
Underwriters does not change the taxable steps taken by Mr. Hann
The Underwriters’ Commission Is Not cherned By § 83 or § 1012
Plaintiffs argue that because Mr. Hann could not have exercised the options without paying
the Underwriters’ commission, the commission could either be an “amount paid” to exercise the
options under 26 U.S.C. § 83 or be capitalized in the stock’s basis under 26 U.S.C. § 1012. Under
either scenario, in Plaintiffs’ view, the Underwriters’ commission should reduce the ordinary
income realized from the option exercise, rather than the capital income realized on the subsequent
sale of the option stock to the Underwriters.
Plaintiffs’ theory fails because payment of the Underwriters’ commission was not required
for Mr. Hann to exercise his options, but was compensation to the Underwriters for valuing and
establishing a public market for Wesco stock for the IPO. Contrary to Plaintiffs’ assertions, Mr.
Hann could have exercised the options without paying the Underwriters’ commission, as restricted
by the iock~up agreement IPO participation was separate and distinct from Mr. Hann’s ability to
exercise his options. Rather than effect a cashless exercise, Mr. Hann was entitled to exercise the
options, pay the exercise price, and retain ownership of the option shares in Wesco. §e§ Wesco
Dep. at 22; Holland Dep. 15. Mr. Hann could have waited until the expiration of the lock-up
period to sell his Wesco shares so acquired Joint Stip. 15. Paying the Underwriters’ commission
was only a condition precedent to Mr. Hann’s participating in the IPO, it was not a condition
precedent to his exercising the options.
Accordingly, Plaintiffs must treat the Underwriters’ commission as a capital expense paid
to sell the stock and reduce the amount realized on the sale Spreckles v. Comm’r, 315 U.S. 626,
630 (l942).
The Underwriters’ Commission Is Not a Business Expense
Plaintiffs argue the Underwriters’ commission is an ordinary and necessary expenditure
incurred in a trade or business, and therefore deductible from gross income under 26 U.S.C. § 162
and 26 C.F.R. § 1.162-1. Section 162(a) permits the deduction of all ordinary and necessary
expenses paid in carrying on a trade or business Plaintiffs claim Mr. Hann’s trade or business
was being “an executive of Wesco Aircraft” and that the Underwriters’ commission was “an
ordinary and necessary business expense directly connected with the exercise of the option and the
related generation of ordinary income.” Pls.’ Mot. 4.
Mr. Hann was Wesco’s Chief Financial Officer; his trade or business was being a Wesco
employee An individual may be in the trade or business of being an employee 26 C.F.R. § 1.162~
17(a); Mitchell v. United States, 408 F.2d 435, 439 (Ct. Cl. 1969) (“[B]eing a corporate official .
. . constitutes the ‘carrying on’ of a trade or business within the meaning of section l62(a).”).
Exercising his options made Mr. Hann a shareholder in Wesco ~ separate from his status as an
employee When he immediately sold his shareholder interest in Wesco to the lPO Underwriters,
he sold a capital interest in the corporation
An individual who is both an employee and shareholder must acknowledge that dual status
and separately determine the tax consequences of each activity. §c_e United States v. Generes, 405
U.S. 93, 100 (1972) (a “taxpayer’s dual status relative to the corporation . . . las] both a shareholder
and an employee . . . occasion different tax consequences.”). Expenses associated with one’s trade
or business as a corporate executive are deductible as a trade or business expense But expenses
incurred in one’s capacity as a shareholder, where profit comes from appreciation in the value of
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business and distributed earnings, must be allocated to one’s capital interest in the corporation
As the Tax Court, citing Spreckles, explained:
selling commissions paid in connection with the disposition of securities may not
be deducted as ordinary and necessary expenses by one not a dealer in securities,
and [these] commissions are to be treated as offsets against the sale price in
determining the gain or loss incident to the disposition of property.
Davis v. Comrn’r, 4 T.C. 329, 333 (1944), affd, 15l F.2d 441 (Sth Cir. l945), cert. denied, 327
U.S. 783 (1946). Because Mr. Hann was not in the trade or business of selling securities, Plaintiffs
cannot deduct as a trade or business expense commissions paid to sell securities lnstead, the
expenses l\/ir. Hann incurred selling his capital interest in Wesco may offset the amount Plaintiffs
realized in the transaction Sp_reckles, 315 U.S. at 630.
The Substance OVer Form Doctrine Is Inapplicable
Plaintiffs make a purported “substance over form” argument, positing that the “true
economics of the transaction” should be reflected in the tax result, allowing them to offset their
ordinary income Plaintiffs argue that “[t]he income generated to the [P]laintiffs is ordinary
income and there is no situation in which the exercise of these options could be treated as a capital
gain[,] therefore the expenses required to generate this ordinary income should be ordinary in
nature as well.” Pls.’ Mot. 5 . Plaintiffs’ focus on the ordinary income generated by the option
exercises ignores the second transaction and the economic reality that Mr. l-lann sold his Wesco
shares and opted to participate in the IPO. The lPO participants including Mr. Hann paid the
Underwriters’ commission in order to sell their shares to the Underwriters, not in order to exercise
their options ln short, the true economics of the transaction are reflected in the tax result Plaintiffs
received
Conciusion
Plaintiffs’ motion for summary judgment is DENIED, and Defendant’s motion for
summary judgment is GRANTED.
M RY LLEN COSTER WILLIAMS
Judge
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