An employee’s income from employer stock options was taxable in the year the employee exercised them, not when he paid off the margin loan used to purchase the stock.
P entered into two agreements with his employer, M, giving him options to purchase shares of M’s stock. P exercised the options, financing the stock purchase with a loan from O, a third-party investment company. The shares were deposited in an account maintained by O in P’s name. However, P became the registered owner and acquired the right to vote the shares, receive dividends and pledge the stock as collateral for a loan. O obtained a security interest in the shares; M was completely divested of any interest in the shares, because it had been paid in full with the funds from the margin loan.
Per his agreement with O, P was not required to make any periodic principal or interest payments on the margin loan. Rather, he merely was required to maintain a predetermined minimum balance of cash and/or collateral in the account. The loan agreement included deficiency clauses, under which O was authorized to liquidate the stock if the account balance fell below this minimum threshold; P agreed to be liable for any deficiency in his accounts.
In March 2001, P paid off the O margin loans. P asserts that the stock transactions were taxable when he paid off the margin loan in 2001, rather than when he obtained ownership of the stock from M in 2000.
Under Sec. 83(a), the financial gain realized by an employee on exercising stock options is taxable as gross income in the year the options were exercised if two prerequisites are met. First, under Regs. Sec. 1.83-1(a)(1) and -3(a)(1), the shares must be “transferred” to the employee, which occurs when the employee acquires “a beneficial ownership interest” in the stock. Second, the shares must become “substantially vested” in the employee, which happens when the stock becomes “either transferable or not subject to a substantial risk of forfeiture.” If both conditions are satisfied, the employee realizes gross income equal to the difference between the stock’s fair market value at the moment it became substantially vested and the amount paid to exercise the options.
Transfer: Whether a transaction is a stock transfer or the grant of an option to purchase the stock in the future is a question of fact under Regs. Sec. 1.83-3(a)(2). This determination is made by analyzing “the type of property involved, the extent to which the risk that the property will decline in value has been transferred, and the likelihood that the purchase price will, in fact, be paid.”
On exercising his stock options, the purchase price of the stock was, in fact, paid to M, and P became the stock’s beneficial (and actual) owner. Any risk of decline in the value of the shares was transferred from M to P. Whether P ultimately transferred that risk to O has no bearing on our analysis; a transfer from M to P indisputably occurred in 2000.
P incorrectly cites Regs. Sec. 1.83-3(a)(7), Example 2, as support for his position that a transfer did not occur until he repaid the margin loan. However, the corporation in that example was never paid for the stock and, because the employee did not have any personal liability on the note used to pay for the stock, there is a very real possibility that the corporation would never be paid. This case is significantly different, because M was paid in full and transferred all of its rights in its stock to P.
Substantially vested: Whether the stock was substantially vested is also a question of fact under Regs. Sec. 1.83-3(b) and (c). Stock becomes substantially vested “when it is either transferable or not subject to a substantial risk of forfeiture.” “A substantial risk of forfeiture exists” when the transferred property rights are conditioned “upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer [under which] the possibility of forfeiture is substantial if such condition is not satisfied” (Regs. Sec. 1.83-3(c)(1)).
There is no evidence of any possibility that P’s rights in the stock could have been revoked by M. That O could have sold P’s stock in certain situations is of no moment. The transfer from M to P had already occurred, and what P chose to do with his stock thereafter is irrelevant. The stock became substantially vested in P at the moment he executed his options in 2000.
Thus, the transaction was a taxable event in 2000, the tax year during which P exercised the stock options, rather than when he fully repaid the loan in 2001; accord, Ricardo Cidale, 5th Cir., 1/9/07; James H. Tuff, 469 F3d 1249 (9th Cir. 2006); Miller, 9th Cir., 12/4/06; see Jean-Remy Facq, 363 FSupp2d 1288 (WD WA 2005); Robert C. Racine, TC Memo 2006-162.