Exercise of Stock Options Results in Taxable Income and Compensation Deduction

Expenses & Deductions

The IRS held that a taxpayer’s cashless exercise of stock options resulted in taxable income to the taxpayer and a compensation deduction for the company that issued the options.

Background

Allen Davis was a shareholder in CNG Financial Corporation (CNG), an S corporation founded by his son Jared that owned a subsidiary that engaged in the payday loan business. In return for loans from Allen, CNG issued him stock options, which he exercised in 2000. At the time of the events at issue in the case, Jared was president and CEO of CNG, but Allen had previously served in that capacity. After he resigned as president and CEO, Allen continued to serve as an independent consultant to the company and participated in its day-to-day management. Under a large credit agreement with a bank syndicate, CNG would be in default of the agreement if Allen did not continue to participate in CNG’s activities. The credit agreement was CNG’s principal source of outside financing, and a default on the agreement would have put a halt to CNG’s rapid expansion plans for its business.

In 2001, Allen’s wife, Judith, filed for divorce. The divorce was acrimonious, and in the proceedings Judith sought half of Allen’s stock in CNG. Allen threatened, on numerous occasions, to leave CNG if his ownership interest was reduced, which would have put CNG in default of its credit agreement. Jared, in an effort to end the conflict and avoid default, forced Allen and Judith to agree to a plan in which Allen transferred half his stock to his wife, but ultimately ended up with an option with a cashless exercise provision to repurchase the shares.

Allen exercised this option in 2004. CNG treated the stock issued to Allen through the exercise as compensation, and CNG took a $36,962,694 compensation deduction on its return for 2004 (based on the value of the stock received, calculated under a formula included in the cashless exercise provision of the stock option). This deduction was passed through to CNG’s shareholders, which (other than Allen) included Jared, his brother David, and a third man (the other shareholders). However, Allen did not treat the exercise as taxable and did not include the stock’s value in his gross income for 2004.

Because Allen and the other shareholders took inconsistent positions with respect to the stock Allen received through the option exercise, the IRS issued whipsaw deficiency notices, based in Allen’s case on an understatement of income due to his omission of the income and in the other shareholders’ cases on an overstatement of deductible expenses due to their inclusion of the expenses on their returns. Allen and the other shareholders petitioned the Tax Court to determine whether the value of the stock was compensation income to Allen and whether it was a reasonable compensation expense that CNG could deduct.

The Tax Court’s Decision

The Tax Court held that Allen’s receipt of the CNG stock was compensation, the full $36 million value of the stock was reasonable, and the other shareholders could deduct their share of the expense.

In determining that the transfer of the stock was compensation (i.e., that it was transferred in connection with the performance of services per Sec. 83), the key factor identified by the Tax Court was the existence of the credit agreement with the bank syndicate. The Tax Court stated that Sec. 83 only applies if there is some relationship between the services performed and the property transferred, even if there are other reasons for the transfer. Based on Jared’s testimony, the court concluded that CNG granted Allen the option for the stock to induce Allen to stay so the company would not default on its credit agreement. According to the court, this established that the stock Allen received was related to his performance of services for CNG and that any other reasons CNG might have had did not alter this fact.

The Tax Court’s decision on the reasonable compensation issue was also related to the credit agreement. The court explained that Allen’s options represented a contingent compensation agreement and that, in the case of such an agreement, if the amount ultimately paid ends up being more than the amount that would be paid under ordinary circumstances, the compensation is still deductible if it is the result of arm’s-length or free bargaining. In this case, CNG granted the option in an arm’s-length transaction because Allen’s interest was adverse to CNG’s other principal owners, Jared and David, and the facts indicated that, at the time CNG granted the option, the brothers were looking out for their own interests.

The Tax Court also noted that the agreement was fair to CNG. Because of Allen’s continued participation in CNG, it was able to continue to have access to the credit agreement that financed the company’s expansion in the time between the grant and exercise of the options. Through this expansion, CNG’s operations increased greatly in size and in revenue, and the value of its stock also increased greatly. Because the option grant was not a one-sided bargain, the court found it was reasonable. As a result, the Tax Court held that the full value of the stock transferred was reasonable compensation that CNG could deduct.

Reflections

The IRS argued that the determination of whether Allen’s compensation was reasonable should be based on the services he performed in 2002, the year Allen was granted the options. The Tax Court, because Allen did not exercise the options until 2004, chose to look at the value of his services from when the options were granted until they were exercised. As the Tax Court admitted, there is no precedent supporting the approach it took, so given the large dollar amount involved, an appeal from the IRS may be in the offing.

Davis, T.C. Memo. 2011-286