Phantom stock: Termination of right to buy or sell, treatment of asset and basis

Editor: Mark G. Cook, CPA, CGMA

In Hurford Investments No. 2, Ltd., No. 23017-11 (Tax Ct. 4/17/17) (order), the Tax Court considered whether the redemption of phantom stock was treated as a sale of a capital asset and what the tax basis in the redeemed phantom stock was.

Background

Gary Hurford owned “phantom stock” in Hunt Oil Co. The phantom stock was a form of deferred compensation that Hunt Oil paid to its employees; a share of phantom stock was valued at approximately the share price of Hunt Oil’s common stock and would be adjusted for its increase or decrease in value at the end of each calendar year.

Under the terms of the phantom stock agreement, after Hurford’s death, which was considered a “qualified termination of service,” a five-year countdown was started. During this time Hunt Oil would continue to pay out dividends and adjust the stock for any growth or decline in value. At the end of the fifth year Hunt Oil would automatically redeem the stock; both parties had the right to liquidate the account at any time.

When Gary Hurford died in 1999, Thelma Hurford, his wife, inherited the phantom stock. Thelma decided to transfer the phantom stock into Hurford Investments No. 2 Ltd. (HI-2) in 2000, one of three limited partnerships Thelma’s attorney formed as part of her estate plan after Thelma was diagnosed with cancer. On March 22, 2000, Hunt Oil formally recognized HI-2 as the holder of this stock. At the time of the transfer, the value of the stock was $6,411,000, and the receipt was reported on HI-2’s Form 1065, U.S. Return of Partnership Income, as a short-term gain.

Thelma died in 2001, and the value of the stock on the date of her death was $9,639,588. In 2004, the five-year period that began on Gary’s death was up, and Hunt Oil exercised its right to terminate the phantom stock. In 2006, Hunt Oil distributed $12,985,603 to HI-2. The IRS argued that the difference between the $12,985,603 distribution and $6,411,000 should be treated as ordinary income (deferred compensation) and argued that HI-2 should be considered an invalid partnership for federal income tax purposes since there was no transfer of phantom stock until after Thelma died. HI-2 and the estate argued the phantom stock should be treated as a long-term capital asset in HI-2’s hands, which would also establish HI-2’s validity as a holder and recognize it for income tax purposes.

Is phantom stock a capital asset?

In Thelma Hurford’s hands, the termination of phantom stock generated ordinary income (deferred compensation), but it is pertinent to note that the character of property may change depending on who holds it, e.g., a laptop is inventory for a retailer but a capital asset for most buyers. “Capital asset” has a broad definition under Sec. 1221, which defines the term as all property that is not specifically excluded in a list of exceptions. The types of property excepted from Sec. 1221 are (1) stock in trade; (2) depreciable property used in a trade or business; (3) a copyright or other similar item; (4) an account or note receivable acquired in the ordinary course of business; (5) a U.S. government publication; (6) a commodities derivative financial instrument; (7) a hedging transaction; or (8) supplies used or consumed in the ordinary course of business.

Because HI-2’s interest in the phantom stock does not fit into one of the exceptions listed in Sec. 1221, the Tax Court found that it was a capital asset. This designation makes more sense when one thinks about the nature of the asset. HI-2 acquired an asset that had its value linked to the stock value of Hunt Oil, and HI-2 had no influence over the underlying Hunt Oil common stock, holding it in the hope that it would appreciate. According to the Tax Court, this distinguishing characteristic is enough to conclude that the phantom stock was a capital asset.

Does Hunt Oil’s redeeming the phantom stock constitute a sale?

Under Sec. 1234A(1), the gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation for property that is a capital asset in the taxpayer’s hands is treated as a gain or loss from the sale of a capital asset. HI-2 argued and the Tax Court agreed that when Hunt Oil liquidated the phantom stock and distributed the proceeds to HI-2, it ended HI-2’s right to sell the phantom stock. Thus, under Sec. 1234A, there was a termination of a right to buy or sell a capital asset, and HI-2 was entitled to capital gain treatment.

What is the basis of the stock?

The IRS argued the basis of the stock should be $6,411,000, which was HI-2’s original interest in the phantom stock upon Gary Hurford’s death; the difference between the value at termination of $12,986,603 and $6,411,000 would be the long-term gain. HI-2 argued that the basis in stock should be stepped-up to the value of $9,639,588 as of Thelma’s death. Because the phantom stock was included in Thelma’s estate, the Tax Court found that HI-2 was entitled to a step-up in basis under Secs. 1014(a) and 1014(b)(9). The court noted that Sec. 1014(c) specifically excludes from step-up in basis “property which constitutes a right to receive an item of income in respect of a decedent under section 691.” However, it concluded that Sec. 1014(c) did not apply because the phantom stock had been converted into a capital asset in HI-2’s hands and as such was no longer an item of income in respect of a decedent.

‘Appreciation’ is a hallmark of a capital asset

According to the Tax Court, the phantom stock was a capital asset in HI-2’s hands as determined by Sec. 1221; it was treated as long-term capital gain when Hunt Oil terminated the program and liquidated the phantom stock account. The partnership could not affect the value of the stock in any way and could only hope for the phantom stock value to appreciate; this characteristic was enough to classify the stock as a capital asset. Per Sec. 1234(A), it was also determined that Hunt Oil’s liquidation of the stock was a termination of HI-2’s right to sell the phantom stock and constituted a sale of an asset. Lastly, the partnership had basis in the phantom stock equal to its fair market value as of Thelma’s death. The fair market value of $9,639,588 was included in Thelma’s estate, and under Sec. 1014(b)(9), that was the partnership’s basis in the stock.

EditorNotes

Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.