Commissioner v. Smith
Headline: Employee stock-option gains taxed when options with no initial value are exercised, as the Court upholds taxing the difference between market price and option price for workers receiving employer stock options.
Holding: The Court held that when an employer gives an option with no present value and the employee later exercises it for stock worth more than the option price, the excess is taxable income as compensation in the year received.
- Requires employees to report option-to-stock spread as income when exercised.
- Treats employer stock options with no initial value as taxable when stock is received.
- Limits treating option exercise as merely a capital purchase for employees.
Summary
Background
An employee of a company that managed a struggling paper firm was given an option to buy stock at a fixed low price as part of compensation for his work reorganizing that firm. The option, granted in 1934 and later confirmed by the employer’s board, had no demonstrable market value when given. Years later, after the employer received the stock, the employee exercised the option in 1938 and 1939 and bought the shares at the low option price while the market value exceeded that price by substantial sums.
Reasoning
The central question was whether the excess of market value over the option price was taxable compensation in the years the employee received the stock. The Court relied on the tax law and Treasury regulations saying property an employer gives an employee for less than fair market value is income to the extent it is compensation. Because the option had no present value when granted, the Court treated the economic benefit realized when the option was exercised—the market-price excess—as the intended compensation and taxable in the years the stock was received. The Court affirmed the Tax Court’s factual findings and its tax conclusion.
Real world impact
Employees who receive employer stock options that have no measurable value when granted may have to report the later difference between market price and option price as taxable income when they exercise the option. The decision distinguishes between options that already have value when granted and options that only yield compensation upon exercise; different facts could lead to a different tax result.
Dissents or concurrances
One Justice disagreed and would have reached the opposite result for reasons stated by the federal appeals court, arguing the exercise should be treated as a capital purchase.
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