Opinion ID: 3039769
Heading Depth: 2
Heading Rank: 2

Heading: the taxable event

Text: [1] A question of first impression in this circuit: When an employee exercises a non-qualified stock option2 granted by the employer to purchase shares with money borrowed from a third party, pledging the shares as collateral for the loan, is the property “transferred” and “substantially vested” for tax 2 Statutory stock options are compensatory options that meet certain criteria and are treated differently under the Internal Revenue Code. See I.R.C. § 422. Options that do not meet these requirements, such as the RealNetworks options in this case, are nonstatutory, or nonqualified, stock options. Cramer v. Comm’r, 64 F.3d 1406, 1408-09 (9th Cir. 1995). 19026 UNITED STATES v. TUFF purposes at the time the option is exercised, or at the time the shares are later liquidated? Citing no relevant authority, Tuff contends that in these circumstances no taxable transfer occurs when the option is exercised. An overview of the statutory and regulatory provisions governing the taxation of stock options is useful to understand Tuff’s arguments. A. Statutory and Regulatory Framework for Taxation of Stock Options [2] When an employee receives a non-qualified stock option that does not have a readily ascertainable fair market value, as was the case with the options at issue, the receipt of the option generally is not taxable. I.R.C. § 83(e)(3). Rather, the employee is taxed upon exercising the option and receiving shares if two conditions are met. First, the shares must be transferred to the employee. Under the applicable regulations, a transfer occurs when the employee acquires a beneficial ownership interest in the shares. 26 C.F.R. § 1.83-3(a)(1). Second, they must be substantially vested in the employee. I.R.C. § 83(a); 26 C.F.R. § 1.83-1(a). Shares are substantially vested in the employee when they are either transferable or not subject to a substantial risk of forfeiture. 26 C.F.R. § 1.83- 3(b). If both conditions are met, the employee must recognize income in the amount by which the shares’ fair market value exceeds the exercise price paid. I.R.C. § 83(a). Whether a risk of forfeiture is substantial depends on the facts and circumstances. 26 C.F.R. § 1.83-3(c)(1). Shares (or any other property transferred in connection with the performance of services) are subject to a substantial risk of forfeiture when the owner’s rights to their full enjoyment are conditioned upon any person’s future performance of substantial services. I.R.C. § 83(c)(1). Property is transferable if the employee can sell, assign, or pledge his or her interest in the property to a person other than the transferor, and this thirdparty transferee is not required to give up the property or its UNITED STATES v. TUFF 19027 value if a substantial risk of forfeiture later materializes. 26 C.F.R. § 1.83-3(d). [3] In this case the RealNetworks shares were transferred to and substantially vested in Tuff when he exercised his stock options. RealNetworks issued the shares to Tuff, who then held legal title to the shares and was entitled to receive dividends. After Tuff exercised his options, RealNetworks imposed no further conditions upon his ownership interest. He had the right to vote the shares. He had the right immediately to sell the shares, because he exercised his options during open trading windows. Tuff had the right to pledge the shares as collateral, and indeed did so to secure his loan from Morgan Stanley. [4] Under the general rules described above, the transfer of the stock to Tuff in 1999 was a taxable event. Seeking to avoid this result, Tuff argues that under the Morgan Stanley agreement, he received only another option rather than the shares themselves. B. Exception for Certain Transfers Treated as the Grant of an Option [5] Treasury Regulation § 1.83-3(a)(2) (“section 1.83- 3(a)(2)”) provides that income is not recognized when a “transfer” of property occurs by treating the exercise of some stock options as the grant of another option, rather than a transfer of shares. Section 1.83-3(a)(2) states: [I]f the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option. The determination of the substance of the transaction shall be based upon all the facts and circumstances. The factors to be taken into account 19028 UNITED STATES v. TUFF include 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. 26 C.F.R. § 1.83-3(a)(2). The regulations illustrate how section 1.83-3(a)(2) operates in this example: Example (2). On November 17, 1972, W sells to E 100 shares of stock in W corporation with a fair market value of $10,000 in exchange for a $10,000 note without personal liability. The note requires E to make yearly payments of $2,000 commencing in 1973. E collects the dividends, votes the stock and pays the interest on the note. However, he makes no payments toward the face amount of the note. Because E has no personal liability on the note, and since E is making no payments towards the face amount of the note, the likelihood of E paying the full purchase price is in substantial doubt. As a result E has not incurred the risks of a beneficial owner that the value of the stock will decline. Therefore, no transfer of the stock has occurred on November 17, 1972, but an option to purchase the stock has been granted to E. 26 C.F.R. § 1.83-3(a)(7) Example (2) (“Example (2)”). Attempting to fit this example, Tuff argues that a transfer occurs within the meaning of I.R.C. § 83 only when an employee places his own capital “at risk.” Because he paid for his options with borrowed money, using debt secured by the stock, Tuff argues he had no capital at risk, and therefore no UNITED STATES v. TUFF 19029 transfer occurred until the RealNetworks stock was later sold to satisfy Morgan Stanley margin calls. We disagree.3 C. Tuff’s Stock Purchases Financed by Third Party Margin Debt Do Not Qualify for the Treasury Regulation § 1.83(a)(2) Exception [6] Section 1.83-3(a)(2) states that a transfer of property may be the same in substance as the grant of option when the amount paid in exchange for property “is an indebtedness.” In this case, RealNetworks transferred stock to Tuff and was paid in full. RealNetworks never held a note, or any other form of indebtedness, in exchange for the stock. Nonetheless, Tuff contends that section 1.83-3(a)(2) and Example (2) turn on what an employee pays for property, rather than on what the employer receives. Therefore, Tuff argues, if an employee borrows money to purchase stock, without placing his own capital, other than the stock, at risk, no transfer has occurred within the meaning of I.R.C. § 83. This is nonsense. Example (2) does not address the source the employee chooses to fund the payment or what an employee places at risk. Instead, Example (2) illustrates how a transaction styled as a sale operates, in substance, to grant an option to purchase property. Rather than giving the employee an option to purchase stock at a set price for a set time, the employer in Example (2) actually transfers stock to the employee in exchange for a note. However, the structure of the transaction allows the employee to choose whether to finalize the exchange by paying on the debt. In substance, the employer 3 Although we appear to be the first court of appeals to address these arguments, we note that both the United States Court of Federal Claims and the United States Tax Court have recently considered, and rejected, many of the same arguments Tuff urges here. See Palahnuk v. United States, 70 Fed. Cl. 87 (2006); Racine v. Comm’r, T.C.M. 2006-162, 2006 WL 2346444 (2006); Hilen v. Comm’r, T.C.M. 2005-226, 2005 WL 2387488 (2005). We largely agree with the analysis undertaken by these courts. 19030 UNITED STATES v. TUFF has created, and the employee holds, an option to purchase the stock at a later time. Contrary to Tuff’s arguments, whether an employee has capital at risk is entirely irrelevant to the transaction in Example (2). Instead, Example (2) is concerned with whether an employer has in substance created an option to purchase property. [7] Therefore, when examining the similarity of Example (2) to Tuff’s purchases, the critical inquiry is what RealNetworks transferred and when it received payment, not how Tuff financed his purchases. See Palahnuk v. United States, 70 Fed. Cl. 87, 91-92 (2006). [8] In Example (2), it is uncertain whether the employer will receive the full purchase price, and equally uncertain whether the employer will transfer unconditional ownership of the stock. In Tuff’s case, unlike Example (2), RealNetworks received the full purchase price of the stock in exchange for transferring unconditional ownership to Tuff. Although Tuff used debt to exercise his options, he borrowed the money from Morgan Stanley, rather than paying by incurring debt to RealNetworks. If he failed to pay the loan, his shares were subject to forfeiture to Morgan Stanley, not to RealNetworks. In light of these fundamental differences between the instant case and the hypothetical posed in Example (2), we reject Tuff’s argument that financing the exercise of stock options with third party margin debt is in any way similar to the alternative method of granting employee stock options described in Example (2). Not only do Tuff’s purchases fall outside the ambit of Example (2), but consideration of all the facts and circumstances confirms they are not in substance the same as the grant of an option under 26 C.F.R. § 1.83-3(a)(2). As to the first factor, Tuff held title to the publicly-trades shares, had the right to receive dividends, and could vote, sell, and pledge the shares. Tuff in fact did pledge the shares as collateral for the margin loan from Morgan Stanley. In these circumstances, UNITED STATES v. TUFF 19031 this factor weighs against a claim that Tuff’s purchases were in any real way similar to the grant of an option. The second factor in section 1.83-3(a)(2) considers the extent to which the risk of decline in the value of the property has been transferred. Tuff argues that he had no capital at risk because under the Agreement with Morgan Stanley, if the collateral in his account fell below the debt balance multiplied by 1.33, Morgan Stanley would sell the shares to satisfy Tuff’s debt and thus Tuff would avoid the possibility of a deficiency ever arising. Thus, Tuff contends, he did not assume the risk that the value of his stock would decline, and therefore that risk was never transferred. He is wrong. [9] Tuff’s “capital at risk” arguments, and the structure of his Agreement with Morgan Stanley, are entirely beside the point. The regulation does not require that the risk of decline in value be transferred to and permanently vested in the employee, but rather considers only whether it has been transferred from the employer. 26 C.F.R. § 1.83-3(a)(2). That Tuff may have later shifted this risk to Morgan Stanley has no bearing on our inquiry, and we need not entertain Tuff’s arguments under I.R.C. § 465 that his debt to Morgan Stanley was in the nature of non-recourse debt for which he had no personal responsibility.4 In this case RealNetworks transferred the shares to Tuff unconditionally, and with them, all risk that they might decline in value. The second factor thus also weighs against concluding that Tuff’s purchases were in substance the same as the grant of an option. 4 Moreover, Tuff did bear some risk that the RealNetworks shares would decline in value. The Agreement provided that if the value of the collateral in Tuff’s account fell below a certain level, he would be required to deposit additional assets or Morgan Stanley would sell RealNetworks shares to satisfy the debt. Because this could occur only if the stock declined in value, Tuff did bear some risk that the stock value would decline. Furthermore, language in the Agreement made Tuff “personally liable for any deficiency remaining” after Morgan Stanley sold the RealNetworks shares. 19032 UNITED STATES v. TUFF [10] The final factor concerns the likelihood that the purchase price will be paid. In this case Tuff paid the purchase price in full to RealNetworks upon exercising his options, thereby extinguishing any possibility that his purchases could be treated as the grant of an option. [11] In light of these facts and circumstances, Tuff’s exercise of RealNetworks stock options in 1999 were not similar in substance to the grant of a stock option, and therefore 26 C.F.R. § 1.83-3(a)(2) does not control this issue. Accordingly, we hold that a taxable transfer of property within the meaning of I.R.C. § 83 occurred each time Tuff exercised his RealNetworks options.