Court Opinion

ID: 9467582
Source: CourtListenerOpinion
Date Created: 2023-08-05 01:52:04.677818+00
Date Added: 2024-06-11T17:40:25.258834
License: Public Domain

FAY, Circuit Judge,
dissenting:
This Court today holds that a tax may be levied on purported gain from the exercise of certain stock options even though the Internal Revenue Service (Service) has stipulated that the actual value of those options at the time of the taxable event would not give rise to the realization of income asserted by the Service were the gain to be measured by the difference between the actual value and the cost of the options to petitioner-taxpayer. I respectfully dissent.
The facts of this case are very straight forward. In 1970, petitioner received, as compensation for employment, the option to purchase 30,000 shares of stock of his employer company. In 1971, petitioner exercised his options and purchased the shares, paying the agreed on option price of $200,-000. The stock received by petitioner was “lettered.” This was solely the result of the requirements of section 4(2) of the Securities Act of 1933, relating to the disposition of stock distributed in a “private placement.” That section makes it unlawful to publicly trade stock issued in a private placement for a period of at least two years from the date of issuance.1 Both parties agree that the exercise of the options was the taxable event giving rise to the realization of compensation income by petitioner. Most significantly, both parties agree that, at the time of the taxable event, the restrictions placed on the stock received by petitioner resulted in its actual value2 being 35% less than the value of the same number of such shares that were not subject to the restrictions imposed by section 4(2) of the Securities Act. The Service nonetheless contends that, pursuant to section 83 of the Internal Revenue Code of 1954 (Code), petitioner may be taxed as though the value of the stock were what it would be were the legal restrictions not placed on it. Petitioner responds that the Service’s position is premised on a wholly erroneous interpretation of Code § 83 and that to tax such admittedly non-existent gain is unconstitutional.
Before considering the specific statute in question, a review of certain fundamental truisms of tax law might be helpful in properly focusing the issues. To begin with it is accepted that the power of Congress to levy taxes is not without limit. Prior to the adoption of the Sixteenth Amendment, a time which though so close is so very far away, the imposition of an income tax was unconstitutional. Subsequent to its adoption, Congress was authorized to institute a progressive tax, but only to the extent that the tax applied to income. Income is, as it was classically defined in Eisner v. Macomber, 252 U.S. 189, 40 S.Ct. 189, 64 L.Ed. 521 (1920), the “gain derived from capital, from labor, or from both combined.. .” 252 U.S. at 207, 40 S.Ct. at 193. It is “something of exchangeable value proceeding from, the property ... and coming in, being ‘derived’ that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit, and disposal — that is income derived from property. Nothing else answers the descriptions.” 252 U.S. at 207, 40 S.Ct. at 103. I think it significant to remember that, although the definition of income has become more complex in response to the intricate tax laws and tax problems resulting therefrom, when the government seeks to tax something as income, it may do so only to the extent that “something of exchangeable value” was derived from labor or capital. By way of simple example, it is clear that if A, attorney, agrees to draft P, painter’s, will in exchange for a painting worth $200, and at the end of the transaction P gives A a painting that would be worth $200 but for a *295hole in the canvas, that fact making it worth only $100, A may only be taxed to the extent of $100. A may only be taxed on the value of what he actually received, not on the value that the property would have had but for a condition affecting such value.
The general rule for the taxation of compensation income upon the receipt of property, rather than cash, is very simple. The taxpayer may be taxed on the fair market value of the property received less any amount which the taxpayer may have paid to receive the property. Taxable gain equals fair market value minus basis. Fair market value is that “price which would probably be agreed upon by a seller willing, but under no compulsion, to sell, and a buyer willing, but under no compulsion, to buy, where both have reasonable knowledge of the facts.”3
The last and most indisputable truism is that people generally do not like to pay taxes. To that end, taxpayers have often gone to great lengths to devise schemes whereby they can avoid taxation on what properly should be taxable. Such schemes are known as “tax avoidance devices.” Both Congress, by legislation, and the Service, by regulation, may recharacterize such schemes when their primary purpose is tax avoidance or deferral. Individual taxpayers are prevented thereby from agreeing to carry out transactions in a tax-free or tax-reducing form when the substance of the transaction should properly be structured as a fully taxable event.
Turning to the transaction in question, it appears without equivocation that, but for section 83 of the Code, the only gain on which petitioner would be taxable is the difference between the fair market value of the stock, as that value is decreased by the restrictions placed thereon, and the price paid for the stock.4 The question then becomes whether section 83 was intended to affect the amount by which “lettered stock” would be taxed and, if so, whether that effect is constitutionally permissible. I resolve both of those issues in the negative.
Section 83 provides in pertinent part: If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of—
“(1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over
“(2) the amount (if any) paid for such property shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable.
It surely must be clear that to the extent Code § 83 is applied to the present case in such a manner as to impose a tax on an amount greater than the difference between the stipulated value and the stipulated price of the stock, the statute is unconstitutional. The Service simply may not tax the excess of the value of unrestricted stock over the value of the restricted stock actually received. Whatever that excess is, it most certainly is not income. To say, as the Tax Court did in this case, that “[wjhile *296some unfairness and inequity may result from the operation of section 83, Congress could rationally have concluded that such a result was justified by the ease and certainty of the section’s operation,” is to absolve both Congress and the Service of their duty to impose taxes within the parameters established by the Constitution.
The majority opinion suggests that this case requires this Court to determine the value of appellants’ stock. That is incorrect. The value was stipulated by the taxpayer and Service as 65 percent of the market value of an equal number of freely tradeable shares. The issue in this case should be whether the government can tax an amount greater than the undisputed value of the property received. Rather than confront that question, the majority says, “A stipulation as to the value of property if sold under certain circumstances does not necessarily reflect the value of the property in the hands of the current owner, (footnote omitted) Although the taxpayer could receive only 65 percent of the fair market value of the stock if sold during the period of the restriction, it does not necessarily follow that the only value the taxpayer received as compensation was 65 percent of the stock’s fair market value.” At 291. While those statements may be true in a case in which valuation is contested, I am at a loss to understand their relevance to this case, because the parties agree on the value of the property received. Moreover, if there is some value other than that stipulated to by the parties, the majority gives no hint as to what it may be. The majority opinion goes on to say, “The full value of the stock existed from the moment of purchase; it was only temporarily subject to a diminution in value if exchanged because of the securities restrictions.” Id. Not only is that statement contrary to the parties’ stipulation, it is logically unsupportable. In the first place, how can it be said that the full value existed at the time of purchase? It is undisputed that appellant could not have found anyone to give him that full value in exchange for the restricted shares. The logic of the majority opinion would lead to the conclusion, by way of simple example, that the holder of a ten-year bond whose present value is $100 and whose value at maturity is $200 could be taxed at the greater value because its present lower value was a temporary condition. Secondly, the majority makes the totally unsupported assumption that the present diminution in value is a temporary condition. When the restrictions on the stock lapse, its value will be the then existent market value. That value may be more or less than, and is unlikely to be the same as, the present market value. It is conceivable that the stock had reached an all-time high at the time the parties agreed to its value. In that situation, it would be grossly unfair to say that the value of the stock was only temporarily diminished.
To the extent that this Court and the Tax Court relied on Sakol v. Commissioner, 574 F.2d 694 (2d Cir. 1978), aff’g 67 T.C. 986 (1977), cert. denied, 439 U.S. 859 (1978), to justify the results reached here, I conclude that their reliance is misplaced. Moreover, it demonstrates a fundamental misunderstanding of the reasons for the adoption of Code § 83. Sakol involved a contractual agreement between employer and employee that restricted the transferability of the stock purchased. Sakol did not involve stock whose value was affected by legal restrictions imposed by the Securities Act. Sakol said that section 83 could be constitutionally applied so as to value the stock at an amount equal to that which it would have had without the contractually created restrictions. The rational for that holding was simply that the statute could be constitutionally applied to privately created contractual restrictions because such agreements had been used historically as a tax avoidance or tax deferral device to disguise income where it actually existed. In its holding in Sakol, the Second Circuit Court of Appeals specifically justified the application of section 83 to contractually created restrictions on stock saying, “Because non-qualified plans have been the vehicles of tax avoidance Congress may clothe the tax incidental to them with a ready-made, rather than a custom-tailored, suit.” 574 F.2d *297at 701. The language of both courts’ decisions makes it unequivocal, however, that the statute was only intended to apply to privately created contractual restrictions, not legally imposed restrictions. In framing the issue for the Second Circuit, Judge Oakes began the opinion by saying, “Is it constitutional ... in taxing a corporate employee in connection with his purchase of his employer’s stock, not to take into account any diminution in value of the stock that may be present by virtue of temporary restrictions on transfer in the employer's underlying stock purchase plan?” (emphasis added) 574 F.2d at 695. In discussing the manner in which Congress intended section 83 to operate, the Court went on to say,
It requires a taxpayer to include in gross income the excess of the stock’s fair market value over its cost, as soon as the taxpayer’s interest is no longer subject to a substantial risk of forfeiture. The actual value of the stock arguably may be less than the value of stock readily transferable on the open market because of restrictions imposed by the stock purchase plan. Nevertheless, these restrictions, other than permanent, nonlapsing restrictions, may not be considered in determining fair market value.
(emphasis added) Id. at 695-96. In the opinion affirmed by the Second Circuit, the Tax Court said, “[t]he section [83] provides that property transferred in connection with the performance of services is to be included in the income of the transferee in an amount which exceeds the employees’ cost by the fair market value of the property transferred, without regard to any contractual restriction on its disposition....” (emphasis added) 67 T.C. at 989. The Tax Court later said, “... to minimize the potential for continued tax avoidance and to further discourage the use of restricted stock purchase plans as a means of obtaining an equity interest in one’s employer, Congress decided to measure the income derived from such arrangements without regard to transitory restrictions imposed by the parties on the shares purchased.” (emphasis added) 67 T.C. at 99. It is clear, therefore, that Sakol allows the application of section 83 to privately created restrictions on stock transfer only because those restrictions may operate as tax avoidance schemes. The same cannot be said of governments lly imposed restrictions on stock transfer.
It seems to me there is a critical distinction between holding that section 83 may constitutionally be applied to private agreements that restrict the transfer of stock, because such agreements are often used to disguise the existence of income, and holding that section 83 may constitutionally be applied to governmentally imposed restrictions on the transfer of stock, when the effect is to tax income that does not exist.5 Our government does not have the authority to tax that amount. In this case the Service has stipulated that such value does not exist. The government’s position distills to a combination of semantic gymnastics and bureaucratic convenience neither of which could possibly justify our violating such a fundamental principle.6 It is unfortunate that this Court chooses to give an unconstitutional interpretation to a statute whose purposes and proper interpretation are constitutional.
Accordingly, I respectfully dissent.

. Stock subject to the restrictions of section 4(2) does not automatically become freely tradeable at the end of the two-year period. The Securities Act prescribes certain additional conditions that must be satisfied. Those conditions have no relevance to this appeal.

. By actual value, I mean the amount which the parties stipulated as the fair market value of stocks so restricted.

. Newberry, 39 BTA 1123 (1939).

. This is the standard measure of recognizable gain. Prior to adoption of section 83, the amount actually taxed would have been less than this standard measure. This was the result of the operation of regulations adopted in 1959, 1.421-6(d)(2), Income Tax Regs., providing that the tax on bargain purchases of stock subject to restrictions having a significant effeet on value would be imposed only when the restrictions lapsed or the property was sold in an arm’s-length transaction. The measure of income as ordinary gain income at that point was the lesser of the fair market value of the stock at the time of its acquisition, determined without regard to any restrictions, or the fair market value at the time the restrictions lapsed, over the cost of the stock.

. The majority dismisses the distinction I draw between the contractually created restrictions in Sakol and the governmentally imposed restrictions here as “insufficient to require a different result.” 1 am at somewhat of a loss to understand how such a significant difference can be disposed of with so little consideration. See Opinion notes 8 and 14 and accompanying text.

. The majority points out that, even with its ruling, all is not lost for the taxpayer. Should the value of the stock at the time it becomes freely tradeable equal its present value of 65 percent of market value, the taxpayer may recoup the $239,137 deficiency he has paid, as a capital loss. What the majority fails to note is that, assuming the appellant can take the maximum annual capital loss of $3,000, as provided for in Code section 1211, the entire amount could be recouped in slightly under eighty years. I cannot imagine that this offers great solace to the taxpayer.