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Frank v. Commissioner of Internal Revenue

June 14, 1971

M. P. FRANK AND BEATRICE FRANK, APPELLANTS,
v.
COMMISSIONER OF INTERNAL REVENUE, APPELLEE



Swygert, Chief Judge, and Fairchild and Pell, Circuit Judges. Pell, Circuit Judge (dissenting).

Author: Swygert

SWYGERT, Chief Judge.

This is a petition to review a decision of the United States Tax Court*fn1 which determined deficiencies in the federal income taxes for calendar year 1960 paid by petitioners-appellants.*fn2 The Tax Court determined that taxpayer realized ordinary income in the amount of $530,328.66 during that year due to the exercise on September 28, 1960 of stock options granted in 1958 to M. P. Frank by Mortgage Guaranty Insurance Company ("MGIC") and Guaranty Insurance Agency, Inc. ("GIAI"), both Wisconsin corporations. Taxpayer appeals the determinations of the Tax Court that: (1) M. P. Frank was an employee of both corporations, and the options were granted by reason of such employment; (2) the options did not have a readily ascertainable market value at the time they were granted; (3) the stock subject to the options was not subject to any restriction which had a significant effect upon its value within the intendment of Treasury Regulations, § 1.421-6(d)(2)(i), so as to preclude taxation of any gain at the time of exercise of the options; and (4) the stock underlying the options had a fair market value of $18.50 per adjusted share*fn3 at the time of exercise of the options. We affirm the decision of the Tax Court in all respects.

The facts relevant to a determination of this review are recited in meticulous detail in the opinion of the Tax Court,*fn4 and the statement of facts which follows is only so much as is necessary to understand our disposition of this review. In 1956 taxpayer and two others organized and promoted a Wisconsin corporation under the name of Mortgage Guaranty Insurance Corporation for the purpose of engaging in the business of insuring mortgagees against losses on residential first-mortgage loans. Prior to incorporation, the incorporators adopted a resolution that, in return for their activities (then uncompleted) in organizing the corporation and promoting the sale of the original issuance of stock, the promoters, including taxpayer, would receive an option to purchase 100 shares of stock of MGIC at any time prior to December 31, 1959 for $500 per share, $25 less than the issue price.

In 1957 the organizers and promoters of MGIC also organized and promoted a second Wisconsin corporation under the name of Guaranty Insurance Agency, Inc., for the purpose of selling insurance issued by MGIC and financing the payment of commissions. On January 9, 1957 taxpayer was elected to the board of directors of MGIC and was also made its first secretary-treasurer. On May 6, 1957 he was elected to the GIAI board, and on May 23, 1957 he became GIAI's first president. Also in 1957 MGIC executed a four-for-one stock split, and the original issue of GIAI stock was distributed to MGIC shareholders at a ratio of one share of GIAI per four shares of MGIC stock held at a price of $25 per share.

Then in 1958, and before any of the three promoters had exercised their 1956 MGIC options, the boards of MGIC and GIAI adopted similar resolutions granting options to taxpayer and the other two promoters to purchase 400 shares at $125 per share and 100 shares at $25 per share, respectively, at any time up to December 31, 1962. In mid-1959 both MGIC and GIAI split their stock eight -for-one, and early in 1960 the 1958 options granted to taxpayer by MGIC and GIAI were revised to reflect the stock splits. Other stock splits occurred before taxpayer's exercise of the options which were taken into account upon exercise of the options, although no other amendments were made to the options themselves.

Initially, we note that the scope of our review of the trial court's decision is circumscribed by the proposition that we may reverse findings of fact by the Tax Court only if they are clearly erroneous.*fn5 That being the case, we conclude that there is sufficiently substantial evidence stated in the opinion of the Tax Court to justify its determinations that taxpayer was an employee of MGIC and GIAI, that both corporations granted the options here in question by reason of such employment, and that the stock underlying the options had a fair market value of $18.50 per adjusted share on September 28, 1960 when the options were exercised. Accordingly, we affirm those determinations without further comment.

As to the determination that the stock subject to the options had no readily ascertainable market value at the time of the granting of the options, we believe we are similarly bound by Duberstein to the clearly erroneous standard. However, because of the importance placed upon that issue by the taxpayer, we are impelled to discuss that issue in spite of the Tax Court's extensive discussion of it.*fn6

Taxpayer contends that the granting of the options to taxpayer in 1958 is the taxable event, if any there be, deriving from the options. He asserts that the stock underlying the options and the options themselves could be valued at the date of granting, and any income taxable to taxpayer must be calculated on the basis of the value of the options at grant. We disagree.

In Commissioner v. LoBue,*fn7 the Supreme Court held that a compensatory, nontransferable stock option granted by a corporation to an employee generated income to the employee which was taxable at exercise. The Court stated:

It is of course possible for the recipient of a stock option to realize an immediate taxable gain [ i. e., at grant]. * * * The option might have a readily ascertainable market value and the recipient might be free to sell his option.*fn8

That statement led by negative implication to the adoption of Treasury Regulations, § 1.421-6,*fn9 which incorporates the readily ascertainable standard. Section 1.421-6(c)(3)(ii) of the regulations provides:

The fair market value of the option is not readily ascertainable unless the value of the option privilege can be measured with reasonable accuracy. In determining whether the value of the option privilege is readily ascertainable, and in determining the amount of such value when such value is readily ascertainable, it is necessary to consider --

(a) Whether the value of the property subject to the option can be ascertained;

(b) The probability of any ascertainable value of such property increasing or decreasing.

The Tax Court held that the options did not have a readily acertainable fair market value at grant, noting that there was conflicting evidence as to whether the underlying stock could be valued and preferring to believe the evidence tending to establish that it could not.*fn10 The determination of the Tax Court that "the fair market value of the stock here involved, and the probability that such stock would increase or decrease in value could not be ascertained with reasonable accuracy"*fn11 is clearly correct. The stock of MGIC and GIAI had been the subject of only a few isolated sales to third parties when the options were granted, and there was no market price then available. Indeed, taxpayer's expert seems to have relied exclusively on the issue price of the stock as the base from which he attempted to determine the value of the options. Moreover, the customary method of using "comparables" -- stocks of similar businesses which are publicly traded -- to ascertain the value of a closely held corporation's stock could not be used here because MGIC and GIAI were unique in that no other private businesses in the country were involved in a similar enterprise. In addition, MGIC had been in business less than two years, had suffered a net loss of $53,283.14 during 1957 and was to suffer a net loss of $15,770.00 during 1958. GIAI was also a new business and suffered a net loss of $26,722.00 in 1958. Nor has anyone contended that book value has any relation to the fair market value of these stocks. It is clear, therefore, that the stock underlying the options could have no "readily ascertainable market value" as envisioned by the Supreme Court in LoBue.

Taxpayer contends in the alternative that, assuming the options were compensatory and had no readily ascertainable market value at grant, he is not required to recognize any income at the date of exercise because the stock underlying the options was subject to a restriction which had a significant effect on its value within the meaning of Treasury Regulations, § 1.421-6(d)(2) (i). Taxpayer asserts as alternative bases for this contention the following facts: (1) the stock was not registered with the Securities and Exchange Commission, and taxpayer would suffer limitations on the types and amounts of possible dispositions deriving from the lack of registration and his position as an insider with the corporation; (2) registration of taxpayer's shares with the SEC would be unreasonably expensive when viewed with regard to the number and value of shares involved; (3) registration was probably not possible in any event, "since the company was new, struggling and a public offering would look like a 'bail-out' to the investing public;" (4) redemption of the shares was not possible because the company was suffering liquidity problems; (5) stock sold by taxpayer would have to be sold subject to investment letter restrictions on the purchaser. In support of his position, taxpayer cites Ira Hirsch, 51 T.C. 121 (1968), as standing for the proposition that restrictions on the transfer of stock deriving from the operation of the Securities Act of 1933 ...


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