Rosenberg v. Commissioner
20 T.C. 5; 1953 U.S. Tax Ct. LEXIS 201 (1953)
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Rule of Law:
If an employee stock option granted before February 26, 1945, was intended to provide the employee with a proprietary interest in the corporation rather than as compensation for services, the difference between the option price and the market value of the stock upon exercise is not considered taxable income.
Facts:
- In 1938, Abraham Rosenberg negotiated an employment contract with a corporation.
- The contract specified a salary and a percentage of sales and profits, which was explicitly defined as Rosenberg's 'full compensation'.
- During final negotiations, a provision was added granting Rosenberg an option to purchase company stock.
- The option allowed Rosenberg to purchase shares at $5.40 per share.
- At the time the option was granted in 1938, the market value of the stock was approximately $3.00 to $3.25 per share, which was less than the option price.
- The option's terms and the number of shares available were not contingent on Rosenberg's performance or the company's profitability.
- In 1946, Rosenberg exercised a portion of this option, purchasing 2,500 shares.
Procedural Posture:
- The Commissioner of Internal Revenue determined a tax deficiency in Abraham Rosenberg's 1946 federal income tax return.
- The Commissioner added the difference between the market value and the option price of stock exercised by Rosenberg to his gross income.
- Rosenberg filed a petition with the Tax Court of the United States to challenge the Commissioner's determination of deficiency.
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Issue:
Does the difference between the market value and the option price of stock constitute taxable income to an employee when the option, granted before February 26, 1945, was intended to provide a proprietary interest rather than serve as compensation?
Opinions:
Majority - Arundell, Judge
No. The difference between the market value and the option price does not constitute taxable income because the option was not given as compensation but rather to enable the petitioner to acquire a proprietary interest in the corporation. The court's reasoning is based on several key factors. First, the employment contract explicitly defined Rosenberg's salary and profit percentage as his 'full compensation,' and the stock option was added separately without altering these terms. Second, and most significantly, the option price ($5.40) was substantially higher than the stock's market value (~$3.25) at the time the option was granted, which is inconsistent with an intent to provide immediate compensation. The court also noted that the option was not tied to performance metrics and that boilerplate language in the contract suggesting the option was an 'inducement' was not conclusive. The employer's later decision to claim a tax deduction for the transaction is not binding on the employee's tax liability.
Analysis:
This decision solidifies the 'intent' test for employee stock options granted prior to the Supreme Court's 1945 decision in Commissioner v. Smith. It establishes that for these pre-1945 options, courts must undertake a fact-intensive inquiry into the circumstances of the grant to determine its purpose. The case provides a clear roadmap of factors that indicate a 'proprietary interest' intent, such as an option price above the current market value and the separation of the option from the primary compensation package. This ruling served as important guidance for taxpayers with older options, distinguishing their tax treatment from the stricter rules that would later classify the bargain element of nearly all employee stock options as compensatory income.
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