The opinion
Fay, J., dissenting: I respectfully dissent as to the majority’s holding that "the readily ascertainable fair market value” rules of sections 1.61-15 and 1.421-6, Income Tax Regs., are valid insofar as they apply to stock warrants received as compensation by independent contractors. I disagree with what I consider to be the majority’s conclusory analysis and its expansive use of prior case law to resolve this issue.
First, the majority emphasizes that the regulations here in issue have been in existence for over 20 years and are thus entitled to great deference. Such emphasis implies that the regulations have been applicable to all options granted since the date of their adoption. In fact, however, these regulations apply to options granted before July 1, 1969. See sec. 1.421-6(a)(2), Income Tax Regs. As to options granted on and after that date, section 1.83-7, Income Tax Regs., and not section 1.421-6, Income Tax Regs., is the controlling authority. See sec. 1.83-8(b), Income Tax Regs. Thus, while the regulations may have been in existence for over 20 years, they have been inapplicable with respect to options granted during the last 15 of those years.
Moreover, the majority cites several cases which it contends support the validity of the regulations. See pp. 1215-1217 supra. However, none of these cases specifically considered whether section 1.61-15, Income Tax Regs., is valid in making the rules contained in section 1.421-6, Income Tax Regs., applicable to independent contractors. Neither this Court, nor any other Court to our knowledge, has specifically addressed this issue before.
The majority first cites Victorson v. Commissioner, 326 F.2d 264 (2d Cir. 1964), and notes that "although the years involved in that case preceded the effective date of the regulations, the Second Circuit expressly stated that 'Treas. Regs. §1.421-6(d)(2)(i) * * * was made applicable to underwriters’ stock options by Treas. Dec. 6669.’ [ 326 F.2d at 267 n. 2.]” It is difficult to see how this statement, which appears in a footnote in the Second Circuit’s opinion, supports the validity of applying the regulations to independent contractors. That court did not even apply, let alone consider the validity of, the regulations. Rather, it merely observed that T.D. 6669 (Dec. 11, 1963) made the rules of section 1.421-6, Income Tax Regs., applicable to options received by underwriters.
The majority next cites LeVant v. Commissioner, 45 T.C. 185 (1965), revd. and remanded on another issue 376 F.2d 434 (7th Cir. 1967). It states that, in LeVant, this Court "discussed at length the valuation rules of section 1.421-6, Income Tax Regs., and specifically commented on the application of section 1.61-15, Income Tax Regs.” In LeVant, however, which involved an option received by an employee, the Court did not address the application of section 1.61-15, Income Tax Regs., to independent contractors, nor did it consider whether such application would be valid. Rather, in the context of discussing options granted to employees, it simply paraphrased the language of the regulation. Thus, LeVant does not support the validity of applying the rules of section 1.421-6, Income Tax Regs., to options received by independent contractors.
The majority next cites Frank v. Commissioner, 54 T.C. 75 (1970), affd. 447 F.2d 552 (7th Cir. 1971). Once again, it seizes upon language contained in a footnote to conclude that "we again commented on the application of section 1.61-15, Income Tax Regs.” In Frank, in which the taxpayer was specifically held to be an employee, this Court similarly did not apply or address the validity of section 1.61-15, Income Tax Regs. It merely observed that that section makes the rules contained in section 1.421-6, Income Tax Regs., applicable to options granted to certain non-employees after July 11, 1963. 1
Thus, the majority concludes that the regulations are valid based on nothing more than the fact that they have been in existence for a long period of time and upon its misconception that several Court decisions support their validity. I do not believe that the majority is justified in implying that the courts in the above-cited cases considered the regulations valid merely because they commented on their applicability. The instant case presents the first opportunity either this or any Court has had to consider the validity of the application of the regulations to options received by independent contractors, and in my view, requires a more thorough analysis.
For the following reasons, I would conclude that sections 1.61-15 and 1.421-6, Income Tax Regs., are invalid to the extent they make the rules of section 1.421-6, Income Tax Regs., applicable to options received as compensation by independent contractors. Accordingly, I would hold that the amount of the corporation’s income arising from the receipt of such warrants must be determined at the time the warrants were received, not when the warrants were subsequently exercised or transferred in an arm’s-length transaction.
Although Treasury regulations are not to be rejected unless they are found to be unreasonable and plainly inconsistent with the statute (Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948)), a regulation is not a reasonable statutory interpretation unless it harmonizes with the plain language of the statute, its origins, and its purpose. National Muffler Dealers Association v. United States, 440 U.S. 472, 477 (1979).
Sections 1.61-15 and 1.421-6, Income Tax Regs., were promulgated to deal with the administrative difficulties respondent faced in attempting to value nonstatutory options not traded on an established market. It is a basic rule under our tax laws that property received as compensation for services must be included in income to the extent of its fair market value at the time of receipt. See sec. 1.61—2(d)(1), Income Tax Regs. Only in rare and extraordinary cases will property not have an ascertainable value. See United States v. Davis, 370 U.S. 65 (1962). In promulgating sections 1.61-15 and 1.421-6, Income Tax Regs., respondent took the position that the receipt of options as compensation can be one of these "rare and extraordinary” cases.
The rules contained in sections 1.61-15 and 1.421-6, Income Tax Regs., were certainly not derived from any specific statutory language. Section 421 provides special tax treatment for certain qualifying options granted to employees; however, no provision is made for options, such as the warrants herein, which do not so qualify. Section 61 simply provides a sweeping definition of "gross income,” including "compensation for services, including fees', commissions, and similar items.” Sec. 61(a)(1).
The origin of these regulations can be traced instead to a series of cases which culminated in the Supreme Court’s decision in Commissioner v. LoBue, 351 U.S. 243 (1956). In LoBue, the Court was faced with the question of the taxability of options granted to employees. The options at issue were nontransferable and their exercise was conditioned upon the continued employment of the recipient. In holding that the options constituted compensation income to the extent of the difference between the option price and the fair market value of the stock acquired upon the exercise of the options, the Supreme Court stated:
It is of course possible for the recipient of a stock option to realize an immediate taxable gain. See Commissioner v. Smith, 324 U.S. 177, 181-182 . The option might have a readily ascertainable market value and the recipient might be free to sell his option. But this is not such a case. These three options were not transferable and LoBue’s right to buy stock under them was contingent upon his remaining an employee of the company until they were exercised. Moreover, the uniform Treasury practice since 1923 has been to measure the compensation to employees given stock options subject to contingencies of this sort by the difference between the option price and the market value of the shares at the time the option is exercised. [Commissioner v. LoBue, 351 U.S. at 249 ; emphasis added.]
Clearly, the distinction made in section 1.421-6, Income Tax Regs., between options with and without a "readily ascertainable fair market value” was derived from this language in LoBue. However, neither LoBue nor any of the preceding cases in this area ever indicated that these rules should be applied, as they are under section 1.61-15, Income Tax Regs., to options received by independent contractors. See Commissioner v. Smith, 324 U.S. 177 (1945). Commissioner v. Estate of Stone, 210 F.2d 33 (3d Cir. 1954), affg. 19 T.C. 872 (1953); McNamara v. Commissioner, 210 F.2d 505 (7th Cir. 1954), revg. 19 T.C. 1001 (1953). For the following reasons, the rationale in LoBue strongly suggests that at least in the typical independent contractor situation the Court would have reached the opposite conclusion.
In LoBue, the Court emphasized that the. stock options at issue were nontransferable and the employee’s right to exercise them was contingent upon his remaining in the employment of the company. When both of these restrictions are imposed, I think it is clear that the intent of the employer and employee is that the value of the "bargain purchase” made at the time of the exercise of the option, rather than the option itself, will constitute compensation. Through his continued employment, an employee contributes to the appreciation in the value of the stock subject to the option from the date the option is received until the date it is exercised. Thus, in the employee stock option situation there is justification for viewing the "bargain purchase” as compensation. Moreover, where the employee is required to remain in the employment of the company as a condition to exercising the option, there is a real possibility that this condition will not be satisfied and that the option will never even be exercisable. Thus, when such a condition is imposed, it is not inappropriate to defer taxation until the time when the condition is satisfied and the option is in fact exercised.
In contrast, the two factors emphasized in LoBue are not present in the typical independent contractor situation. For example, the corporation herein was not under any obligation to perform services after it received the warrants and, thus, exercise of the warrants could not be made contingent upon continued rendering of services. Although there were various restrictions on the transferability of the warrants and the corporation was generally not allowed to exercise them for a certain period of time, these restrictions were not imposed by the issuers to ensure continued rendering of services but instead were primarily intended to satisfy sec requirements. Therefore, such restrictions do not change the intent of the parties that the value of the warrants themselves constitute the compensation for the services rendered. Moreover, the sole restriction on exercise of the warrants in this case was the lapse of time, a condition which was certain to eventually be satisfied. Thus, the uncertainty as to whether the warrants would become exercisable which was present in LoBue, wherein exercisability was contingent upon future employment, is simply not present here. Finally, since the corporation was not under any obligation to render services after it received the warrants, it certainly could not have been assumed that the corporation would thereafter contribute to any appreciation in the value of the stock subject to the warrants or to the resulting appreciation in the value of the warrants, them-, selves. Thus, to treat any part of that appreciation as compensation income strikes me as being unreasonable and inconsistent with the plain meaning of the phrase "compensation for services” in section 61.
It is also noteworthy that measuring compensation income on the basis of the "bargain purchase” made at the time of the exercise of the option, rather than by the value of the option when it is received, can have substantial harsh consequences. The corporation herein will be forced to include as ordinary income, rather than capital gain, the appreciation in the stock subject to the warrants, even though such appreciation resulted from the steep rise in stock market prices and was wholly unrelated to the services rendered by the corporation. The following example is helpful in understanding the unfairness of this result.
Assume that an attorney performs services worth approximately $1,000 for a client and, instead of cash, is given warrants similar to the ones given to the corporation herein. The attorney performs no further services for the client. If the attorney exercises the warrants when the underlying stock has a fair market value of $50,000, he will, under the majority’s holding, have $50,000 of ordinary income at the time of exercise, even though his services were only worth approximately $1,000 and he never again dealt with the client. Since the $49,000 increase in value had no relationship to the value of the services rendered, I believe the correct and fair result is for taxability to be governed by section 1.61-2(d), Income Tax Regs., under which receipt of the warrants would be the taxable event, with the measure of income being the fair market value of the warrants on the date received. Thus, in my example, the attorney would include $1,000 in ordinary income at the time the warrants were received, and the $49,000 increase in value would ultimately be taxed as a capital gain. Following this rationale, identical tax consequences would result whether the attorney received warrants for his services or, instead, was paid cash which he then used to purchase such warrants.
The majority states (at page 1216) that the policy underlying the valuation rules of section 1.421-6, Income Tax Regs., is to require reasonable accuracy in the valuation of stock options and asserts that such policy is as applicable to independent contractors as it is to employees. Thus, the majority apparently believes that the application of section 1.421-6, Income Tax Regs., to the warrants received by the corporation herein is valid because its purpose is to defer taxability to the time when the value of such warrants can be accurately determined. However, its position is contradicted by its discussion (at pages 1220-1223) concerning the question of when the shareholders must recognize dividend income. Therein, the majority refuses to accept respondent’s argument that, as a matter of law, the rules of section 1.421-6, Income Tax Regs., must be followed in determining the taxability of the shareholders with respect to the distribution of the warrants to them. In so doing, it acknowledges that the warrants may in fact be valued at some time prior to their exercise. If, as the majority implies, the warrants may be valued prior to exercise for purposes of determining taxability to the shareholders, I see no reason why they cannot similarly be valued prior to exercise for the purpose of determining the taxability of the corporation.
Furthermore, the majority states that under Burnet v. Logan, 283 U.S. 404 (1931), "the amount to a shareholder of a dividend of property other than cash will be determined at a later time if, as of the date of the dividend or of the declaration thereof, the fair market value of the property distributed cannot be ascertained.” The majority also acknowledges, and subsequent case law has made it clear, that a transaction will be treated as "open” only in rare and extraordinary cases where the fair market value of the property cannot be ascertained. However, the majority fails to articulate why this might be one of those "rare and extraordinary” cases. I do not believe that the open transaction doctrine of Burnet v. Logan, supra, is applicable to the facts before us. I would conclude, consistent with my previous analysis with respect to the corporation, that the warrants can and should be valued when they were assigned to the shareholders.
Since I would hold that sections 1.61-15 and 1.421-6, Income Tax Regs., are invalid as to options received by independent contractors, and that the corporation and shareholders herein have taxable income upon receipt of the warrants, I respectfully dissent.
Goffe, Chabot, Hamblen, Cohen, and Wright, JJ, agree with this dissent. In note 25 of its opinion, the majority cites several memorandum opinions of this Court. However, in these cases the Court neither applied nor considered the validity of applying the valuation rules of sec. 1.421-6, Income Tax Regs., to stock options received by independent contractors.