Harold S. Divine and Rita K. Divine v. Commissioner of Internal Revenue

FRIENDLY, Circuit Judge

(concurring and dissenting) :

I agree wit! so much of Part II of the majority opinion as holds that one taxpayer should not be allowed to use a previous determination of an issue of federal tax law adverse to the Commissioner in a proceeding involving another so as to preclude the Commissioner from pressing the point again, even when, as here, the facts are identical. I base this on special factors relating to federal tax litigation, well described in my brother Waterman’s opinion, which make the application of Zdanok v. Glidden Co., 327 F.2d 944 (2 Cir.), cert. denied, 377 U.S. 934 , 84 S.Ct. 1338 , 12 L.Ed.2d 298 (1964), inappropriate in this context. I would leave open the possibility of issue preclusion in a tax case where the earlier decision turned on the resolution of a complex common issue of fact. 1 And I see no occasion for extended dicta on the limits of Zdanok outside the federal tax field.

I agree also with the majority’s rejection of many of the Commissioner’s arguments on the merits. Nevertheless, I think that the Tax Court was right in Sid Luckman, 50 T.C. 619 (1968), and in its unanimous decision here, 59 T.C. 152 (1972), and that the Seventh Circuit erred in reversing in Luckman v. C.I.R., 418 F.2d 381 (7 Cir. 1969).

The question in this case reduces to whether the “opportunity cost” incurred by Rapid in issuing the stock to the employees at less than its current market value rather than selling it to others is cognizable for purposes of reducing *1058 earnings and profits. There can be no claim that Rapid incurred out-of-pocket costs such as to reduce the earnings and profits available for distribution, to shareholders. Indeed, as an accounting matter, far from reducing proprietorship on Rapid's balance sheet, issuance of the shares here in question added $2,044,748 to capital and paid-in surplus. 2

With all deference, I think the question can only be answered in the negative. See Note, Employee Stock Options : The Effect Upon a Corporation’s Earnings and Profits, 33 Md.L.Rev. 190, 207-08 (1973). Apart from the absence of evidence that Rapid could have sold the optioned stock at the market prices on the respective days of issuance, or would have done so, precisely the same sort of “cost” is incurred on the exercise of a warrant at a price below current" market value, where no one suggests that this spread can be deducted from earnings and profits. The fact that here the options were issued to provide “incentive” to employees is not sufficient to support a different result. Selling stock at less than current market value does not impair the corporation’s ability to make distributions without invading capital or paid-in surplus, which is what “earnings and profits” are mainly about. The effect of the exercise of an option, whether issued to an employee or to an outsider, at a “bargain spread” is to decrease the market price 3 and, in some but not all instances, the book value of the shares of other stockholders. It has no adverse effect on the corporate accounts.

The petitioner’s principal reliance is on two revenue rulings that, despite the general provision of § 1032(a) prohibiting recognition of gain or loss on a corporation’s receipt of money or property in exchange for stock (including treasury stock), a corporation may deduct as a business expense under § 162 the fair market value of stock issued as compensation, whether the stock be treasury or theretofore unissued stock, Rev.Rul. 62-217, 1962-2 Cum.Bull. 59; Rev.Rul. 69-75, 1969-1 Cum.Bull. 52, with the presumable consequence that the same amount may be deducted from earnings and profits. Not only were these payments clearly compensation and nothing more, but the rulings can be rationalized on the basis that since the employee was subject to tax on the fair market value of the stock issued, allowing the deduction to the corporation was necessary to avoid unfairness. The latter is also the explanation given by the Tax Court in its opinion here, rather persuasively in my view, for the Regulation 1.421-6(f), allowing a deduction for the excess of fair market value over option price of stock issued pursuant to unrestricted stock options. Compare Union Chemical & Materials Corp. v. United States, 296 F.2d 221, 224-225 , 155 Ct.Cl. 540 (1961), reasoning from C.I.R. v. LoBue, 351 U.S. 243 , 76 S.Ct. 800 , 100 L.Ed. 1142 (1956). By contrast, in the case of restricted stock options such as that before us, the employee escapes regular income taxation both when the option is issued and when it is exercised. There is therefore no reason to disregard the general principle of allowing no deduction, either from income or from earnings and profits, for mere loss of “opportunity costs.”

In substance § 421 represented a trade-off. In return for the eagerly *1059 sought privilege of tax-free receipt and exercise of stock options by executives, the corporation would forego any deduction under § 162 for the excess of the market value of the stock, when issued, over the option price. In light of the enthusiasm of corporations, perhaps more accurately of corporate managements, for the tax-free stock option, I find the majority’s discovery of a Congressional fear that imposing the “further disadvantage” of not allowing the bargain spread as a reduction in earnings and profits — an issue which apparently has arisen only in this one reported case in 24 years 4 — would “discourage use of statutory stock options altogether” a bit risible. Although I agree with the majority that Congress was not so naive as to ignore that restricted stock options had features of compensation, 5 see, e. g., S.Rep.No.2375, supra, at 59-60, the essence of the § 421 trade-off was that they were to be treated as if they did not. There can be no fair doubt that the Congress that expressly ruled out use of the “bargain spread” to employees as a deduction would also have forbidden its use to reduce earnings and profits if it had ever considered the problem whether the “bargain spread” should enable the corporation to make a later distribution to stockholders as out of capital rather than from earnings and profits in the unusual case where this possibility might exist. Since general principles of accounting and tax law combine in leading to a negative answer, the courts ought not to strain to provide a bonanza in this unusual but nevertheless important case but should carry out the evident purpose of Congress. “Its laws are not to be read as though every i has to be dotted and every t crossed,” United States ex rel. Knauff v. Shaughnessy, 338 U.S. 537, 548-549 , 70 S.Ct. 309, 315 , 94 L.Ed. 317 (1950) (dissenting opinion of Mr. Justice Frankfurter). The much quoted remark of Mr. Justice Holmes in Johnson v. United States, 163 Fed. 30, 32 (1 Cir. 1908), is also applicable here.

I would affirm the judgment of the Tax Court.

. For example, if in a case like this, the previous taxpayer had asserted a higher and the Commissioner a lower fair market value of the stock and another court had decided against the Commissioner.

. In contrast, a cash payment to the employees of the “bargain spread” would have reduced surplus and, to the extent that this was insufficient, capital by $3,626,372. This alone is enough to place in question the Seventh Circuit’s reliance on the analogy to compensation “paid in cash and then used to purchase the stock.” 418 F.2d at 384 . Moreover, unless the employees were required to invest the payments in corporate stock, a requirement which would call into question the reality of the whole arrangement, compare Turner v. C.I.R., 303 F.2d 94, 97-98 (4 Cir.), cert. denied, 371 U.S. 922 , 83 S.Ct. 289 , 9 L.Ed.2d 230 (1962), the attempted analogy does not pay adequate deference to the stated purpose of § 421 to promote stock , ownership by employees. See, e.g., S.Rep.No. 2375, 81st Cong. 2d Sess. 59-60 (1950).

. In fact this will already have been affected by the known possibility of exercise of the options.

. As a practical matter, the problem will only arise with the somewhat unusual combination of a rather low amount of earnings and profits and a large rise in market price after issuance and before exercise of the options.

. Despite language in C.I.R. v. LoBue, supra, at 247 , 76 S.Ct. 800 ; see also Union Chemical & Materials Corp. v. United States, supra, 296 F.2d 221 at 224-225 , it would not have been difficult for Congress to have considered that bargain spread in particular —as distinguished from the institution of the stock option in general — is not in fact predominantly compensatory in nature. The compensation aspect of a restricted stock option is most prominent at the time of issu-anee of the option. By the time of exercise, on the other hand, which the LoBue Court assigned for evaluation of the amount of compensation simply because it is not practical to make the evaluation earlier, the investment aspect of the option has become dominant. Indeed, the very unpredictability of what the bargain spread will be when the option is awarded makes it difficult to look on that sum as having been assigned as compensation ; and this difficulty is accentuated by the fact that, as Judge Waterman accurately observes, the predecessor of § 421, as enacted in 1950, did not require that the employee “remain in the employ of the employer for even one day after acquisition of the option.”