In Gudmundsson v US, 107 AFTR 2d 107 AFTR2d ¶2011-456 (2nd Cir. 2011) the Court of Appeals for the Second Circuit has affirmed a district court decision which dismissed the taxpayers’ claim for refund in tax based on an alleged overvaluation of stock one of the spouse’s received under an incentive (employee) stock option plan where the stock subsequently precipitously fell in value. The lower court found that since the stock received had "vested" for purposes of §83, i.e., the stock was transferable and not subject to a substantial risk of forfeiture on the date of receipt, there was no rule in §83 that would permit the taxpayer to defer the recognition date or the proper time for valuing the stock until a later date.
The taxpayer was an office of a Midwest food concern and was a participant in an incentive stock plan. Under the plan he received the right to the distribution of approximately 73,000 shares of employer stock as part of an IPO of the company. The IPO was effectuated in July, 1998. Under the terms of the plan, the taxpayer was issued and received the shares of stock on July 1, 1999. The taxpayers 1999 return, consistent with the Form W-2, reported that the taxpayer, Olafur Gudmundson, received stock worth $1.3M. This is due to the rules underlying §83 that vested stock received for services is valued for federal income tax purposes on the date of receipt. re not subject to a substantial risk of forfeiture. The stock received was still subject to certain resale restrictions imposed by securities laws and internal agreements.
By the end of 1999, the value of the publicly traded shares fell by over 26%. A further drop in value to 50% of the IPO value occurred in February 2000. Claims of alleged mismanagement of the Company resulted in the filing of indictments in early 2001 against the former officers of the Company who eventually entered guilty please for securities fraud and related charges.
The taxpayers filed an amended return within the 3 year period for filing a claim for refund the taxpayer claimed was due for an alleged overpayment of tax of approximately $300,000 plus statutory interest for 1999. The argument made by the taxpayer that the stock he received on July 1, 1999 should have valued at the market price at the end of the year instead of based on the stock price on date received. The IRS rejected the claim and the taxpayers filed a refund suit in Federal District Court. 104 AFTR 2d 2009-7093.
The District Court rendered a summary judgment and stated that the taxpayer failed to show that the stock was not "vested" for §83 purposes as of July 1, 1999. The Court of Appeals for the Second Circuit examined the timing and valuation issues involved in the case. First it rejected the argument made that the risk that the taxpayer could lose his job did not defer or postpone the proper date for including the value of the stock received in gross income. Such possibility did not constitute under the facts of the case a "substantial risk of forfeiture". What the taxpayer failed to prove was that the stock would be forfeited, not simply the taxpayer’s job. The Court further held that the taxpayer’ claim that he was potentially running the risk of a fraud action filed by the SEC constituted a a substantial risk of forfeiture. However, §83(c)(3) blocked this approach since its application is limited to civil suits other than those brought under §16(b) of the 1934 Securities Act. The Court found that the stock received was transferable under §83.
On the stock value, the taxpayer was held to have failed to offer any legal basis for not valuing the stock received on July 1, 1992 and not some later date. For purposes of §83(a), property received [for services] is valued at its "fair market value (determined without regard to any restriction other than a restriction which by its terms will never lapse)". The taxpayer failed in his effort to convince the appellate court that the trial failed in determining fair market value by not reducing the IPO value by restrictions imposed on him with respect to transferring the shares and lack of marketability. Here such issues were limited in duration and thus were property rejected.