The Ninth Circuit Court of Appeals has reversed and remanded a district court opinion that had permitted a taxpayer to defer recognition of income from the exercise of nonqualified stock options (NSOs) that vested over a period of four years. However, the decision is unlikely to be the last word in interpreting a complex statutory provision that intersects federal tax and securities laws.
Under the rules of Section 83 of the Internal Revenue Code (IRC), employees generally do not recognize income upon the grant of options to acquire stock. Instead, for regular federal income tax purposes, income is recognized in the case of NSOs when the stock options are exercised and in the case of incentive stock options (ISOs) when the stock acquired upon exercise of the options is sold. For alternative minimum tax purposes, however, income is generally recognized in the case of both NSOs and ISOs when the options are exercised.
Under a special IRC rule in Section 83(c)(3), income that would otherwise be recognized upon exercise of a stock option is deferred “so long as the sale of property at a profit could subject a person to suit under Section 16(b) of the Securities Exchange Act of 1934.” Liability to disgorge short-swing profits under Section 16(b) arises when there is either a “purchase and sale” or a “sale and purchase” of securities by certain corporate insiders within a six-month window period. Under a 1991 amendment to the Securities and Exchange Commission (SEC) rules governing Section 16(b), the date a stock option is acquired—rather than the date stock is acquired through exercise of an option—was determined to be the relevant acquisition measurement date for imposition of Section 16(b) liability. The 1991 SEC rule amendment, however, did not specify whether a distinction should be made between the grant of an unvested option (an option that cannot be immediately exercised) and the grant of a vested option in determining when a “purchase” had taken place.
In a case of first impression, the district court decision in Strom had held that the taxpayer was entitled to defer recognition of income from the exercise of a recently vested stock option when “a suit to recover profits earned through the sale of stock within six months of the option vesting date would not have been frivolous.” The Ninth Circuit has now reversed that decision on the grounds that the appropriate standard should be whether there is “an objectively reasonable chance” that a Section 16(b) suit would have succeeded, noting that this standard “roughly equates to the determination of whether a reasonably prudent and legally sophisticated person would not have sold their stock” because of the possibility of Section 16(b) litigation.
Like the district court, the Ninth Circuit rejected the taxpayer’s argument that the vesting of an NSO was a “purchase” for Section 16(b) purposes that marks the inception of a six-month period of potential short-swing profit liability. The court reasoned that an unvested NSO was indistinguishable from unvested stock, the transfer of which the SEC had indicated it considered to be a “purchase” for Section 16(b) purposes. In reaching this conclusion, the Ninth Circuit distinguished a prior district court holding that had suggested that the vesting of an NSO could be a “purchase” for securities law purposes and rejected the taxpayer’s argument that the economic interests represented by an unvested option and unvested stock were quite different.
In discounting the legal significance of vesting, the Ninth Circuit appeared to rely solely on its interpretation of the SEC release accompanying the 1991 amendment without analysis of any regulations or other guidance provided by the IRS. Although not directly on point because it relates to ISOs, Treas. Reg. 1.421-1(c), for example, indicates that the vesting conditions accompanying the grant of an option may, in many circumstances, be viewed as a condition precedent for the grant of the option itself. Although the Ninth Circuit recognized that the incorporation of securities law principles into the Internal Revenue Code “makes for strange bedfellows,” its opinion never inquires what policies are served under either body of law by the interpretation it adopted.
After finding for the government on the above issues, the court nevertheless reversed and remanded the case for a determination on whether the existence of the “pooling-of-interest accounting” rules constituted separate grounds for the taxpayer to defer the recognition of income in the case of NSOs exercised before a merger. The district court had held as a matter of law that these accounting rules applied only to post-merger sales of stock and therefore did not defer income recognized upon pre-merger exercises of NSOs. Because the “pooling-of-interest accounting” rules were repealed in 2001, the outcome of this remand will not be helpful to taxpayers in planning future transactions.
In summary, the latest Strom decision precludes taxpayers from arguing that potential 16(b) liability permits them to defer income for any period of time upon the exercise of an NSO. Because only in rare circumstances would an unvested NSO be exercised within six months of the date of its grant, the potential for 16(b) liability and for income deferral would (in the view of the Ninth Circuit) likely have come and gone before—perhaps even years before—the NSO was exercised and the opportunity to recognize a short-swing profit from the sale of the underlying stock ever arose. Whether this holding is a correct interpretation of tax law, or even of securities law, may be challenged in future litigation.