Taxpayer Suffers One-Two Punch on Stock’s Decline

The Court of Appeals for the Seventh Circuit rejected a taxpayer’s argument that margin loan financing of nonstatutory employee stock options rendered her exercise of the options not a taxable transfer within the meaning of IRC section 83.

Under section 83, non-cash compensation, such as shares of stock, is taxable when it is transferred to the recipient, which according to Treas. Reg. § 1.83-3(a)(2) does not occur for an option until it is exercised.

Between March and July 2000, Gail K. Racine exercised options to purchase 25,257 shares of the stock of her employer, Allegiance Telecom Inc. Based on Racine’s estimated gain of over $1.9 million, Allegiance remitted $625,000 in income tax and withheld clear title for the shares until Racine reimbursed it for the taxes. Racine borrowed $684,000 on margin to cover the tax and the $58,000 exercise price. Soon thereafter, the market price of the stock declined, triggering a margin call for Racine. She sold stock in November 2000 and again in May 2001 to cover the margin, retaining 4,500 shares. However, because of the market’s decline, Racine’s real gain was now $366,070 (stock sales of $332,881 and remaining shares worth $92,000, less purchase price of $58,811), instead of her taxable gain of $1.9 million.

Racine’s remedy was to claim a $368,000 refund on her 2000 tax return, based on the assertion that the shares had not been transferred to her at the exercise date but rather when sold.

The tax refund was granted, but an audit of Racine’s tax return determined that the refund was made in error, and she was assessed $514,000 in taxes and interest. The Tax Court—affirmed by the Seventh Circuit—held that a transfer occurred when the options were exercised because Racine then acquired full legal and beneficial ownership of the shares. The Seventh Circuit acknowledged it was unfortunate for Racine that rather than selling at the exercise date (when the market price was over $78) or utilizing a hedging strategy to mitigate risk, she sold most of her shares in two transactions after the price had dropped by 74% and 80%, respectively.

The taxpayer cited Example 2 in Treas. Reg. § 1.83-3(a), which indicates that exchanging a non-recourse note for stock (buying stock with money borrowed from the broker) is not a taxable event because the taxpayer has nothing at risk and can walk away, allowing the broker to sell the collateral to cover the loan. Racine’s note contract, however, explicitly held her personally liable for the full amount, the Seventh Circuit noted. Thus, she was mistaken in characterizing the margin loan as non-recourse debt, the court held, saying the example more accurately describes a call option.

The Tax Court has consistently rejected the taxpayer’s line of reasoning. Three other circuits have held against taxpayers in similar cases.

Robert C. and Gail K. Racine v. Commissioner, 100 AFTR 2d 2007-5087.

Prepared by Alice A. Upshaw , CPA, MPA, instructor of accounting, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.