Valley Forge, PA

For AMT purposes, an employee is generally required to recognize income when the employee exercises a stock option to the extent that the fair market value of the stock transferred to the employee exceeds the option price at the time the employee exercises the option.¹ However, if the option is “substantially nonvested” in the employee's hands at the time of grant, taxation is deferred until the option becomes substantially vested, even if the option had an ascertainable fair market value at date of grant.² Similarly, if the option would otherwise be taxed at exercise, but the stock received pursuant to the option exercise is substantially nonvested, taxation is delayed until the stock becomes substantially vested.³ For this purpose, property is substantially vested if it is either transferable or not subject to a “substantial risk of forfeiture.”⁴

This “substantially nonvested” exception to current taxation has been the subject of a substantial amount of litigation fueled by taxpayers' attempts to postpone the date of taxation so that subsequent stock losses can be recognized. One of the arguments posited by taxpayers in recent cases is that stock acquired through the exercise of stock options is “substantially nonvested” if the company's insider trading policy prevents employees from trading the company's stock during certain blackout periods. Is the existence of this type of policy analogous to a company policy stating that an employee is required to sell his shares back to the company if he wishes to sell the stock within one year of the option exercise? In Robinson v. Comr.,⁵ the First Circuit held that this type of sellback provision did, in fact, create a substantial risk of forfeiture. Although the purpose of blackout periods is similar to the purpose behind a sellback provision (prevention of insider trading), the appellate courts view them quite differently. In both Merlo v. Comr.⁶ and U.S. v. Tuff,⁷ the courts rejected the taxpayers' arguments that the existence of the blackout periods caused the stock to be subject to a substantial risk of forfeiture. The Merlocourt specifically distinguished the Robinson case by pointing out that the company's remedy, if the employee violated the insider trading rules, was disciplinary action against the employee and not a forfeiture of the shares. A restriction on an employee's ability to transfer the shares is not enough to show a substantial risk of forfeiture. Therefore, the employee is taxed for AMT purposes upon exercise of the options.

The taxpayers in both the Merlo and Tuff cases offered additional arguments to persuade the court that taxation should be deferred. In the Merlo case, the taxpayer argued that the fact that the company could, if the insider trading rules were violated, bring suit against the employee for disgorgement of profits, amounted to a substantial risk of forfeiture. The court rejected this argument. It is important to note here that the Code does provide that a substantial risk of forfeiture exists if a sale of property would subject an individual to suit under Section 16(b) of the Securities Exchange Act of 1934.⁸ However, if the employee is not an executive to which Section 16(b) applies, the threat of a civil suit that could be brought against that employee would not be sufficient to create a substantial risk of forfeiture. In other words, unless Congress amends the Code, an employer's right to compel the disgorgement of the profits from the sale of stock creates a substantial risk of forfeiture only when the employer could bring suit under Section 16(b).

The taxpayer in the Tuff case tried yet another way around current taxation, arguing that no transfer of the stock occurred when the options were exercised because he paid for his options with borrowed money, using debt secured by the stock. Therefore, according to the taxpayer, none of his capital was at risk and no transfer occurred. The court rejected this argument as well, distinguishing this set of facts from the case in which an employer “sells” stock to an employee in return for a note without personal liability. In the Tuff case, the company transferred the stock to the taxpayer and was paid in full. The fact that the taxpayer borrowed the money to pay for the stock was irrelevant to the issue of whether a transfer occurred.

These recent cases indicate, once again, that despite ingenuity and creative argument, it is very difficult to prevail when trying to avoid the AMT tax on the exercise of stock options.

For more information, in the Tax Management Portfolios, see Starczewski, 587 T.M., Noncorporate Alternative Minimum Tax, and Utz, 384 T.M., Restricted Property -- Section 83, and in Tax Practice Series, see ¶3410, Alternative Minimum Tax on Noncorporate Taxpayers.