Perhaps we’re looking into this a bit too much, but we found the Tax Court’s decision this Thursday in Kilker v. Commissioner, 2011-250 to be a bit curious.
In Kilker, the taxpayer (Kilker) was the owner and operator of Allegra Print and Imagining, a printing shop. Kilker was Allegra’s CEO during 2003 and 2004. In 2003, in exchange for providing Zap Corp. (Zap) with printing services, Kilker received 73,529 shares of Zap stock. The stock was restricted stock pursuant to SEC rule 144, meaning Kilker could not sell or transfer the stock for at least 1 year. In 2004, at the end of the 1-year holding period, Kilker sold 30,000 shares for a total of $90,290.
Kilker failed to file a tax return for 2004. The IRS recreated Kilker’s 2004 tax return, and reported the $90,290 as capital gain. The Tax Court agreed:
Section 61(a) defines gross income as all income from whatever source derived. Section 61(a)(3) specifically includes in income gains derived from dealings in property. Respondent argues that petitioner received $90,290 from the sale of 30,000 shares of Zap stock in 2004. To satisfy his initial burden of production with respect to petitioner’s capital gain income of $90,290, respondent provided the Court with a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, and trade confirmations from Edward Jones confirming the information reported on the Form 1099-B. Petitioner has failed to present any evidence to dispute she received this amount or any evidence of her basis in the shares of stock. Accordingly, we sustain respondent’s determination with respect to the capital gain income.
Seems simple enough. But here’s what we’re wondering: Why didn’t the IRS and the Tax Court include the income related to the Zap stock in Kilker’s 2003 tax year,when it was received in 2003, rather than when it was sold in 2004?
When a taxpayer receives stock in exchange for services, the inclusion of the value of the stock in the income of the recipient is governed by Section 83. Generally, stock received in exchange for services is taxable upon receipt for an amount equal to its FMV less any amount paid by the taxpayer for the stock. However, if the stock received is 1) subject to a substantial risk of forfeiture, and 2) not freely transferable, Section 83 defers the taxation of the stock until the stock is no longer subject to a substantial risk of forfeiture and is freely transferable.
In Kilker, the taxpayer received the Zap stock in 2003 subject to SEC Rule 144, which prohibits the sale of the unregistered stock on the public market for 1 year. Now, it may sound like this is a sufficient restriction on transferability to defer income recognition on the receipt of the Zap stock from 2003 (when the stock was granted) until 2004 (when the restriction lapsed under Rule 144 and the stock was sold). However, the District Court of California and the Ninth Circuit have recently held that the restriction on transferability under Rule 144 does not constitute a significant enough restriction to defer income under Section 83, echoing the position tax advisors have adhered to for years based on the general structure and language of Section 83.
In Gudmundsson v. U.S.,107 AFTR 2d 2011-852 (634 F.3d 212), 02/11/2011, the taxpayer (Gudmundsson) received stock options on July 1, 1999 that were subject to several constraints. The Ninth Circuit discussed the Rule 144 element of the constraints as follows:
First, these were “restricted securities” under Securities and Exchange Commission (“SEC”) Rule 144 meaning they were acquired directly from the issuer and not in a public offering, id. Under Rule 144, the Stock could not be sold on a public exchange until the expiration of a holding period that, in Gudmundsson’s case, ended on July 1, 2000. The Stock could, however, be disposed of in a private placement sale or pledged as security or loan collateral.
The Ninth Circuit ultimately concluded that the options were taxable on July 1, 1999, the date of receipt, despite the fact that Rule 144 barred the sale of the options on the public market until July 1, 2000:
The Stock was not subject to a substantial risk of forfeiture on July 1, 1999, and although this is enough for income recognition under Section 83, we briefly address plaintiffs’ arguments regarding the transferability of the Stock, as well. Plaintiffs assert, however, that the Stock was not transferable because “in reality, … [t]he various restrictions imposed by law and agreement made [the Stock] impossible to sell.” Regardless of whether this is true, the argument misunderstands what Section 83 requires. Transferability is not just a question of marketability. In fact, even if sales are prohibited for a period of time, property may be transferable if it can be pledged or assigned.
To summarize, the district court was correct to recognize the Stock as income on July 1, 1999, as the Stock was transferable and not subject to a substantial risk of forfeiture on that day. This conclusion was correct under Section 83(a) and in general, as income in whatever form is taxable in the year in which it is received.
This begs the question: with authority like Gudmundsson out there, why didn’t the Tax Court in its decision in Kilker inlcude the income generated from the receipt of Zap stock in 2003 when it was received? Why did it wait until the stock was sold in 2004?
Clearly, under the principles established in earlier case law, the mere presence of the Rule 144 restriction on the sale of the Zap stock should not have prevented the IRS from including the FMV of the Zap stock in Kilker’s income in 2003. Perhaps there was some other substantial risk of forfeiture that was stipulated between the two parties and was not disclosed in the court documents. Or perhaps by the time the IRS caught wind of Kilker’s failure to file her 2004 tax return, the statute had run on the 2003 return, which apparently was filed. Otherwise, it would seem the IRS missed an opportunity to tax the income in 2003, and potentially increase the amount included in Kilker’s income if the stock price was higher upon receipt in 2003 that upon sale in 2004.