Stock Incentive Units Are Not Capital Assets, Gain Received in Exchange for SIU Rights is Ordinary Income

The taxpayer in the case of Stout v. Commissioner, TC Memo 2015-133 was looking to obtain capital gain tax treatment for the payment he received for the stock incentive units (SIUs) he held in his employer at the time the employer was acquired by another entity.  But it turns out that the fact that SIUs are similar to rights in the stock won’t qualify the taxpayer for capital gain treatment—unlike a game of horseshoes, here close is simply not good enough.

A capital gain is a gain on the sale or exchange of a capital asset. [IRC §1222(1), (2)]  While corporate stock is a capital asset, a right to receive a future payment of ordinary income is not a capital asset. [Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 265-266 (1958); Davis v. Commissioner, 119 T.C. 1, 6-7 (2002)]

So the key question was whether the income that Mr. Stout recognized on this transaction was the sale or exchange of such a capital asset or was it simply a payment to discharge what was his future right to receive ordinary income.

The Court described the SIU program of the taxpayer’s employer as follows:

In January 1995 Pole Zero authorized and instituted a stock equivalent plan (plan) pursuant to which it issued stock incentive units (SIUs) to “full-time salaried employees of the Company who have been employed * * * a minimum of three (3) years and * * * serve in key executive, administrative, professional or technical capacities”.

Pole Zero credited SIUs to accounts maintained for the benefit of plan participants. The value of each SIU was measured by, and adjusted to reflect changes in, the fair market value of a share of Pole Zero common stock. In addition, plan participants received, for each SIU, credits to their plan accounts equal to cash dividends relating to each share of common stock. These dividend equivalents accrued interest.

Stopping at this point, the taxpayer argued that this plan was a §422 incentive stock option plan and that they received stock.  But the problem is that while they received payments that were tied to events economic events related to that stock, they never had any stock.

As the Court continued in describing the plan:

The plan provided that amounts credited to a plan participant’s account “represent only an unsecured promise…to pay in accordance with the terms of the Plan.” Plan participants would not, pursuant to the plan, “acquire any right, title, or interest in any assets of the Company.” Upon a merger or acquisition of Pole Zero, plan participants had the right to receive cash payments equal to the value of their plan accounts.

Thus, the Court held:

The plan provided that Mr. Stout, in consideration for his services, would receive a cash payment on a future date. See sec. 61(a)(1); Downs v. Commissioner, 49 T.C. 533, 539 (1968) (holding that compensation received as consideration for services is ordinary income). The plan did not qualify as a section 422 incentive stock option plan and did not grant Mr. Stout an option to buy or sell any Pole Zero stock. See sec. 422(b) (providing that an “incentive stock option” is an option granted to an individual to purchase the stock of a corporation). Indeed, it expressly provided that participants would not receive any interest in the assets of Pole Zero. Accordingly, the payment to Mr. Stout was ordinary income. See sec. 1222(1), (3); Commissioner v. P.G. Lake, Inc., 356 U.S. at 265-266; Davis v. Commissioner, 119 T.C. at 6-7.

Details matter when attempting to qualify for capital gain treatment and the mere fact that an SIU program may “look” like the participant is holding stock, the reality that no stock is actually issued (and thus that the participant does not possess stock) is crucial to the tax treatment.  Instead, such programs are simply a type of additional compensation to the employee, compensation will be taxed at ordinary income rates.