Employee Could Not Deduct Commissions Paid on Same Day Sale from Stock Option Exercise as Ordinary Loss

In the case of Hann v. United States, Court of Federal Claims Case No. 15-20T, the taxpayer in question was seeking to claim an ordinary loss from aportion of the underwriting commissions paid when he elected to participate an initial public offering (IPO) of his employer’s stock. 

Under the terms of participation, Mr. Hann had to agree to dispose of the same proportion of all stock and stock rights he held as the primary shareholders were selling, which required him to exercise his vested and exercisable stock options to comply with that requirement if he wanted to participate. 

When an employee is granted stock options by an employer as part of his/her employment, there is no current tax on the value of the option if the option has no readily determinable fair market value.[1]  Rather, in that case, the excess of the fair value of the stock at the time of exercise over the exercise price paid by the employee is taxable to the employee at the time of exercise as ordinary income.[2]  That income in reported by the employer on the employee’s Form W-2 for the year of exercise.

When the stock is sold, any amounts paid to effect that sale are treated as a cost of sale, with commissions being a clear example of an expense that was paid to enable a sale to take place.  Thus, if an employee who exercises a stock option instantly sells the option at the same value that was used to value the stock in computing the ordinary income component, the employee will end up with a short-term capital loss that would be equal to the commissions and any other costs of sale that were also incurred. 

The sale and loss end up flowing through Schedule D.  If the taxpayer has no capital gains, and the loss exceeds $3,000, only $3,000 of that loss may be deducted in the current year.[3] 

In many cases employees exercising such options do so via a “cashless” exercise.  In that situation, the strike price is paid for by having a sufficient number of shares sold to pay the exercise price.  Since the wages are subject to withholding, it’s also likely going to be required to sell shares to pay the withholding tax.  As well, in a large percentage of these cases all remaining shares are also sold immediately.

In such a case where a significant portion of the costs of sale are not deductible in the current year, an employee faces paying tax on an amount that is far in excess of what he/she received as cash from the exercise.  It was just such an “unfair” result that brought Mr. Hann’s case before the court to challenge the IRS.

Mr. Hann had several different theories to attempt to justify his ability to claim, either directly or via a reduction in wages indirectly, that he should be able to claim an ordinary deduction for the commissions he paid on the transactions that were a same day sale of his stock options.  Sadly for Mr. Hann, the court did not accept any of his theories.

Mr. Hann argued that, under the agreement to participate in the IPO, he had no option but to exercise all the outstanding options and then immediately sell a fixed proportion of those on the market.  He argued that this was a single transaction, and to tax it as if there were two separate transactions is not appropriate under the law.  Since never actually received the stock, nor did he have an option to do so, the commissions never actually represented income to him.

One problem with Mr. Hann’s argument was that it was only because he wanted to participate in the IPO that he had this “single transaction.”  Nothing prevented him from simply exercising the shares and continuing to hold the—but if he did so, the “lock up” requirements of the IPO would not allow him to sell those shares for another 180 days.

The Court noted:

While Mr. Hann’s participation in the IPO did not entitle him to retain common stock upon exercising his options, in order to participate in the IPO, Mr. Hann needed to acquire Wesco shares via his options and then immediately resell the shares to the Underwriters. Holland Dep. 12-13, 15-17. Mr. Hann held legal — if not physical — ownership of the shares when his Attorneys exercised the options on his behalf. Id. at 19, 29-30. Only after Mr. Hann gained legal ownership of the shares could his Attorneys sell those shares to the IPO Underwriters. The short duration of Mr. Hann’s legal ownership of the Wesco shares did not alter the tax consequences of his ownership and sale of the stock. The acquisition of Wesco stock pursuant to his stock options followed by the immediate resale of the Wesco stock to the Underwriters was necessarily a two-step transaction. That Wesco agreed to accept payment of the exercise price directly from the Underwriters does not change the taxable steps taken by Mr. Hann.

In a similar vein, Mr. Hann argued that because he could not have exercised the options at that point without paying the commissions, the commissions were either an “amount paid” to exercise the option under IRC §83 (that is, effectively part of the exercise price) or be capitalized in the basis of the shares received under IRC §1012 (as an acquisition cost).  In either case, Mr. Hann argued this should reduce the ordinary income that Mr. Hann recognized upon the receipt of the shares.

The Court also rejected this view.  As the opinion notes:

Plaintiffs’ theory fails because payment of the Underwriters’ commission was not required for Mr. Hann to exercise his options, but was compensation to the Underwriters for valuing and establishing a public market for Wesco stock for the IPO. Contrary to Plaintiffs’ assertions, Mr. Hann could have exercised the options without paying the Underwriters’ commission, as restricted by the lock-up agreement. IPO participation was separate and distinct from Mr. Hann’s ability to exercise his options. Rather than effect a cashless exercise, Mr. Hann was entitled to exercise the options, pay the exercise price, and retain ownership of the option shares in Wesco. See Wesco Dep. at 22; Holland Dep. 15. Mr. Hann could have waited until the expiration of the lock-up period to sell his Wesco shares so acquired. Joint Stip. 15. Paying the Underwriters’ commission was only a condition precedent to Mr. Hann’s participating in the IPO, it was not a condition precedent to his exercising the options.

Another ordinary deduction allowed to taxpayer would be any trade or business expense under IRC §162.  This would not likely be the optimal way for Mr. Hann to obtain a deduction in this case since such deductions, incurred as an employee (which he was) is subject to the 2% of adjusted gross income “haircut”[4] and the item would not be deductible in computing the alternative minimum tax.[5]  But that could still be better than only getting a $3,000 deduction, so Mr. Hann argued that a deduction for a business expense should be allowed.

While the Court acknowledged that Mr. Hann was in the business of being an employee for the company in question it noted:

An individual who is both an employee and shareholder must acknowledge that dual status and separately determine the tax consequences of each activity. See United States v. Generes, 405 U.S. 93, 100 (1972)(a “taxpayer’s dual status relative to the corporation . . . [as] both a shareholder and an employee . . . occasion different tax consequences.”). Expenses associated with one’s trade or business as a corporate executive are deductible as a trade or business expense. But expenses incurred in one’s capacity as a shareholder, where profit comes from appreciation in the value of business and distributed earnings, must be allocated to one’s capital interest in the corporation.

The Court applied this rule and found:

Because Mr. Hann was not in the trade or business of selling securities, Plaintiffs cannot deduct as a trade or business expense commissions paid to sell securities. Instead, the expenses Mr. Hann incurred selling his capital interest in Wesco may offset the amount Plaintiffs realized in the transaction. Spreckles, 315 U.S. at 630.

So, Mr. Hann went for one final argument—that the substance of the transaction was that he was paid an amount that did not include the commission, even if the form was two separate transactions (an exercise of the option followed by the sale of the resulting stock).  Mr. Hann argued that, because of this, the doctrine of substance over form required the Court to only tax him on the net proceeds rather than separately recognize the two transactions.

However, Mr. Hann is fighting against the current in this case—it is very difficult for a party to the transaction to succeed in a substance over form argument.  Presumably Mr. Hann was (or should have been) aware of the form of the transaction when he agreed to enter into it.  Only in rare cases does the Court allow a party to the transaction to overcome the form to get a better result by looking at the substance—and this was not one of those cases.

The opinion concludes:

Plaintiffs make a purported “substance over form” argument, positing that the “true economics of the transaction” should be reflected in the tax result, allowing them to offset their ordinary income. Plaintiffs argue that “[t]he income generated to the [P]laintiffs is ordinary income and there is no situation in which the exercise of these options could be treated as a capital gain[,] therefore the expenses required to generate this ordinary income should be ordinary in nature as well.” Pls.’ Mot. 5. Plaintiffs’ focus on the ordinary income generated by the option exercises ignores the second transaction and the economic reality that Mr. Hann sold his Wesco shares and opted to participate in the IPO. The IPO participants including Mr. Hann paid the Underwriters’ commission in order to sell their shares to the Underwriters, not in order to exercise their options. In short, the true economics of the transaction reflected are in the tax result Plaintiffs received.

[1] IRC §83(e)(3)

[2] IRC §83(a)(1), Reg. §1.83-7(a)

[3] IRC §1211(b)

[4] IRC §67(a)

[5] IRC §56(b)(1)(A)(i)