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David Kahen[/caption] Though (as of this writing) the United States appears to be on the verge of substantial changes to its income tax, certain basic rules that have been reflected in the Internal Revenue Code for many years appear likely to survive. One of those rules is that a loss from the sale or exchange of a capital asset cannot be used to offset ordinary income, apart from a de minimis amount of not more than $3,000 for individuals (IRC §1211(b)). Further, the circumstance that income and loss attributable to the acquisition and disposition of a capital asset (such as stock) arise out of what may appear to be, from a business person’s perspective, a single overall transaction, does not necessarily prevent a taxpayer from being in the unfortunate situation of recognizing (1) ordinary income and (2) a capital loss that cannot be offset against such income. A common example of such a mismatch of character of income and loss involves the exercise of compensatory stock options and immediate sale of the stock so acquired. The potential for both ordinary income and capital loss in such situations is illustrated by the recent Court of Federal Claims decision in Hann v. United States, 133 Fed. Cl. 559 (2017), discussed below.
Facts in ‘Hann’
Gregory Alan Hann (Hann or the plaintiff) was executive vice president and chief financial officer of Wesco Aircraft. In 2009, Hann received, in connection with his employment, options to purchase common stock of Wesco, which was a privately held corporation at that time. A prospectus for an initial public offering (IPO) was filed with the U.S. Securities and Exchange Commission in July 2011 (the year at issue) providing for the sale of stock by the two primary stockholders of Wesco. The company advised its employees that they could exercise their stock options (to the extent then exercisable) and sell the stock so purchased in the IPO. However, each employee who participated in the IPO in this manner would have to pay or bear an underwriter’s discount or commission. At the time of the IPO, Hann’s options related to 356,558 shares and his exercise price was $6.293333 per share. The public offering price would be $15 per share. Hann was not required to exercise his options and sell stock in the IPO. He could refrain from exercising his options at that time, or could exercise but not sell the stock so acquired. Under a lock-up agreement, however, Hann was precluded from selling shares of stock of Wesco during a lock-up period of 180 days after the IPO, other than through the IPO. Hann decided to exercise some of his options and to sell the shares so purchased in the IPO. Under a so-called “cashless exercise” procedure, Hann signed various documents that authorized exercise of his options, the immediate sale of stock so purchased to the lead underwriters, and the withholding from the sale proceeds of the exercise price. The opinion states that Hann sold the stock so acquired to the underwriters for $14.1375 per share, equal to the public offering price minus the underwriter’s commission of $0.8625 per share. (It is not entirely clear whether the underwriters purchased his shares as principal, or acted as agent in facilitating the sale of his shares in the IPO.) The gross proceeds from the sale of the 89,139 shares Hann purchased under the options was $1,337,085, and he received and retained that amount minus the sum of the associated option exercise price ($560,981) and underwriter’s commission ($76,882). Wesco issued to Hann a Form W-2 for 2011 that reported ordinary income from the IPO of $776,104, being the excess of the fair market value of the shares he acquired pursuant to exercise of the options based on the public offering price (89,139 x $15 = $1,337,085) over the option exercise price (see IRC §83(a)), and his 2011 tax return was timely filed reflecting that amount as ordinary income. Upon the exercise of a compensatory stock option, the basis of the person exercising the option in the stock so acquired is, generally, the sum of the exercise price paid for the stock and the amount included in gross income by reason of exercise (Reg. §1.61-2(d)(2)(i)). Accordingly, the basis for the stock purchased by Hann was the sum of the option exercise price of $560,981 and the $776,103 included in income, or $1,337,085. The stock was sold by Hann for an amount realized of $14.1375 per share, or $1,260,203. Consistent with these calculations, Hann’s 2011 tax return also reported a short-term capital loss of $76,882. Hann filed an amended tax return on April 19, 2012, that treated the underwriters’ commission as a reduction of gross income from the exercise of the option, and sought a tax refund on that basis. The IRS denied the claim for refund and Hann timely filed suit in the Court of Federal Claims. Cross-motions for summary judgment were made by the parties.