LoBue received options to buy
his employer's stock $5 a share.
A few years later, LoBue
exercised his options to buy 340 shares. It cost him $1700 to buy the
shares, and at the time he bought them 340 shares were selling for $9900
on the open market.
When he filed his taxes LoBue
did not report any of the stock as income. The IRS disagreed and assessed
a deficiency.
The IRS argued that the full
$9900 was compensation for services rendered and so was a classic example
of gross income under the tax code
(then 26 U.S.C. §22(a), now §61(a)).
The IRS also argued that
LoBue should be taxed on the amount he gained when the options were
exercised ($9900 - $1700 = $8200) as ordinary income on the date he exercised the options.
LoBue argued that where a
company gives options to an employee in order to elicit the employee's
loyalty, that this was a "proprietary interest" that should not
be considered compensation.
Basically, LoBue was arguing
that the company wanted LoBue to have an interest in how well the
company did, so they gave him the ability to buy some stock and become a
co-owner.
LoBue also argued that even
if the money was taxable, then he should be taxed on the value of the
options when they were received ($1700) as ordinary income, and that the rest (the $8200) should only be
taxed as long-term capital gain.
The Tax Court found for LoBue.
The IRS appealed.
The Tax Court found that the
stock options had been provided to give LoBue "a proprietary
interest in the corporation, and not as compensation for services."
The Appellate Court affirmed.
The IRS appealed.
The US Supreme Court reversed.
The US Supreme Court found
that all income is taxable unless there is a specific exemption.
The Court noted that the
only possible exemption this could fit under was gift, but it wasn't a gift. Since there was no other exemption it might
fit under, it must be compensation and therefore taxable as ordinary income.
"Since the employer's
transfer of stock to its employee LoBue for much less than the stock's
value was not a gift, it seems impossible to say that it was not
compensation."
The Court found that
compensation is received at the earliest possible time when the fair
market value of the compensation can
be known.
Therefore, the taxable gain
to LoBue should be measured as of the time the options were exercised,
and not the time they were granted. So the entire $8200 was ordinary
income.
