Exercise of stock options results in taxable income and compensation deduction.

• Author: Beavers, James A.

The IRS held that a taxpayer's cashless exercise of stock options resulted in taxable income to the taxpayer and a compensation deduction for the company that issued the options.

Background

Allen Davis was a shareholder in CNG Financial Corporation (CNG), an S corporation founded by his son Jared that owned a subsidiary that engaged in the payday loan business. In return for loans from Allen, CNG issued him stock options, which he exercised in 2000. At the time of the events at issue in the case, Jared was president and CEO of CNG, but Allen had previously served in that capacity. After he resigned as president and CEO, Allen continued to serve as an independent consultant to the company and participated in its day-to-day management. Under a large credit agreement with a bank syndicate, CNG would be in default of the agreement if Allen did not continue to participate in CNG's activities. The credit agreement was CNG's principal source of outside financing, and a default on the agreement would have put a halt to CNG's rapid expansion plans for its business.

In 2001, Allen's wife, Judith, filed for divorce. The divorce was acrimonious, and in the proceedings Judith sought half of Allen's stock in CNG. Allen threatened, on numerous occasions, to leave CNG if his ownership interest was reduced, which would have put CNG in default of its credit agreement. Jared, in an effort to end the conflict and avoid default, forced Allen and Judith to agree to a plan in which Allen transferred half his stock to his wife, but ultimately ended up with an option with a cashless exercise provision to repurchase the shares.

Allen exercised this option in 2004. CNG treated the stock issued to Allen through the exercise as compensation, and CNG took a $36,962,694 compensation deduction on its return for 2004 (based on the value of the stock received, calculated under a formula included in the cashless exercise provision of the stock option). This deduction was passed through to CNG's shareholders, which (other than Allen) included Jared, his brother David, and a third man (the other shareholders). However, Allen did not treat the exercise as taxable and did not include the stock's value in his gross income for 2004.

Because Allen and the other shareholders took inconsistent positions with respect to the stock Allen received through the option exercise, the IRS issued whipsaw deficiency notices, based in Allen's case on an understatement of income due to his...