This is an appeal from a decision of the Tax Court upholding income tax deficiencies in the amount of $17,482.38 determined by the Commissioner of Internal Revenue for the calendar year 1961
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The decision below is reported in
The facts are undisputed. Taxpayers are husband and wife who file joint tax returns. During the taxable year he owned 100,000 shares of Rapid American Corporation (“Rapid”) common stock. In 1961 he received $37,245.75 in corporate cash distributions. In February 1962, Rapid advised its stockholders that *383 such distributions constituted a return of capital and were therefore non-taxable. In reliance on this information, taxpayers failed to include these sums in their income tax return for 1961.
During the period from January 1, 1957, to January 31,1962, pursuant to restricted stock options, 3 Rapid sold its employees 174,395 shares of its authorized but unissued common stock for $1,889,-360. The fair market value of the stock at the time of issuance was $5,307,206. Taxpayers contend that the $3,417,846 difference between the fair market value and the price received represented compensation to the employees of Rapid and reduced the corporation’s earnings and profits account. Such a reduction wоuld create a deficit in earnings and profits, so that the 1961 distributions from Rapid to taxpayers would be a return of capital and not taxable as dividend income. However, the Tax Court held that
“ * * * the statutory language and legislative history of [Section] 421 [of the Internal Revenue Code of 1954] show that Congress did not intend for the exercise of restricted stock options to generate an еxpense, recognizable or otherwise. Thus, earnings and profits cannot be reduced.”50 T.C. at p. 625 .
The full Tax Court denied the taxpayers’ motion for review. We reverse and remand.
The Internal Revenue Code nowhere defines “earnings and profits.” With few exceptions, the Code contains no guide to the effect of specific transactions upon earnings and profits. A corporation’s earnings and profits are neither equivalent to its surplus nor to its total taxable income. R. M. Weyerhaeuser,
The effect of a transaction upon earnings and profits is not necessarily dependent upon the tax treatment of the transaction in determining net taxable income for a given year. Thus certain items which are excluded from taxable income increase earnings and profits. Treas.Reg. § 1.312-6 (b); R. M. Weyerhaeuser,
In the present case, the first question is whether below market value stock options generally represent economic expense to corporations, thereby reducing earnings and profits. As the Tax .'Court observed here,
“Stock options granted at less than fair market value to employees are sometimes recognized by both the accounting profession and [the Treasury’s] regulations as giving rise to ‘actual’ business expenses of corporations, as opposed to artificial deductions, created solely for purposes of computing taxable income. Cf. Grady, ‘Inventory of Generally Accepted Accounting Principles for Business Enterprises,’ 7 Accounting Research Study 215; Finney and Miller, Principles of Accounting — Intermediate (6th ed. 1965); sec. 1.421-6 (f), Income Tax Regs. Such actual expenses, when recognized for income tax purposes, are generally considered to reduce corporate earnings and profits available for dividends. Cf. Bittker, Federal Income Taxation of Corporations and Shareholders, sec. 5.-04 (1965); sec. 1:312^6(a) and (b), Income Tax Regs.”50 T.C. at p. 624 .
Such options represent a clearly discernible and taxable economic gain to the employee to the extent the stock value exceeds the cost to him. Commissioner' of Internal Revenue v. Lo Bue,
“ * * * if the additional compensation had been paid in cash and the cash had been used to acquire the stock, no question * * * could have been raised as to its deductibility.”3 F. Supp. at 846 .
This point is equally applicable to compensation which is made through the bargain purchasе of stock by the employee on the exercise of his option. Had the compensation been paid in cash and then used to purchase stock, there could be no question that the corporation had incurred a true economic expense which reduced earnings and profits. The amount of corporate assets available for distribution to those who owned stock at the time of the transaction is reduced to the same extent in either case. The economic effect of the two transactions is identical.
The Commissioner has also overlooked the business character and purpose of employee stock options. They represent a form of compensation paid to employees in сonneetion'with successful present and future business performance. They constitute a particularly rewarding form of bonus. They are not distributions with respect to stock and are not comparable to non-taxable pro rata stock dividends. Cf. United States v. Ogilvie Hardware Co.,
The question remains whether Congress intended to prohibit expense treatment in the case of restricted stock options. There is no sрecific language either in Section 421 or elsewhere in the Code to that effect, in contrast to the treatment of wash sales. Cf. Section 312 (f) (1). The Tax Court felt, however, that Section 421(a) (3), limiting the amount received by the corporation to the option price paid for the stock, constituted an expression of Congressional intent that the exercise of restricted stock options results in a purely capital transaction, termed here as an expenditure matched by the receipt of employee good will (
The original purpose of subparagraph (3) was to limit the taxable gain of the corporation to the option price where the stock’s value exceeded that amount. Cf. General Electric Co. v. United States,
The remainder of Section 421 leads us to conclude that this Section was intended to lay down rules relating to the specific income tax treatment of applicable transactions. As the Tax Court concluded, subparagraphs (1) and (2) of Section 421(a) “clearly refer only to the tax treatment of the options for income tax computation purposes.”
The Commissioner contends, however, that the intent of Congress is manifest in the legislative history accompanying the bill as it was originally enacted. To this end he calls attention to the description of Section 130A of the 1939 Code, the precursor to Section 421, contained in ‘Senate Report No. 2375, 81st Cong., 2d Sess. (August 22, 1950), 1950-
“ * * * [Special] treatment is limited to the ‘restricted stock option' for thе purpose of excluding. cases where the option is not a true incentive device. Options which do not qualify as ‘restricted stock options’ will continue to be taxed under existing law.
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“Since the options which qualify for special treatment are regarded as incentive devices rather than compensation, no deduction * * * is allowed the corporation under section 23(a) [of the 1939 Code] with respect to a transfer of stock pursuant to a restricted stock option.”
From this the Commissioner has inferred that Congress wished to alter the fundamental character of stock options so that restricted stock options would be treated entirely as capital transactions, with no effect upon earnings and profits.
This meager legislative history dоes not indicate an intent that restrictive stock options are to be deemed to have such a radically different character from other stock options. The Finance Committee’s rationale for the symmetrical tax treatment of corporation and employee at the time of the option contains no indication of any intended effect on eаrnings and profits. Specific policies calling for nonrecognition of a transaction for income tax purposes do not carry over into the computation of earnings and profits unless the transaction also lacks any real economic significance. Such an extension of the policies of nonrecognition would be both unusual and unwarranted without an exрress statement on the part of the legislature. We feel that Congress would have made an express exception had it wished earnings and profits to remain unaffected by the exercise of restricted stock options under Section 421.
The remarks of the Senate Finance Committee clearly reveal that Section j 421 was never intended to serve more than the narrow purрose of liberalizing' the income tax treatment of stock options to employees. Prior to the passage of the 1950 Act, Treasury Regulations provided that gain realized by the employee on the exercise of his option was *387 taxed as ordinary income. The Finance Committee expressly stated:
“Since the employee does not realize cash incomе at the time the option is exercised, the imposition of a tax at that time often works a real hardship. An immediate sale of a portion of the stock acquired under the option may be necessary in order to finance the payment of the tax. This, of course, reduces the effectiveness of the option as an incentive device.” S.Rep.No. 2375, 81st Cong., 2d Sess., August 22, 1950.
Congress accomplished this narrow objective in Section 421(a) by simply providing for the nonreeognition of the transaction for current income tax purposes. At no time did the legislature express any misapprehension of the nature of the transaction or its economic effect. The treatment of disqualifying transactions prescribed by Section 421(f) (substantially incorporated in the рresent Section 421(b), 26 U.S.C. § 421(b)) clearly demonstrates this fact.
A few lines of inconclusive legislative history and barely consistent statutory treatment are not sufficient to justify disregard of the plain language of the Section. Cf. American Community Builders, Inc. v. Commissioner of Internal Revenue,
On these facts, we agree with taxpayers that the consequences were these: stock having a fair market value of $5,-307,206 was sold to employees for $1,-889,360, resulting in an increase of cash of $1,889,360 and an increase in paid-in capital account of $5,307,206, and a decrease in the earnings and profits account of $3,417,846, which was the value received by the employees in excess of their payments. Looking at substance rather than form, Rapid is entitled to treat the $3,417,846 as an expense, just as if it had paid this amount in cash to its employees. Since Rapid was entitled to reduce its earnings and profits by the amount of this expense, the case must be remanded for consideration of the three subsidiary questions presented and not yet resolved by the Tax Court. 5
Reversed and remanded.
Notes
. The original deficiency was determined to be in the amount оf $24,475.13, based upon the taxpayers’ alleged receipt of $49,666. Since that time, the Commissioner has stipulated that the income in question totaled $37,245.75.
. As defined by Section 421(d) (1) of the Internal Revenue Code in effect during 1961, a “restricted stock option” refers to an employee stock option where the option price equals at least 85% of the then market value. The option is largely nontransferable and must usually be exercised within ten years, normally by an employee owning less than 10% of the stock. The definition is now found in 26 U.S.C. § 424(b).
. The key provisions are found in the following part of Section 421 of the Internal Revenue Code in effect in 1981:
“(a) Treatment of restricted stock options — If a share of stock is transferred to an individual pursuant to his exercise after 1949 of a restriсted stock option, and no disposition of such share is made by him within 2 years from the date of the granting of the option nor within 6 months after the transfer of such share to him—
“(1) no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share;
“(2) no deduction under section 162 (relating to trade or business expenses) shall be allowable at any time to the employer corporation, a parent or subsidiary corporation of such corporation, or a corporation issuing or assuming a stock option in a transaction to which subsection (g) is applicable, with respect to the share so transferred; and
“(3) no amount other than the price paid under the option shall be considered as received by any of such corporations for the share so transferred.”
. See 50 T.C. at pp. 622, 623.