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HARRISON v. UNITED STATES

July 24, 1979

BRIAN G. and MAUREEN HARRISON
v.
UNITED STATES OF AMERICA



The opinion of the court was delivered by: LUONGO

This suit presents a challenge to the aforementioned method of valuation. Applying the principles prescribed by § 1.57-1(f)(3), the Internal Revenue Service (IRS) determined that the plaintiff-taxpayer *fn2" had received an item of tax preference in 1971 and assessed a deficiency. Plaintiff paid the assessment, filed a timely claim for refund, and after six months had elapsed without agency action, instituted this suit pursuant to I.R.C. § 7422, alleging jurisdiction under 28 U.S.C. § 1346 (1976). Presently before me is the Government's motion for summary judgment. After consideration of the arguments advanced by the parties in their memoranda, I agree with the Government that the valuation mechanism outlined in the challenged regulation is legally sound.

 The principal facts, to which the parties have stipulated, are as follows. On January 24, 1967, Harrison entered into a stock option agreement (qualified under I.R.C. §§ 421, 422) with General Numismatics Corporation, the predecessor to Franklin Mint Corporation (Franklin Mint). On November 24, 1971, while he held the position of Executive Vice-President of Franklin Mint, Harrison exercised the option to purchase 12,000 shares of Franklin Mint common stock at the option price of $ 1.08 per share. *fn3" Although the trading price of the stock on the American Stock Exchange on the date of exercise was considerably higher than the price paid by Harrison, he did not report the transaction as an item of tax preference (subject to the minimum tax imposed by I.R.C. § 56) on his 1971 federal income tax return. After an audit of that return, the IRS concluded that plaintiff's exercise of the option generated a tax preference. In determining the amount of the preference, the IRS set the fair market value of the stock acquired under the option at $ 42.25 per share, which was the highest trading price of the Franklin Mint stock on the American Stock Exchange on November 24, 1971, the date of exercise. The IRS assessed the deficiency for 1971 at $ 44,110, which plaintiff paid together with interest in the amount of $ 15,368.19. He subsequently complied with the procedural prerequisites to a judicial adjudication of his claim and now petitions this court for a refund of the $ 59,478.19, plus interest and costs.

 Whether the plaintiff is entitled to recover all or a part of the claimed refund depends, of course, upon whether the amount of the tax preference determined by the IRS accurately reflects the bargain element of the stock acquired under the option. Harrison, an executive officer of Franklin Mint when he exercised the option, takes the position that § 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b) (1976), which requires a corporate director or officer to disgorge to the corporation any profits realized from the sale of the corporation's stock within six months of its acquisition, is a restriction that significantly affects the fair market value of the stock. Harrison advances two alternative arguments: (1) that the fair market value is the option price, and (2) that the effect of the § 16(b) restriction on the fair market value of the stock creates a material issue of fact which requires expert testimony and which must therefore be reserved for trial. *fn4"

 In moving for summary judgment, the Government argues that § 1.57-1(f)(3) prohibits consideration of all stock restrictions except nonlapse restrictions, and that inasmuch as § 16(b) is not a nonlapse restriction, the impact of § 16(b) may not be taken into account when calculating the fair market value of the transferred stock. As the regulation states, *fn5" the prescribed method of valuation derives from § 83(a)(1) of the Code. Section 83, as a general proposition, requires that the bargain element of property transferred in connection with The performance of services be included in the Gross income of the person who rendered the services. In calculating this addition to income, "the fair market value of such property (is) determined without regard to any restriction other than a restriction which by its terms will never lapse . . . ." I.R.C. § 83(a)(1). The regulations define a nonlapse restriction as

 
a Permanent limitation on the transferability of property
 
(i) Which will require the transferee of the property to sell, or offer to sell, such property at a price determined under a formula, and
 
(ii) Which will continue to apply to and be enforced against the transferee or any subsequent holder (other than the transferor).
 
. . . Limitations imposed by the registration requirements of State or Federal security laws or similar laws imposed with respect to sales or other dispositions of stock are not nonlapse restrictions.
 
Treas.Reg. § 1.83-3(h) (emphasis added).

 The language of the regulation is quite explicit. Clearly, the requirement that insider profits resulting from the purchase and sale of stock within a six-month period inure to the corporation is not a nonlapse restriction. Section 16(b) applies only to the insider, not to the transferee. Furthermore, its proscription is of limited duration, applying only to purchases and sales occurring within six months of each other. Therefore, the Government is correct in its assertion that the effect of § 16(b) on the market value of stock acquired by an insider should be excluded when valuing the stock both under § 83(a)(1) (for income tax treatment) and, through § 1.57-1(f)(3)"s incorporation of the § 83(a)(1) valuation mechanism, under § 57(a)(6) (for minimum tax treatment).

 Harrison attempts to overcome the obstacle created by § 1.57-1(f)(3) by attacking the validity of that regulation. He argues that by adopting the principles of § 83(a)(1), the regulation directly violates § 83(e)(1), which declares § 83 inapplicable to a transaction to which § 421 applies. Section 421 embraces qualified stock options (defined in I.R.C. § 422(b)) and restricted stock options (defined in I.R.C. § 424(b)) which (according to § 57(a)(6)) are subject to the minimum tax. Harrison contends that because the stock options to which § 57(a)(6) applies are by definition transactions within the purview of § 421, § 83(e)(1) flatly prohibits the use of § 83 valuation principles.

 Harrison urges that I adopt the position expressed by the two judges who concurred only in the Kolom result, I. e., that the regulation and the statute are irreconcilable. Suggesting that a share of stock transferred to an insider "provides significantly less compensation to him than would an otherwise identical share awarded to a person not so subject," the concurring judges believed that the regulation overreached § 57(a)(6). They pointed to the definition in § 57(a)(6) of tax preference (the excess of "fair market value" over the option price) and stated that "the statute nowhere authorizes (the ...


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