Nock v. Commissioner

*263 Respondent determined a deficiency in income tax of Pauline E. Nock for the calendar year 1961 in the amount of $ 35,721.27. The principal issue to be decided is whether or not Pauline E. Nock realized*6 and was required to recognize ordinary income when she exercised a restricted stock option in 1961 which she acquired by bequest from her deceased husband. If so, the correct amount of the gain must be determined also. Various adjustments with respect to itemized deductions or the standard deduction and with respect to the basis of certain shares of the stock acquired by exercise of the option and sold in the same year depend upon the resolution of the principal issue and can be determined under Rule 50.

*264 FINDINGS OF FACT

Some of the facts herein have been stipulated by the parties. They are hereby found accordingly and adopted as our findings.

Pauline E. Nock was a legal resident of McDonald, Ohio, until the time of her death on October 23, 1965. She timely filed her Federal individual income tax return with the district director of internal revenue at Cleveland, Ohio, for the calendar year 1961. On November 22, 1965, her daughter, Barbara Ann Lytle, also a resident of McDonald, Ohio, was appointed administratrix, with will annexed, of her mother's estate. The petition herein was filed by Barbara as such administratrix on December 31, 1965.

The late John S. Nock, Pauline's*7 husband, died on December 1, 1960. During his lifetime he had been employed for many years by the United States Steel Corp. On August 26, 1953, while he was a supervisory employee at the Duquesne, Pa., works of United States Steel, he received a restricted stock option, serial No. 52, to purchase 500 shares of United States Steel common stock at $ 37 per share. This was pursuant to a stock option incentive plan adopted by United States Steel in 1951. On that date the stock had a fair market value of $ 36.8125. The option price of $ 37 per share obviously exceeded 95 percent of the per share fair market value on August 26, 1953. At that time John did not possess more than 10 percent of the total combined voting power of all classes of stock of United States Steel Corp. or of its parent or subsidiary corporations.

After a 2-for-1 split of the common stock of United States Steel Corp. on June 2, 1955, John held an option to purchase 1,000 shares of United States Steel Corp. common stock at $ 18.50 per share.

In October of 1959, when Nock was division superintendent of the Rolling Division of the Duquesne works of United States Steel, he became seriously ill. Prior to this illness*8 he had been working extremely hard and at all hours of the day and night because a new facility was being put into operation at Duquesne. He last worked on October 22, 1959, and thereafter until August of 1960 he was absent from his duties on sick leave; he was carried on the payroll of the Duquesne works and continued to receive his regular salary.

On August 10, 1960, John requested that he be retired because of permanent disability. Because of his continuing illness and disability, the personnel services supervisor of the Duquesne works took the necessary application forms to John at Youngstown, Ohio, on August 16, 1960, after they had been prepared. On that date John executed two applications for United States Steel pensions: (1) A special retirement pension, contributory, to commence at retirement, by reason of permanent incapacity; and (2) a noncontributory pension for *265 permanent incapacity with date through which wages were, or will be, paid specified to be August 31, 1960, and date of retirement also specified to be August 31, 1960.

The contributory pension application was executed by Nock as prepared but when he proceeded to execute the application for the noncontributory*9 pension he placed the date "Sept. 1, 60" in a blank space to specify his retirement date. When it was explained to him at that time by the personnel services officer that under the pension fund rules he would receive no pension for September unless his retirement was effective on August 31, 1960, he consented that the date of retirement in his declaration portion of the form be changed to August 31. This change was made by the personnel services officer after discussion with Nock and with his full knowledge, acquiescence, and approval.

The contributory pension application was then certified by the general payroll superintendent of United States Steel on August 22, 1960, showing that Nock "retired or was terminated" on August 31, 1960, that the last deduction of contributions was made on the payroll ending that same date, and that the retirement date agreed with like information shown on the employee's noncontributory pension application.

The noncontributory pension application stated that Nock last worked on October 22, 1959; that his wages were, or will be, paid through August 31, 1960; that his date of retirement was August 31, 1960, and that his pension would commence September*10 1, 1960. His record of continuous service "through retirement date" ended with "8-31-1960." The United States Steel Corp.'s vice president of steel operations approved such pension application on August 29, 1960, after other company officers had certified the correctness of the information set forth.

The rules of the noncontributory pension fund specify, inter alia, that the first installment of a regular pension "shall be payable for the first full calendar month following the month in which retirement occurs, if application for pension is made not later than the close of such full calendar month." If John Nock's retirement had not been effective on or before August 31, 1960, he would not have been paid his pension for September of 1960.

Although he performed no services for United States Steel on August 31, 1960, as a result of his physical disability, John was listed, for the purpose of receiving salary payments, on the payroll records of United States Steel Corp. as an employee of such corporation on August 31, 1960. The attendance report for the week ended September 3, 1960, shows him on sick leave through Wednesday. August 31, and "Disability Pension 9/1/60." He received*11 his full, *266 regular monthly salary of $ 2,054.85 for August 1960, but thereafter no further salary payments for any further period of time were received.

John S. Nock was not an employee of United States Steel Corp. on September 1, 1960, and was not listed, for the purpose of receiving salary payments, on the payroll records of United States Steel Corp. as an employee of such corporation on September 1, 1960.

The United States Steel and Carnegie Pension Fund sent John notices dated September 30, 1960, stating that he would receive, commencing with the month of September 1960, a regular pension (noncontributory) of $ 749.53 per month and a retirement pension (contributory) of $ 146.26 per month. Such pension benefits for the months of September, October, November, and December were disbursed from the fund. Nock's United States Steel and Carnegie Pension Fund retirement number was 54151. He was listed on the September 1960 pension payroll register but not on that register for August 1960.

At the time of his death on December 1, 1960, John had not exercised his restricted stock option to purchase 1,000 shares of United States Steel Corp. common stock. United States Steel *12 Corp. common stock had a fair market value of $ 71.3125 as determined by its per share sale price at a high of 72 and a low of 70 5/8 on that date.

Pauline E. Nock, John's widow, was appointed executrix of John's estate on January 4, 1961, by order of the Probate Court, Trumbull County, Ohio. She was named as sole beneficiary in John's will, and as a result acquired her husband's restricted stock option to purchase 1,000 shares of United States Steel common stock and all of the rights incident thereto.

On January 4, 1961, Pauline executed a "Notice of Exercise of Option" for the purchase of 1,000 shares of United States Steel Corp. common stock. Such notice, together with payment in the amount of $ 18,500 was mailed to United States Steel Corp. on January 7, 1961.

United States Steel Corp. acknowledged the receipt of the executed "Notice of Exercise" in a letter to Pauline dated January 9, 1961. United States Steel Corp. common stock had a fair market value, as determined by its sale price at a high of 80 3/4 and a low of 79 7/8, on January 9, 1961, of $ 80.3125. The parties are in agreement that this was the date of the exercise of the option and that the 1,000 shares had a fair*13 market value of $ 80,312.50 on that date.

Ten stock certificates, each dated January 13, 1961, for 100 shares of United States Steel Corp. common stock, bearing serial Nos. V311698-V311707, inclusive, were issued to Pauline in early February 1961.

On November 30, 1961, Pauline sold 200 shares of the United States Steel stock she had received under and by virtue of the exercise of the *267 stock option. This was the first sale of any of the stock she had received under the restricted stock option plan. In her 1961 income tax return she reported this sale as follows:

One half of this long-term gain was reported as income from sales reported on Schedule D.

In an attached statement, Pauline stated that her basis of 1,000 shares was $ 71,212.50, computed by adding the option price paid, $ 18,500, to the value of the option as reported in Federal estate tax return of John S. Nock, $ 52,812.50; her per share basis was accordingly reported to be $ 71.2125. *14 (Apparently a mathematical error in addition was made in this statement because the total basis should have been $ 71,312.50 and the per share basis therefore $ 71.3125.)

A Federal estate tax return had been filed for the Estate of John S. Nock on December 18, 1961, and the restricted stock option, valued at a total of $ 52,812.50, was returned therein as an asset of the estate. The reported value of the option was computed by subtracting the $ 18,500 option cost from the fair market value of 1,000 shares of United States Steel common stock on the date of John's death, $ 71,312.50.

In the deficiency notice issued by respondent it was determined that there was a deficiency in income tax for the year 1961 of $ 35,721.27. The following explanation of adjustments was made:

(a) It has been determined that income of $ 61,812.50 realized on the stock option granted by the United States Steel Corp. and exercised by you in 1961, does not qualify for exclusion under the purview of Section 421 of the Internal Revenue Code. Accordingly, your income has been increased by that amount.

(b) Adjustment is made to disallow itemized deductions in the amount of $ 476.16 and allow in lieu thereof the*15 standard deduction in the amount of $ 1,000.00.

(c) Adjustment is made for capital gains and losses in the amount of $ 1,295.38, computed as follows:

(d) Adjustment is made to allow the standard deduction in the amount of $ 1,000.00, in lieu of itemized deductions in the amount of $ 476.16.

*268 In an attached schedule of adjustments it was shown that the capital loss on the sale of 200 shares of United States Steel stock was computed as follows:

ULTIMATE FINDINGS OF FACT

John S. Nock was employed by United States Steel through August 31, 1960. His employment terminated on September 1, 1960, the day following his retirement, and on that date he ceased to be an employee*16 of United States Steel. On December 1, 1960, the date of his death, John Nock was not an employee of United States Steel but that date was within 3 months after the date he ceased to be such an employee.

OPINION

The parties are not in complete agreement as to the issues presented but they are agreed that the principal issue should be determined by deciding whether or not John S. Nock would have been required to recognize ordinary income if he had exercised his restricted stock option on the date of his death, December 1, 1960. If on that day he could not have qualified for the no-income treatment provided for by subsection 421(a) of the Internal Revenue Code of 1954, ¹ then his widow, Pauline, could not so qualify.

At the date of his death on December 1, 1960, *17 John held an unexercised restricted stock option to purchase 1,000 shares of United States Steel common stock at $ 18.50 a share. Under section 421(d)(6) a person who acquires a restricted stock option by inheritance or bequest is afforded the same tax treatment upon its exercise as the deceased employee; it is undisputed that Pauline, John's widow, qualifies for this identical treatment under section 421(d)(6). The principal issue here is therefore controlled by the provisions of section 421 as it existed in 1961 when the stock option here involved was exercised by Pauline after John's death.

*269 By the Revenue Act of 1950, Congress added new section 130A to the 1939 Code affording special no-income treatment for exercising employee incentive stock options under certain limited conditions if they met the definition of "a restricted stock option." ² The legislative history indicates that the beneficial provisions were to apply if the restricted option were exercised while the grantee was still an employee of the granting employer or within a period of 3 months following termination of his employment. S. Rept. No. 2375, 81st Cong., 2d Sess. (1950), 1950-2 C.B. 526;*18 H. Rept. No. 3124, 81st Cong., 2d Sess. (1950), 1950-2 C.B. 586. This provision was reenacted without substantial change as section 421 of the 1954 Code, with the addition of a paragraph (6) to subsection (d), and as effective in 1961 the pertinent portions are set forth below. ³ The statute specifically excludes application of the relief afforded if the optionee is not an employee of the corporation which granted the option at the time of its exercise unless he exercises it "within 3 months after the date he ceases to be an employee" of such corporation. Section 421(d)(6)(A) then extends the relief from taxability after death of an employee to persons who acquire restricted stock options by bequest "to the same extent as if the option had been exercised by the decedent" eliminating the employment requirements of subsection (a).

*19 Paragraph (6) of subsection (d) of section 421 was added by the 1954 Code and the legislative intent is set forth in H. Rept. No. 1337, to accompany H.R. 8300 (Pub. L. 591), 83d Cong., 2d Sess. (1954), as follows:

Under present law the tax treatment of the exercise of a "restricted stock option" after the death of an employee is not provided for even though "restricted *270 stock options" are transferable by will. Your committee believes that the untimely death of an employee should not penalize his estate or beneficiaries by denying an option the status of a "restricted stock option" merely because of the employee's death. For that reason the bill provides that the exercise of "restricted stock options" by the estate or beneficiary of a deceased employee is to have the same tax effect as if the employee had exercised the option. * * *

The petitioner insists that Nock could have exercised the option on December 1, 1960, and reaped the benefits of section 421 at that time, whereas respondent insists that he could not. Petitioner urges us to conclude that Nock ceased to be an employee of United States Steel on September 1, 1960; that that day should not be counted in computing*20 the 3-month period specified in section 421, and that therefore on December 1, 1960, Nock could have exercised his restricted stock option and obtained the no-income treatment afforded employees who exercise such options "within 3 months after the date" they cease to be employees. We agree with petitioner.

Although Nock's applications for pensions requested that he be retired on August 31, 1960, instead of September 1, 1960, this was merely to comply with the pension fund rules specifying that the first installment of any pension granted under United States Steel's pension fund shall be payable for the first full calendar month following the month in which retirement occurs. To conform to the already typed portion of the application indicating his retirement date as August 31, 1960, and to make sure that his pensions would begin when his wages stopped, the retirement date was specified as August 31, 1960. However, it was specified repeatedly that Nock would be paid through August 31, 1960, and that his employment would continue through that date. We conclude and hold that he was an employee of United States Steel through August 31, 1960, and ceased to be such an employee on*21 the following day, September 1, 1960.

The parties agree and we concur that under the proper rule to be applied in computing the 3-month period specified by section 421, the day upon which Nock ceased to be an employee is to be excluded and the last day of the 3-month period is to be included. Sheets v. Selden's Lessee, 2 Wall. 177, 190 (1864); Harriet M. Hooper, 26 B.T.A. 758 (1932); Rev. Rul. 66-5, 1966-1 C.B. 91. Excluding September 1, 1960, and including December 1, 1960, the day of Nock's death, it is clear and we hold that Nock's right to benefit by the no-income treatment afforded by section 421 had not expired on December 1, 1960, the end of 3 months after the date he ceased to be an employee of United States Steel. As we interpret the statutory requirement Nock could have exercised his option on August 31, 1960, the day through which he was employed by United States Steel or at any time within 3 months after September 1, 1960, the date he ceased being such an employee. On the day that he died, December 1, 1960, he still could have exercised the option and qualified*22 for section 421 treatment.

*271 Respondent contends that under his regulations, sections 1.421-3(b) (1) and 1.421-5(d)(1), an optionee must be a bona fide employee of the granting corporation at the time he exercises the option or within 3 months prior thereto, and in the case of a legatee that the optionee must have been an employee "at the time of his death or within three months before such time." Applying this analysis of the regulations to the facts of the instant case, he asserts that Nock was not an employee of United States Steel on the date of his death, December 1, 1960, nor had he been such an employee within the 3 months immediately before that date.

Petitioner candidly admits that if the strict and exact language of the regulations is applied without reference to the statutory language itself, Nock would be deprived of section 421 treatment as of the date of his death, and likewise his widow would not qualify for the no-income benefit of 421. Petitioner argues that the legislative history and the statutory language itself should control and the regulations be construed in harmony therewith; that the law does not require that an optionee be an employee within the*23 3-month period before the option is exercised; and that the sole statutory requirement is that the option be exercised within 3 months after the employee ceases to be employed by the granting corporation. She points out that two entirely different tests or criteria are established and that she loses 1 day if the regulations alone are applied and is thus improperly deprived of section 421 benefits granted by the statute.

Nowhere in the legislative history, in the statute itself or in the regulations is there a suggestion that the regulations were intended or designed to reduce the period "three months after the date he ceased to be an employee" by 1 day or any other period of time. Indeed, respondent himself has recognized that in applying section 421(a) of the Code prior to 1964, the result argued for by petitioner follows. In Rev. Rul. 66-5, 1966-1 C.B. 92-93, the following statement appears:

Section 421(a) of the Code, as then in effect, provides for certain Federal income tax results if, among other requirements, an option is exercised by the employee within 3 months after he ceases to be an employee of the grantor * * *

It is*24 long and well established that, in computing a period of "years" or "months" prescribed in a contract or statute, "from" or "after" a designated day, date, act, or other event, the day thus designated is excluded and the last day of the prescribed period is included, unless a different intent is definitely evidenced. * * *

* * * *

the principles enunciated above are applicable in determining the 3-month * * * [period] referred to in section 421(a) of the Code as in effect prior to the enactment of section 221(a) of the Revenue Act of 1964. Thus, for example, if an individual ceases to be an employee on April 30, 1963, the last day of the 3-month period thereafter would be July 31, 1963, * * *

*272 This revenue ruling nowhere even suggests the construction of the statute here urged by respondent to reduce the time allowed by applying the computation method prescribed by the regulations. We cannot accept respondent's argument that we should construe the statutory language of section 421 by a literal reading of the narrow language of the regulations standing alone. We conclude that any conflict between the clear provision of the statute and the regulations was inadvertent and*25 unintentional, and, accordingly, we interpret the regulations to permit section 421 treatment as the statute itself directs if any optionee exercises his option within 3 months after he ceases to be an employee of the granting corporation. If an employee has ceased to be an employee within the 3-month period before the date of exercise of the option, the statute and the regulations applied together should result in the same tax treatment.

If we thus apply the statutory language and the regulations in the light of the legislative history quoted at length hereinabove (S. Rept. No. 2375, supra; H. Rept. No. 3124, supra), we are persuaded that petitioner's arguments here must prevail. Since John Nock ceased to be an employee of United States Steel on September 1, 1960, and since he died thereafter on December 1, 1960, he could have obtained the benefits of section 421(a) if he had on that day exercised his option; the last day of the 3-month period after he ceased to be a United States Steel employee was December 1, 1960, not November 30, 1960, and he ceased to be an employee of United States Steel within 3 months before he died.

This interpretation of the statute and seemingly*26 inconsistent and restrictive regulatory provisions, is in apparent accord with the congressional understanding of the meaning of section 421. When that section was modified and portions thereof reenacted as section 424 of the Code by the Revenue Act of 1964, the legislative history reflects congressional understanding and belief that the statute and the regulations here involved are properly so interpreted. Section 424(a)(2), as enacted by the 1964 Revenue Act, provides that 421(a) shall apply if at the time the optionee exercises a restricted stock option he is an employee of the granting corporation or "he ceased to be an enmployee * * * within the 3-month period preceding the time of exercise." This is regarded by Congress as meaning the same thing as was meant by the preexisting language of the statute as interpreted by the regulations in question. H. Rept. No. 749, 88th Cong., 2d Sess. (1963), 1964-1 C.B. (Part 2), 326, reads, in part, as follows:

Employment requirement

Paragraph (2) of section 424(a) is identical with the employment requirement of the existing section 421(a) and requires that the individual be an *27 employee of the granting corporation, its parent or subsidiary corporation, or a corporation or its parent or subsidiary corporation issuing or assuming a stock option in a *273 transaction to which section 425(a) applies, at the time the option is exercised, or within the 3-month period preceding the date of exercise. [Emphasis added.]

We conclude and hold that an optionee is entitled to benefit by section 421 if he has not ceased to be an employee of the granting corporation for more than 3 months prior to his exercise of a restricted stock option. This interpretation is in accord with the statutory language that section 421 shall not apply unless the option is exercised "within 3 months after the date he ceases to be an employee" and does not result in reducing the time specified by the statute itself. Applying it to the facts here, Nock would have been entitled to section 421 benefits if he had exercised his option on December 1, 1960, the date of his death. He had ceased to be an employee of United States Steel on September 1, 1960. Until 3 months thereafter had passed, which period would include December 1, he qualified for section 421 treatment if the statutory*28 language alone is applied. See Rev. Rul. 66-5, supra. Likewise Nock had ceased to be an employee within 3 months before December 1, 1960, so that applying the statute and regulations as thus interpreted, the same result follows and section 421 applies.

The provisions of section 421(d)(6)(A)(i) of the Code, providing that the holding period and employment requirements of subsection (a) shall not apply in the case of the exercise of an option by a legatee, do not lift the other restrictions of section 421(a). The subsection itself and the legislative history previously set forth dictate the conclusion that a legatee or heir seeking the benefit of section 421(a) stands in the shoes of the deceased optionee and can qualify only "to the same extent as if the option had been exercised by the decedent."

Since we have concluded that Nock had the right to exercise the restricted stock option he received on August 26, 1953, until December 1, 1960, the no-income treatment afforded by section 421(a) of the 1954 Code was available, either to him, if he had lived throughout that date, or to his wife who inherited his option rights. McTighe v. United States, 187 F. Supp. 606 (1960).*29 We therefore conclude and hold that Pauline Nock, John's legatee, was entitled to the "no income" benefit granted by section 421(d)(6), when on January 13, 1961, she exercised the stock option she inherited from her husband. The respondent's determination denying section 421 treatment to her cannot be sustained.

Having reached the conclusions already stated as to the principal issue, it is not necessary to determine the amount of gain in issue because Pauline's exercise of John's stock option qualifies for section 421 treatment. However, the various other adjustments made by respondent in his deficiency notice must be recomputed in accordance with the views expressed herein. To provide for such necessary adjustments,

Decision will be entered under Rule 50.

*274 Simpson, J., dissenting: I must dissent from the interpretation of the statute adopted by the majority. It is unfortunate that the outcome of this case turns on 1 day. However, whenever the qualification for some favorable tax treatment turns on whether the taxpayer acts before a specified day or before the expiration of a specified period -- and the tax laws contain innumerable provisions of this *30 type -- some lucky taxpayers are going to qualify by just 1 day; whereas, less fortunate taxpayers are going to miss by a single day. Such consequences must have been anticipated by the lawmakers when they adopted such a limitation. When the statute uses a general standard, we must use reason and judgment in its construction and application; but when the statute is precise and definite, our compassion for the less fortunate gives us no authority to extend the statutory time for qualifying for the favorable tax treatment.

The statutory provision which was applicable in the circumstances of this case made the qualification for the favorable tax treatment of the option depend upon whether a retired employee exercised the option within 3 months after the day on which he ceased to be an employee. The majority finds as a fact that John ceased to be an employee on September 1, 1960. However, I believe that this conclusion results from the application of an erroneous interpretation of the statute to the evidence in the case. Webster's New International Dictionary (3d ed. 1961) states "to cease" means "bring to an end * * * to come to an end * * * to bring to an end an activity or action." *31 Since John was not able to work during August of 1960, the time when his employment ended must be determined solely from the intention of the parties. There is some suggestion in the case that John was subject to call at all times during the day so that his employment did not end until the last moment of August 31. Whenever his employment ended, even if it was at the last moment of the day, at that same moment his employment ceased; it was brought to an end; it came to an end. There is no dispute over the fact that August 31 was the final day of his employment; consequently, when a proper definition of the statute is applied, it is clear that his employment ceased on August 31, not September 1.

The petitioner attempts to present this case as involving a conflict between the statute and the regulations and requiring us to choose between them. Without doubt, if there were such a conflict, we would be guided by the statute; but if the statute and the regulations are properly construed, there is in fact no conflict between them.

The statute and the regulations use different language and different means of expressing the rule, but both reach the same result. If we recognize that John*32 ceased to be an employee of United States Steel on August 31, 1960, then we apply the statutory rule by beginning counting on September 1, and the 3-month period ended on November *275 30. On the other hand, if we apply the regulations, we count backward beginning with November 30, 1960, and ending on September 1 of that year. Thus, although the statutory rule counts forward from the day after he ceases to be an employee, and the regulatory rule counts backward from the day before the day of his death, both reach the same result -- under both applications of the rule, John would not have qualified for the favorable tax treatment of section 421 if he had exercised the option on December 1, the day of his death.

Before now, no one has suggested that there was a conflict between the statute and the regulations. The regulations were first adopted in 1952. The statutory provision was reenacted in 1954, with no indication that anyone involved in the legislative process considered the regulatory interpretation improper. The same regulatory interpretation was again adopted and remained in effect throughout the years. Furthermore, when the revision of the stock option provisions*33 was adopted as a part of the 1964 Revenue Act, the statutory provision was changed to use the "look-back" rule, and the accompanying committee report indicated that the employment requirement was identical and described it by using language similar to the regulatory interpretation. In so doing, Congress indicated that it considered the regulations and the statute to have the same effect. This longstanding approval of the regulations -- both implicit and explicit -- indicates to me that people have generally considered them not to be in conflict with the statute.

The majority opinion attempts to reconcile the statute and the regulations by modifying the clear language of the regulations. However, if the statute is properly construed, such modification is unnecessary. The clear language of the regulations and the longstanding assumption that it means the same as the statute confirms my understanding of the statutory expression "within 3 months after the date he ceases to be an employee."