United States Tax Court, No. 17291–07, February 1, 2010
KEY QSBS TAKEAWAY(S): In Natkunanathan v. Commissioner, the taxpayer misused the definition under §1202(f) and argued stock options are equivalent to the sale or exchange of stock. Another key takeaway is the taxpayers failure to provide evidence that the original company (Cognet) was a “qualified small business” under §1202(d) or that the taxpayer held any of the stocks acquired (from Cognet or Intel) for the minimum 5-year period under §1202(a).
QUESTION PRESENTED: How does §1202 play a role when an employee exercises a companies stock options during a merger and acquisition agreement between two companies?
- The word “stock” in §1202, excludes unexercised stock options (i.e. option to acquire stock).
- In the case of a “tax-free” (i.e. stock for stock) merger, the time period stock was previously held “tacks” onto the new holding period of the shares received in the merger. If the acquiring company is a Qualified Small Business (QSB), additional appreciation may be eligible for QSBS tax treatment, however if the acquiring company is not a QSB, QSBS tax treatment will only apply to the ‘recognized gain’ at the time of the merger (provided the other QSBS eligibility criteria are met), however will not apply to any further stock appreciation.
- The taxpayer could not prove that the original equity held in Cogent met the QSBS eligibility criteria, and therefore it is important to be able to support your case for being able to claim the QSBS exemption.
MAIN QSBS ISSUES ADDRESSED:
(1) failure to prove that the stocks acquired were from a business defined under §1202(d); (2) what does the Tax Court define stock options under §1202(f); and (3) failure to hold stocks for 5-year period under §1202(a)
The taxpayer failed to claim 50% of capital gains on their tax return from the sale of stock acquired from Intel in 2003 for a total of $295,285. The taxpayer acquired Intel stocks from a merger and acquisition agreement with his previous employer, Cogent Microsystems, in the year of 2001. The taxpayer originally acquired stock options from Cognet sometime after his employment before 2001 as compensation for their work. The taxpayer assumed the companies were QSBS under §1202(d) and did not hold the stocks for the minimum 5-year holding period under §1202(a).
The Petitioner, Natkunanthan, was an employee at Cognet Microsystems, a Domestic C Corporation, before the year 2001. As compensation for working, the petitioner received stock options within Cognet—which is allowed under §1202(c)(1)(B)(ii). Petitioner retained these options after Cognet merged with Intel Corp. (Intel), another domestic C corporation, in 2001.
Not long after Cognet merged with Intel Corp in the later months of 2001, the petitioner at the time, still had possession of Cognet stock options. The merger agreement between the two corporations allowed for Cognet stocks to be converted to Intel stock; in which, the petitioner exercised the option to purchase Intel stock in the late months of 2003. On the same exact day of the transaction (purchasing the Intel stock), the petitioner sold the stocks and received a gain of $295,285.
Out of the $295,285 total capital gain, the IRS determined a deficiency of $126,089. Hence, the issue that the petitioner failed to claim 50% of capital gains in their 2003 tax return.
The Petitioner is arguing that:
“…[H]e is not liable for the deficiency but is, in fact, owed a refund of at least $26,437, the entire amount of Federal income tax withheld for 2003. In support of this claim…. he contends that the qualified small business stock exclusion of section 1202 applies to his sale of Intel stock and, therefore, he is entitled to exclude 50 percent of the resulting gain.”(quoting T.C. Memo. At *2)
This discussion is surrounding a 50% tax exclusion because the stock was acquired between August 11, 1993, and February 17, 2009, the eligibility of gain exclusion was maximized at 50% and subject to 7% AMT. A crucial point within this case relies on §1202(a)(1) which provides that a taxpayer—other than a corporation—gross income will not include the 50% of any gain from sale or exchange of QSBS unless it was held for more than a 5-year period.
Another point falls under §1202(d)(1) which relays that a “Qualified Small Business” occurs when it is a domestic C corporation and the aggregate gross assets did not exceed $50,000,000 during and immediately after issuance of the stock. The petitioner did testify that the Intel stocks were sold on the same day the petitioner exercised them; however, petitioner argues that the Intel stocks were QSBS because they were received through converting the Cognet stock options following the merger of the two corporations.
“In support, petitioner cites section 1202(f), which provides: ‘If any stock in a corporation is acquired solely through the conversion of other stock in such corporation which is qualified small business stock in the hands of the taxpayer— (1) the stock so acquired shall be treated as qualified small business stock in the hands of the taxpayer, and (2) the stock so acquired shall be treated as having been held during the period during which the converted stock was held.'”(quoting T.C. Memo. At *3); see §1202(f).
As seen in Holmes v. C.I.R., the petitioner in this case failed to provide any balance sheets that would show the Owner’s equity in Cognet; with that being said, at the time of the issuance of stock options, the court cannot determine that Cognet was ever a “Qualified Small Business” under §1202(d)(1). The record also shows a lack of evidence that proves the petitioner held the stock options for the 5-year minimum holding period under §1202(a)(1). The only facts that in the case is that the petitioner acquired the Cognet stock option in 2001 and subsequently after the merger with Intel, sold the stocks in 2003. Evidencing that there was, at the most, a 3-year holding period.
Another thing to consider, the petitioner failed to establish that the definition of QSBS used in §1202 refers to the option to “acquire” stock options. Instead, §1202 states that the tax exclusion occurs from the “sale or exchange of qualified small business stock.” See §1202(d)(1)
“Section 1202 was added to the Code by the Omnibus Budget Reconciliation Act of 1993, Pub.L. 103–66, sec. 13113(a), 107 Stat. 422. The accompanying conference report included the following statement: ‘Stock acquired by the taxpayer through the exercise of options….is treated as acquired at original issue. The determination whether the gross assets test is met is made at the time of exercise…. and the holding period of such stock is treated as beginning at that time.’ H. Conf. Rept. 103–213, at 526 (1993), 1993–3 C.B. 393, 404 (emphasis added).”(quoting T.C. Memo. At *4)
The court decided in this case that:
- The word “stock” in §1202 will exclude the petitioner’s option to acquire Intel stock for the QSBS tax exemption
- The court held that the petitioner in no way could have reached the 5-year holding period requirement under §1202(a)(1). Technically the holding period was only 1 day because the acquired Intel stock was sold within the same day
- The petitioner was never entitled to a 50% tax exclusion because: (1) there was no evidence proving Cognet was originally a QSBS, and even if so, (2) the holding period was only 3 years, at most, and (3) the word “stock” according to the court excludes the taxpayers option to acquire stock, therefore the 5-year holding period was never met in the first place. Even if the period was satisfied, the petitioner could not prove Intel was “qualified” under §1202 during issuance or immediately after.
United States Tax Court, No. 17291–07, February 1, 2010
Natkunanathan v. Comm’r, T.C. Memo. 2010-15, aff’d, 479 F. App’x 775 (9th Cir. 2012)
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.