Appellate Court Rules Options Taxable When Exercised

In the first time it has considered the issue, a federal appeals court has ruled that an employee's nonqualified stock options from his employer became taxable when the options were exercised.

The 9th US Circuit Court of Appeals decided that the taxable event connected with the options was not when they were later liquidated by a company that provided the employee with a margin loan to purchase the options. The appellate panel upheld the decision by US District Judge Thomas Zilly of the US District Court for the Western District of Washington.

In a case involving stock options granted by RealNetworks Inc. to James Tuff, appellate judges decided that the options were “transferred” and “substantially vested” for tax purposes when exercised.

The judges turned aside an argument by Tuff that the a taxable transfer only occurs when an employee places his or her own capital “at risk.” Tuff argued that because he paid for his options with money borrowed on margin from Morgan Stanley – using debt secured by the stock – he had no capital at risk. The transfer didn’t take place until later when the RealNetworks stock was sold to satisfy Morgan Stanley margin calls, Tuff asserted.

The argument, the judges declared, was “nonsense.” The only issue was when RealNetworks transferred the stock to Tuff and was paid for them and that how Tuff financed the purchase was immaterial.

According to the appellate opinion, Tuff and his wife originally filed a joint income tax return for tax year 1999, reporting $540,543 in income, which represented Tuff’s salary plus the aggregate spread from the exercise of his stock options.

However, the couple later filed an amended tax return in 2002, asserting that no income arose when Tuff exercised the options in 1999. The Internal Revenue Service issued the Tuffs a refund of $208,513, but later reconsidered its position and sought to recover the refund.

The appellate ruling in United States v. Tuff, 9th Cir., No. 05-35195, 12/4/06 is here.