Commissioner of Internal Revenue v. LoBue

PETITIONER:Commissioner of Internal Revenue
RESPONDENT:LoBue
LOCATION:

DOCKET NO.: 373
DECIDED BY: Warren Court (1955-1956)
LOWER COURT: United States Court of Appeals for the Third Circuit

ARGUED: Mar 06, 1956
DECIDED: May 28, 1956

Facts of the case

Question

Audio Transcription for Oral Argument – March 06, 1956 in Commissioner of Internal Revenue v. LoBue

Earl Warren:

Number 373, Commissioner of Internal Revenue, versus Philip J. LoBue.

Mr. Elman.

Philip Elman:

May it please the Court.

This case is here on certiorari of the United States Court of Appeals for the Third Circuit.

It’s a federal income tax case and presents the question, whether an employee of a corporation who receives the right which he exercises to buy stock in the corporation at a price, which is considerably lower than the fair market price of the stock when he buys it.

It’s taxable on the gain thus realized.

In other words, on the spread between what the corporation sells the stock to him for and what the corporation would receive for that stock, had it been sold on the open market, the Tax Court and the Court of Appeals —

Stanley Reed:

What — on his sale of that stock?

Philip Elman:

On his purchase of the stock.

The question is whether the employee is taxable on the difference between what he pays for the stock to the corporation, what the corporation sells it to him.

Stanley Reed:

Before he sells it?

Philip Elman:

That’s right, sir, on the — on his exercise of the option right given to him by the corporation on the purchase of the stock.

Now, the Tax Court and the Court of Appeals have held that the employee, the taxpayer in this case is not taxable on that gain, and there is no dispute as to the facts which are in the main stipulated.

This agreement here as in the lower courts centers solely, entirely on the legal validity of the criteria or standards used by the Tax Court and the Court of Appeals in reaching the conclusion that no tax was due even though there was an undoubted economic gain or benefit received by the employee when he purchased this stock at the favorable price.

The — before going into the detailed facts of the case, I should like if I may, in order to put the legal issue in the proper frame of reference, to refer briefly to the statutory provision which all agree is controlling here, that Section 22(a) of the 1939 Revenue Code which is set out in our brief at page 2.

Section 22 (a) is the basic definition of income.

It provides that gross income includes gains, profits and income derived from salaries, wages or compensation for personal service and the material that’s omitted there indicated by the italics is just a parenthetical clause providing that — including personal service for — personal services rendered by officers of states, or compensation for personal service of whatever kind and in whatever form paid.

And it goes on to specify various categories of income, and there is a concluding catchall clause which the Court is familiar with.

That was before the Court in last term in the so-called windfall cases, the Glenshaw and General American Investors cases involving punitive damages under the antitrust laws and the Security Exchange Act.

The catchall clause, or gains or profits and — and income derived from any source whatever.

And as the Court has noted on several occasions in recent terms that the statutory definition of income is so broad as to include all gains and only those gains are excluded from tax which Congress specifically excludes.

And we have set out here the provisions of Section 22 (b) (3), which provides that the value of property acquired by gift, bequest, devise or inheritance shall not be included in the gross income and shall be exempt from taxation under this chapter.

The comprehensiveness of the — of the statute has been noted not only in the cases last term, but also in — in cases such as the Rankin case involving illegally extorted payments and the Robertson case involving a prize received for a musical composition.

But perhaps, the most important case in this context is the case of Commissioner against Smith in 324 U.S. 177 in which — which is the leading case dealing with taxability of gains received under employee stock options and Mr. Chief Justice Stone’s statement in that opinion has been frequently quoted that Section 22 (a) is broad enough to include any gains or benefits concertedly conferred on employees as compensation, whatever the form or mode that that compensation is given.

Now, under the broad statutory provision as construed by the Court, it’s therefore immaterial that the compensation does not take the form of cash.

It takes the form of property and merchandize and stocks, or bonds or whatnot.

It’s also immaterial that the compensation is not given pursuant to a legal obligation or contract obligation.

It’s given voluntarily such as tips or Christmas bonus or something of that sort.

It’s taxable as compensation nonetheless, and it’s also immaterial that the compensation takes the form of a byproduct of what might be called a noncompensatory, non-compensation motive on part of the employer.

For example, in the Robertson case where the taxpayer was held to realize taxable income, what he received was a prize in the context for a symphonic composition.

Philip Elman:

The donor of the prize, Mr. Henry Reichhold was a philanthropist.

And his interest was not in compensating Mr. Robertson.

His interest was in — in furthering the cause of symphonic music generally and the particular cause of the Detroit symphony.

And the Court held that nevertheless, since the payment was made in return for services rendered, it was taxable as income regardless of Mr. Reichhold’s motives.

As another example, if an automobile manufacturer were to decide for purposes of publicity or advertising, that it would compensate each of its employees, in part at least by giving them a new car each year, the value of that car would still be taxable to the employee even though an incidental purpose was served by the employee made them essential requirements of this new employee’s —

Harold Burton:

Aren’t the findings here — aren’t the findings here by both Courts that this stock wasn’t given for services?

Philip Elman:

The finding in this case, sir, are based on what we conceive to be an erroneous standard that the —

Harold Burton:

Well, they do make that finding, don’t they?

Philip Elman:

Yes, sir.

The — the fining is that in this case, there was no compensation because the employer intended the employee to acquire a proprietary interest.

Now, we say that the Tax Court reached the wrong conclusion, made the wrong finding of fact because it asked the wrong question.

We don’t think that that — under the statute that is the test and I shall elaborate my argument on that.

I think it would be better to do so after going into the details of the facts.

Now, in this case, the tax years involved are 1946 and 1947.

The taxpayer was the New York sales manager of a — of a Michigan chemical company, a rather small company which enjoyed a substantial expansion and prosperity in the immediate post war period, largely as a result of its sales of DDT in which it had done pioneering work for the army beginning early in 1944.

In March 1944, the stockholders and directors of the company apparently realizing that it was on the brink of a period of expansion, decided upon a plan for allocation of 10,000 shares of common stock authorized but not issued to the — to such key employees that should be determined by the Board of Directors over the ensuing three years and the option price, price specified was $5, which at that time was slightly more than the market price of the stock.

There’s been a stipulation that March 1944 when the plan, the general plan was agreed upon, the price was $4.50.

Excuse me.

Now, on June 29th 1944 and I shall be reading from the record beginning at page 17.

In June 1944, the Executive Vice President of the corporation, a man named T.C. Davis wrote to the taxpayer that — informing him of the stockholder’s action and setting aside this 10,000 share allocation.

He stated in the letter that the purpose of this is to provide an incentive to key employees, especially to permit such men to participate in the success of the company.

In the next paragraph, he says, “Allotment of the stock will be made by the committee for the key men of the company on results accomplished.

In other words, you will stand on your own record and participate in the stock purchase plan to the extent of your efforts, cooperation, and results.

And in this letter, he tells him that he has been tentatively alloted 10 shares, and he repeats that the — that in January 1945, when they actually make the — the final allocation to particular employees, that assignment will be made on the basis of results accomplished.

I am now reading from the middle of page 18, “You may be assigned a greater or less amount of stock based entirely upon your individual results and that of the entire organization.”

Then, it goes on to enumerate the basic factors which will be taken into account, the labor costs, general efficiency in operation, increase in production and so on.

And Mr. Davis said, “May I suggest that that you select those things wherein you can make the greatest contribution and strive to make the kind of record of which you and I maybe proud.”

Then, on January 18th 1945, Mr. Davis informs the taxpayer that he has been definitely alloted 150 shares.

And he says, this is in the middle of page 19, “That this allotment of stock is made by the committee and is in recognition of your contribution and efforts in making the operation of the company successful,” and he concludes that letter.

On top of page 20, you’ll of course understand that further allotments of stock under our plan will be recommended by the committee during 1945 and 1946.

Philip Elman:

It is up to you to justify your participation in the plan during the next two years.

In January 1946, once again, Mr. Davis writes to inform Mr. LoBue that he has received a further allotment of 150 shares.

And in the paragraph beginning at the bottom of page 20, he says, “The committee’s selection of the names of employees to receive the right to purchase this stock, the number of shares assigned to each selectee is determined by the committee after a careful appraisal of the individual’s contribution to the company in the way of job performance during the past year.

In other words, the extent of your participation to the plan is based on how well you handle your job during the year.”

Then, in January 1947, Mr. LoBue is alloted 40 shares which represented his portion of the balance of the shares which have been available, and this letter too contains statements that the allocations were made after a careful appraisal of his contribution and it concludes, “I congratulate you on having earned this recognition given to you by the committee and trust that your future services, suggestions and interest in the corporation’s welfare will warrant even greater recognition.”

Now, Mr. LoBue exercised his rights under these three options by purchasing 300 shares of stock in 1946 at a time when the market price of the stock was $30.50 a share.

His — he paid $5 a share, which meant that for $1500, he acquired stock worth $9600, and the value of that gain, perhaps, can be measured by the fact that his regular salary was $6600 a year.

Stanley Reed:

He gets — he gets all at one time?

Philip Elman:

No, he didn’t get it all in one time.

He got it — he got — he exercised his option under the third option, the 40 shares in February 1947.

At that time, the stock was worth somewhere around $19.

Now —

Stanley Reed:

Well, all the rest he exercised at one time?

Philip Elman:

He exercised his — the first two options at one time.

There were three options.

He exercised the first two options by — by paying for the — by paying for the purchase price of the stock in February 1946.

Now, I might — may say that there is a question in this case as to whether the exercise of the option may not have occurred in an earlier period in 1945 when the taxpayer gave some promissory notes.

That question was not reached by the Tax Court or the Court of Appeals because on the view the Tax Court took, there was no compensation at any time in connection with the acquisition of shares of stock.

So that we — we would suppose that that question will — will be open to the taxpayer on remand if the Government’s contention should prevail and the judgment should be reversed, but we don’t think it’s necessary for Your Honors to reach that question here.

Now, I might — I might also mention although it’s —

Stanley Reed:

He gave no indication that whether he would or wouldn’t take it until —

Philip Elman:

Until he gave the promissory notes.

Stanley Reed:

Well, until just before January 1947?

Philip Elman:

Yes, sir.

When the — when the —

Stanley Reed:

Clear option up to that time.

Philip Elman:

It was a clear option I assume was binding on a corporation.

There is no suggestion it wasn’t.

Stanley Reed:

(Voice Overlap) —

Philip Elman:

Yes, sir, there is no question about that I assume but the —

Stanley Reed:

But not binding on him?

Philip Elman:

Oh, certainly not.

If the stock had gone down, he certainly would not have exercised it.

It was — it was contingent in that sense.

Stanley Reed:

Just like he bought an option to buy the cause, something like that?

Philip Elman:

Well, I — I would suppose that there would be no difference from our point of view whether it was going to — whether it was put in Colony or not.

It was — there was certainly no obligation on him to exercise the option basically.

Now, I might —

Harold Burton:

Do you charge him with any income if he had received the option and did not exercise it?

Philip Elman:

The options were not transferrable, Mr. Justice.

There — there has never been any suggestion in this case prior to the filing of the brief on the merits of this Court by the respondent that the receipt of the option itself might be compensation.

In fact, contention had been reached — had been made.

It certainly should have been considered by the Tax Court because it’s — it’s clear that if — if an option has value and if it’s assignable, there is a determinable market value that it has.

It’s a piece of property in which it — if it’s — if that were intended to be compensation under the Smith case, the tax could be imposed, but I had — I don’t think that question is in this case.

It — it was never in the case until it was brought into it by the respondent, his brief on the merits.

And since the option was not transferable, it’s hard to see how any market value could have been given to it.

Stanley Reed:

Is the stock putting transfer transferrable?

Philip Elman:

No, the — it was not transferable because the — the option — the option specifically provided that the —

Stanley Reed:

When he got the stock it was?

Philip Elman:

Mr. Davis told Mr. LoBue that one of the conditions was that the option, the right to purchase the stock, is not transferrable.

He couldn’t give it to anyone else.

Stanley Reed:

So, all you have to do is to exercise and then sell the stock?

Philip Elman:

He could exercise.

He was under no obligation to sell a stock.

He could have held on to it.

For all I know, he has held onto it.

There’s nothing on the record on that.

Felix Frankfurter:

(Inaudible)

I do not quite see him assuming the option was in and of itself after they did come through him under the status of an employee and that would have them.

Now, that would ignore if they see a greater gain coming from the option which came in later.

Philip Elman:

Well, the — the question as to whether the compensation was the option or was the exercise of the option resulting in his acquisition of shares of stock.

It was the question that was before this Court in the Smith case and there, it was — there, the option when it was received had no value because the market price was not in excess of the option price and the — this Court said, “Well, in no circumstances, certainly, the — the mere receipt of the option couldn’t have been intended to be the compensation.

It was the exercise of the option that was the compensation.

Well, the Tax Court in the Court of Appeals has been pointed out.

It held that in this case, there was no compensation.

It’s a finding of fact, no compensation and we are not challenging the evidence, the evidentiary basis for lack of it from such a finding.

What we are saying is that the Tax Court and the Court of Appeals applied the wrong test.

Now, the test that was applied is known as the proprietary interest versus compensation test, and it — it’s fairly stated in the opinion of the Court of Appeals on page 160, Judge Maris points out that a virtually unbroken line of cases supports the Tax Court in holding that if the — now, we disagree with Judge Maris as the authority, but that’s not material at this point, the cases support the Tax Court in holding that if the grant of a stock option by a corporation to its employee is intended as additional compensation to him, the excess of the fair market value over, the option price is income taxable to him when the option is exercised.

Now, that — that certainly can’t be disputed.

But he goes on to say, “But on the other hand, if the grant of the option is intended to provide him with a proprietary interest in the business, no taxable gain is recognized when the option is exercised, and whether the grant of the option is the one or the other being in every case a question of fact.

So, the question is under the view ,taken by the — of the law taken by the Court of Appeals and Tax Court, you asked was this intended to his compensation?

If so, taxed.

Was it intended as to give the employee a proprietary interest?

It’s not taxed.

And curiously, in — in almost every opinion that I have examined on this subject, the — the latter question is asked first, if the — if the employer is found to have intended the employee to acquire proprietary interest in the company.

That is conclusive of the question of whether there was compensation.

Now, that — that is the approach that was taken by the Tax Court in this case, and that was the — apparently approved by the Court of Appeals.

Now, we — our difficulty with the proprietary interest test begins with our — our inability to find any statutory authority for it.

Under the — under the rule of the Court of Appeals, there’s a — there is a middle ground between taxable compensation on the one hand and a nontaxable gift on the other hand.

Right in the middle is an area of a benefit or gain received by an employee which isn’t taxable to him not because it’s a gift.

There’s no — there’s no finding here of a gift, no argument of a gift, not because it’s a gift, but because of the existence of this intention on the part of the employer that by acquiring the stock in the corporation, the employee should have a proprietary interest.

Hugo L. Black:

For what purpose?

What purpose —

Philip Elman:

Now —

Hugo L. Black:

Did it appeared that he work harder if he had a proprietary interest?

Philip Elman:

Well, it seems — it seems to us that the — that the analysis of the conception of a proprietary interest that is accepted by lower courts is — is really incomplete, because almost every time, every time I should say, a corporation sells stock.

It’s implicit in the transaction that the purchaser acquires proprietary interest.

That’s — that’s just — that’s particularly true in a case where the — where the corporation sets a price which is, for its stock, which is lower than that on the market.

Now, when a — when a corporation offers stock to its employees or to some of them at a substantial discount to say that it intends the employees to acquire proprietary interest, it doesn’t answer the question why it so intends and what the corporation receives in return.

Why the corporation should wish to sell its stock at less than what it can get in the marketplace?

Philip Elman:

And — and it seems — it seems to us that the regulations adopted by the treasury are reasonable and — and valid in providing that unless it’s found to be a gift, unless you find that the employer was motivated by considerations of affection, their friendship and so on, the — the reason why he wishes the — the employee to acquire the stock is to improve the employee’s interest in his work, his devotion, his morale, whatever it be called.

There is a relationship between — between giving him a discount and his services, which should be taxable as compensation even though it takes the form of stock rather than cash.

Felix Frankfurter:

What’s the relation, its relevance, Mr. Elman?

Philip Elman:

That’s set forth in our brief beginning at page 3.

I should say our principle —

Felix Frankfurter:

What’s the thought of that?

Philip Elman:

The — the number that is, unless — unless it’s a gift —

Felix Frankfurter:

(Voice Overlap) —

Philip Elman:

— unless it’s a gift — unless it’s a gift, if — if property is transferred by a corporation to its employee, it’s taxable to the extent of the difference between the —

Felix Frankfurter:

What does the Tax — Tax Court do with the regulation?

Philip Elman:

Tax Court thought that that regulation had a kind of automatic conclusive presumption effect that it precluded any inquiry into the fact.

I think it was a — that was a misconstruction regulation.

It is not our position that there is anything automatic about this.

There is — there are questions of fact where the issue is raised as that the gain was intended as a gift, but we think that where that — where the question is answered in the negative, this — the normal presumption of compensation has nothing over to come and it should be taxable as such.

Before I sit down, I should like to call the Court’s attention, the provisions of the 1950 Amendment of the tax law.

In 1950, Congress in response to the suggestion that the treasuries regulations resulted in — in employees who have received such option being compelled to sell, to sell stock in order to pay taxes, Congress responded to that argument to a very limited extend.

It — it set up a category of restricted stock options.

Stanley Reed:

Where is that?

Philip Elman:

Pardon.

Stanley Reed:

Where did you Act for this?

Philip Elman:

We have not set forth the 1950 Act in the statutes involved section, sir, because this Act — this — the — the Act is not involved strictly speaking.

That’s a 1950 Act, and the reason I mentioned it is that if the court below in this case is right, it creates a real incongruity in the tax law because under the 1950 Act, the restrictive stock option is defined as one in which the option price was at least 85% of the market price at the time it was given.

It-s — it’s an option which can be exercised only during employment.

The — the stock has to be held for at least two years after the option is given or six months after the option is exercised.

The employee can’t hold more than 10% of the stock of the corporation.

It’s not transferable and so on.

There are quite a number of restrictions that have to be met.

And if all those conditions are met, then under the 1950 statute, the employee does not pay a tax when he buys the stock, but when he sells it.

But then, he is taxed at the ordinary income tax rates to the extent of the difference between the option price and the market price, and the statute further provides that unlike this case, no deduction can be taken by the corporation and there is a further provision which I think is especially important.

If the employee dies without selling the stock, his estate has to pay an income tax just if he had sold it during his lifetime.

Philip Elman:

Now, under the decision of the Third Circuit in this case, the practical result is that the employee, when he buys the — when he buys the stock, pays no stock at all.

If he dies without selling the stock, his estate pays no tax because they take it on the basis of its market value at the time of his death.

If he does sell it during his lifetime, he is taxed at the ordinary — at the long-term capital gain rate, and the difference between the result in this case which turns on the existence of a proprietary interest motive and the 1950 Amendment in which there is no reference at all for proprietary interest, the only conditions are those that I have enumerated, seems to us to be highly significant.

Earl Warren:

Mr. Barrett.

Richard F. Barrett:

There are two basic questions presented in this case.

The first is, is there a presumption under Section 22 (a) of the Internal Revenue Code of 1939, a conclusive presumption that stock options are granted to employees for one reason only, to compensate?

The commissioner says, and as regulation say, that there is such a conclusive presumption that the courts are precluded from looking into the true intent of the transaction.

The taxpayer says, “There is no such conclusive presumption and that if it is established as a fact that there is no purpose to compensate through the transaction, then the exercise of the option represents a mere purchase of property.”

The Tax Court found that there was no intention to compensate.

It did not find, as my Brother has said, that there was no intention to compensate because there was an intention to give a proprietary interest.

It laid out very expressly and clearly of the criteria that if there is any intention to compensate, then there is compensation.

But if there is a complete absence of intent to compensate and there happens to be another motive, which is the wish to sell stock to the employee, then the sale is a pure sale.

The second question is whether this finding of the Tax Court, which is concurred in by the Circuit Court of Appeals, will be reviewed by this Court.

Of course, it’s a conclusive presumption of the Commissioner’s regulations as upheld, then, this Court has no place for such a review.

The Commissioner, however, argues in the alternative that the — this Court will review this finding of fact and that it should reverse it as erroneous.

The taxpayer contends that it is not subject to review here under well established principles of this Court, that such a two-court finding of fact will not, under Section — Rule 52 (a) of the Federal Rules of Civil Procedure be reviewed except in the presence of very exceptional circumstances which are not present here.

Now, it has been stated that the taxpayer contends there is conclusive presumption.

I might say parenthetically that Mr. Justice Frankfurter asked for the gist of the regulations.

They were not stated exactly as I understand them to be.

They lay down a flat mandate without any exception to the gift.

All words relating to love and affection, they state, and this appears at page 5 of the Commissioner’s brief, the top of page 5, “If property is transferred by an employer to an employee for an amount,” this is any property, stock, or any other property, “for an amount less than its fair market value, regardless of whether the transfer is in the form of a sale or exchange.

The difference between the amount paid for the property and the amount of its fair market value is in the nature of compensation and shall be included in the gross income of the employee.”

And those are the only words in the statute, in the regulation, which is significant to this case that bear upon today.

If the fact establishes that there is no purpose to compensate, the taxpayer says, “It’s a transaction purchase, a purchase transaction.”

Once this absence of intent to compensate is established, the employee relationship becomes insignificant and the employee stands in the same position as any other purchaser of property.

This view has been consistently supported by the courts including this Court.

In Smith against the United States, to which my Brother referred, this Court held that the exercise of an option by an employee resulted in compensation on the expressed grounds that the option was given in consideration to services.

In Palmer against the United States, 302 U.S. 63, an advantageous exercise by stockholders of an option granted to them was held by this Court not to create a dividend since the purpose and intention of the grinding of the option was not to distribute earnings.

The Palmer case is of special significance here because of the high degree of analogy in fact in the issues of the cases to the present case.

In both cases, at the time of the adoption of the option plan, market value was either equal to or greater than as is true in this case, the option price in both cases when the option was exercised, market price was in excess of the price paid pursuant to the option.

Richard F. Barrett:

This Court said in the Palmer case, “That one does not subject himself to income tax by the mere purchase of property even at less than its true value and the taxable gain does not accrue to him before he sells or otherwise discloses of it.”

The Commissioner contended that this discount in the Palmer case represented a dividend to the stockholders.

This was rejected by the Court on the grounds, the expressed grounds that there was no purpose or intention to distribute a dividend.

This is precisely the principle that the lower courts have applied in this case and in all other stock option cases involving employees.

But the Commissioner argues that purpose and intention are immaterial where there is the employee relationship that the courts, if there such a relationship precluded from looking in to the question of intent.

The influence of the employee relationship is so overriding in the view of the Commissioner as to require a complicit presumption of law that compensation is involved.

Now, this Court has, on many occasions, expressed that this favor was statutory conclusive presumptions.

As in violation of the due process provisions of the Fifth and Fourth Amendments, I do not cite these cases in my brief, so I like to take the liberty of citing three of the leading cases at this time, Helvering against Rankin, 295 U.S. 123, Heiner against Donnan, 285 U.S. 312, Hoeper against Tax Commission, 284 U.S. 206.

Certainly, regulations, which attempt to provide a conclusive presumption, must themselves be arbitrary and invalid.

Now, the Commissioner’s conception of the law has not always been as it is now.

From 1939 to 1946, his regulations regarding employee stock options provided that compensation was a question of fact.

He also applied the same factual test in his regulations regarding stockholder’s stock options.

He also expressed this view in his brief in the Smith case to which we have referred before.

At Page 14 of his brief, the Commissioner stated, “In determining whether a particular transaction involved,” this is his — this is his brief in the Smith case, previously before this Court where he expressed this view of the transaction compared to what he is expressing now.

“In determining whether a particular transaction involves the payment of compensation for personal services, the decisive factor is that of intention.”

This is of course a question of fact.

This is exactly the position of the courts below in this case and in all other stock option cases of employees and it’s the taxpayer’s position here.

When did the Commissioner change his view?

Richard F. Barrett:

He changed his view in 1946 for what represents one of the great mysteries of the tax field.

He dated the options on the same date.

I mean the change in the regulations on the same date.

The effective date of them was the decision of this Court in the Smith case.

And the Smith case offers no discernible basis for a chain from a determination of fact as to whether compensation exist to a determination to a conclusive presumption that it does, because in the Smith case, this Court said the options resulted in compensation because they were as a fact given in consideration for services.

As a matter of fact, that fact was admitted and conceded in the Tax Court and in the Circuit Court of appeals and the case came to this Court on the fact that the options were given as compensation for service.

Now, he also —

Felix Frankfurter:

Mr. Barrett, may I ask you to indicate what is it be the meaning of proprietary interest?

Does that mean that he enjoyed the satisfaction of the services of the stockholder?

Is that what it means?

Richard F. Barrett:

Yes, Mr Justice Frankfurter.

He becomes a partner in the business.

Richard F. Barrett:

He is one of the owners as a (Voice Overlap) to an employee.

Felix Frankfurter:

That is true to the extent to — of every stockholder?

Richard F. Barrett:

Very true, sir.

Felix Frankfurter:

That is true (Inaudible)

Richard F. Barrett:

Very true, sir.

Sherman Minton:

Suppose he had made this offer to a person who was not a stockholder on exactly the same terms, will it be taxable to them?

Richard F. Barrett:

Then traditionally and historically, based on this Court’s view in the Palmer case and other cases, the question is, what was the intention involved?

Sherman Minton:

If they were not employees just outside persons, they –-

Richard F. Barrett:

And there was knowledge.

Under the Jacobson case before this Court, it’s cited in my brief.

I can’t remember the volume and page at the moment.

If there was no attempt by the seller to get all that he could for the property, it was a gift for income tax purposes and exempt.

Now, I would like to address my remarks to the point that Mr. Justice Harlan raised and go on to the change in 1946 and the regulations where this change was made to a conclusive presumption that because of the employer relationship, there must be compensation in every stock option case.

The interesting point about that is, at the same time, there was no change made in the stockholder option regulations that related to dividends.

Those remained the same that it would still open the question of facts just as to whether the purpose and intention was to declare a dividend.

There seems to be a rather hypnotic influence exercised on the Commissioner by the employee relationship, one and one makes two for a stockholder, but the same in the case of an employee makes three.

The regulations admit of no exception.

Now, the Commissioner does do lip service in this case in his argument, not in these regulations to one exception, gift, but it’s through lip service because the whole rationale of his argument is that if you’re an employee, the employer will not make a gift to you.

However, he says there’s no middle ground that may not be a purchase transaction such as this case held there could be if that is the intent and purpose in the Palmer case.

Now, the logical invalidity of the Commissioner’s position can be illustrated by a rather homely and down to earth illustration.

Corporation X, which is a closely held corporation and whose stock has no established market value, announces to all its employees that the stockholders are making an offer to them that they may buy a stock for a period of three months at the market price for the stock.

The announcement states that this is in response to request from employees that they would be allowed to become stockholders.

And the stockholders think that it would be sound for the corporation to have its employees participate in the stock ownership.

The announcement also states that because of the unestablished market value of the stock, three independent competent appraisers will be selected to determine the market value.

Many of the stockholders accept the offer, and in each case, the fair market value which is to be the purchase price, is determined on a bonafide careful basis by this committee of independent, expert and competent appraisers.

Some stockholders turned down this opportunity because they object to the price determined as being too high.

The Commissioner, using capitalization of earnings and book value and other evaluation formula methods, determines that the market price is an excess of that for which the stock was sold, and the Tax Court uphold this determination.

Now, under the regulations, that discount for market is conclusively presumed to be compensation.

It’s perfectly clear that no gift is involved.

It is also — it’s equally clear that the stock option was granted because of the employee relationship, but it certainly is equally clear that there was no intention to compensate.

Richard F. Barrett:

It was merely an intention to make the sale of stock, but because the sale was at a market price, in excess of the option price, the Commissioner says there is a conclusive presumption of compensation.

Hugo L. Black:

Did you say there was no gift?

Richard F. Barrett:

No gift because there was an effort made on the part of the seller, the corporation, to get all that it could in the transaction.

That’s the rule laid down by this Court in the Jacobson case.

Hugo L. Black:

What was the stock worth at the time they gave the offer?

Richard F. Barrett:

The independent investment experts appraise the stock at — we will say $100 a share.

There is no established market value, Your Honor, so they had to do it by appraisal.

The Commissioner came in and said, “I say it’s worth a $125 a share,” and the Tax Court upheld it to make a simpler illustration.

The tax —

Hugo L. Black:

Well, what was the option value?

Richard F. Barrett:

The option —

Hugo L. Black:

What was the —

Richard F. Barrett:

— the option price was $100 a share, the fair market value.

Hugo L. Black:

Do I understand that the option price is in $100, and the actual value is in $5000?

Do you say that would be no gift, no —

Richard F. Barrett:

No, I would say there that I would conceive that there was obviously a purpose of compensating the employee.

Hugo L. Black:

Another words, your argument —

Richard F. Barrett:

If there is, if — if it is shown as a fact that the purpose is to compensate then your illustration would certainly demonstrate it conclusively then there is compensation.

Hugo L. Black:

Your argument is based on the fact then that by reason of the closeness of the option price to the extra value.

Richard F. Barrett:

My argument in the — in the hypothetical case is based on the fact that the seller made every effort to determine by independent appraisers how much the stock was worth.

He had no listing on the New York Stock Exchange to look at.

It was an untraded stock.

He made every effort of other formula devices used by the Commissioner and upheld by the Tax Court say, “No our guess is that it’s worth more.”

Hugo L. Black:

What does the book say?

Richard F. Barrett:

I was giving a hypothetical –-

Hugo L. Black:

I mean, here.

Richard F. Barrett:

Oh, here, I do not know.

There’s — there’s no issue on facts as to evaluation here.

Hugo L. Black:

Well, then, what I want to get at, how much is it conceded, in fact the worth, and how much was the option price?

Richard F. Barrett:

At the time that the option plan was adopted, the price was — the — the stock was worth $4.50 a share and the option price was $5.

Richard F. Barrett:

The plan was to sell it above the option — above market.

Now —

Hugo L. Black:

Do you mean at the time they gave him the stock, it was worth —

Richard F. Barrett:

At the time they gave him the — at the time —

Hugo L. Black:

At the time they gave him the option.

Richard F. Barrett:

At the time they gave him the option, the market price had become higher than the option price, but the time that the plan was adopted, the market was —

Hugo L. Black:

(Voice Overlap) was put in effect.

When he got the options, did he —

Richard F. Barrett:

Market —

Hugo L. Black:

— get more than his money is worth on the value of the option?

Richard F. Barrett:

The market was higher than the option price, yes sir.

Hugo L. Black:

How much high?

Richard F. Barrett:

I think in one case, in one option, a $1.5 from $5 to 6.50 in another.

I think from $5 to $19.50.

Hugo L. Black:

And why do you say that was either a gift or a payment for something in so far as the difference between the values is concerned?

Richard F. Barrett:

I say because there was no intention to compensate.

Hugo L. Black:

No intention to compensate but what it did to compensate what it did a year?

Richard F. Barrett:

They adopted the plan.

They didn’t know what the price was going to be when the options were granted.

They adopted a plan.

The stockholders said to the directors, “You take these 10,000 shares and you select employees that are key employees in the company and you give them this option to buy.”

The whole plan was fixed.

The only thing that was left open was who is going to be selected, not whether anyone would be selected.

And at that time, the price of the stock was — the stock was worth less than the price of the option.

Now, at a later time, when the selections have been made and the plan had been carried through at that point, the stock had gone up.

But a host of cases below without any exception have said that if under these circumstances, if the purpose of the whole transaction was not to pass out compensation it’s merely an arrangement to sell property.

And that the time to impose the tax is after you bought the property and you sold it and you find out how much you eventually net out of the transaction.

Hugo L. Black:

I don’t want to waste — waste your time but I do want to state up to this time, my trouble with your case is this that reading these statements, it looks to me like they said in effect, “You’re a good employee.

We want you to be more loyal and do harder work and better work, and we’re going to let you have this stock at an option whereby you make $5000, $6000 or $2000 whatever it was,” and I can’t get to see how they could find that they didn’t go for that purpose.

Richard F. Barrett:

Well, I mean the — the record of course is open in result of the Tax Court to look at all of the facts as to whether the inferences, perhaps on both sides, led to the finding of facts that the company was not intending to compensate or whether it was intending to compensate.

Hugo L. Black:

Well, I was — I’ve read the record entirely there.

I’m not sure what up-to-date is, I can’t see any inference on the other side unless you’re going to say they won’t give it to them.

I can see that.

Richard F. Barrett:

Well, in the Palmer case, we have no gift.

We have a corporation issuing options to stockholders to buy a property at a certain price.

It wasn’t an excessive market.

By the time they got the options and exercised them, the price of the — the market price had gone up.

This Court said, “There wasn’t any purpose here to compensate, to declare a dividend.

The purpose was merely to sell a property.

Hugo L. Black:

But I can understand fully —

Richard F. Barrett:

They said nothing.

But what my point is, Your Honor, that there was nothing said about gift.

There was a middle ground that the Commissioner says can exist to purchase transaction.

That’s what the Palmer case held that you can have a purchase transaction like in the middle —

Hugo L. Black:

I can understand your case where at the time the gift from the stock option, they don’t make it, but I — it’s a little different for me to see why you sell a man a gold dollar for 50 cents, you would need to give him something or give him — or hire in the business.

Richard F. Barrett:

Well, if — if the seller is trying to get all he can, he is obviously not making a gift.

If he happens not to get all that he can, he is obviously in the illustration I gave, not trying to compensate the employee because he’s not trying to sell at less in under the regulation because it was sold at less.

And because it was sold to an employee its compensation, we quarrel with the conclusive presumption.

Hugo L. Black:

But I — that — that’s — I can understand that quarrel and if it’s conclusive presumption where — where they were not getting something, or nothing, or at least get involved in the money’s worth, I can understand that as far as the presumption, I mean the regulation.

Richard F. Barrett:

Well —

Hugo L. Black:

The thing that hits me is how you could find if there’s another gift or the other.

I’m sorry for the (Inaudible)

Richard F. Barrett:

If I can be — If I can be helpful, I’m certainly glad to discuss it I don’t think I have any more help to offer on that point.

As I understand it —

Stanley Reed:

(Voice Overlap) somewhat uncertain about just exactly this contract, as I understand it when the option is given to the employee, he is not expected to exercise it at all.

But later on, after he had performed the services and had worked hard and contributed, then the directors might allot to him some of his 10,000 shares, but he was not given an option the day that the first letter was sent for so many shares.

Richard F. Barrett:

No, he wasn’t given the option because they had to get the thing cleared by the Michigan Securities Commission which —

Stanley Reed:

No, no, but he — even leaving aside all that, he only got an option to buy after his work to the preceding year had been completed and then the directors divided some of the shares, I don’t suppose all the 10,000 at one time against a number of shares among X number of people at the end of the work.

Richard F. Barrett:

Well, of course, there was no end of the work in the sense that his work continued, we’ll say at the end of the calendar, end of the year.

Stanley Reed:

(Voice Overlap) —

Richard F. Barrett:

End of the year.

Stanley Reed:

End of the year.

So, for the preceding year in January, they allotted so many shares to this person if he wanted —

Richard F. Barrett:

Well, the — the —

Stanley Reed:

— to lessen the value.

Richard F. Barrett:

The facts as to the terms of the option and the information given to the employee by the — by Mr. Davis, the Chairman of the Board and the President of the company is given by — my colleague here is highly selective.

I mean, we bring forward in purpose to your attention in our brief all of the other things that was said about.

We want you to be a stockholder.

You should take pride of being an owner.

Its — his statement over here was heavily weighed, it was — which I don’t object at all towards an intention, simply to pick out someone who worked hard, but they were trying to pick out the people who were the key employees.

They couldn’t do it blindfolded and just walk around a game of blind man’s buff picking out this follow and that in the dark its key employees and give them the option.

They had to pick out people on merits so they had to refer to the good job they’ve done and all that type of thing.

May — I can’t understand is why the intention to compensate, the intention to give ownership interest in mutually exclusive concepts.

Richard F. Barrett:

They are not mutually exclusive and they’re not so treated in the courts below.

I think we can dispose of that by simply rating the rationale of criteria, as the courts below call it of the Geeseman case, a 38 B.T.A. case which they’ve expressly adopted in which they said, “This is the criteria we applied.”

At page 7 of our brief, in the quotation near the center of the page, each court applied the criteria set out in Delbert B. Geeseman, “As a prerequisite to the conclusion sought by the respondent,” that’s the Commissioner, which as his — what he seeks is to be a compensation.

“It should definitely and clearly appear that the transaction,” and then in italics, “is in fact to some extent the payment of compensation for services rendered or to be rendered.”

Now, if —

Felix Frankfurter:

Mr. Barrett, did both courts act exclusively on documents?

Richard F. Barrett:

No, they acted on oral testimony?

Felix Frankfurter:

What type of testimony?

Richard F. Barrett:

By the President of the company and the President who conceived the plan.

In my remaining moment or two, may I turn to the procedural aspect of this, if it please the Court, and that is the background of this finding of fact against which — which we submit the Court should review this case.

This Court has taken the position repeatedly that a two court finding of fact is not reviewable under Section 52 (a) of the Federal Rules of Civil Procedure, except, and these are the words of this Court, “In the presence of very exceptional and obvious error.”

Now, on all the evidence here of the Tax Court including the un-rebutted testimony of Mr. Davis, the President of the employer corporation found that there was no purpose to compensate.

And the Court of Appeals concurred without any qualification.

So, we have here a question of whether a regulatory fiat that the acquisition, the advantageous purchase of stock by every employee from an employer is compensation, simply because of the employee relationship, whether because of such a — such a conclusive presumption, the courts are barred from enquiring into the true facts as to the intention and motives.

And really, whether it’s compared to stockholders, employees are somewhat second class taxpayers in the sense that they cannot buy property from their employer corporation if that is the — that there is no purpose to compensate.

Philip Elman:

If the Court please, I don’t know if my time is up.

I believe I have an —

Earl Warren:

Oh, I think you have a minute or two, yes.

Philip Elman:

In very brief points, I should like to make first —

Earl Warren:

Yes, yes.

Philip Elman:

— in response to Mr. Justice Black’s questions to Mr. Barrett.

We have set forth in our brief at page 29 the option prices, the fair market value in issue, fair market and the fair market value inquired.

The 300 shares of stock were acquired in February 1946.

The option price was $5 a share at that time.

It remained $5 of course, and the fair market value was $30.50 –-

Hugo L. Black:

At that time?

Philip Elman:

At that time.

And in January 1947 as to the 40 shares, option price still is $5, fair market value $19.50.

I should like to make the further point, sir, that we do not say that there is a conclusive presumption that when — when stock is purchased at a favorable price by an employee that it’s taxable.

The regulation has expressly recognize that where the transaction is exempt from taxation by law as in the case of a gift, then certainly intention is very material.

If that issue is tendered as it was not in this case, but if it were tendered, the issue should certainly be a canvass, intention to make a gift if found by the triers of fact and if that finding is supported by the evidence, of course, established as a gift.

If those questions of fact, as what — that this Court is indicating a whole line of cases from the Jacobson case and the Robertson case going on back to (Inaudible) and Old Colony Trust Company, was — was this given as an act of generosity, was it motivated by affection, friendship, charity?

Felix Frankfurter:

Was propriety interest to be equated with gift?

Philip Elman:

Not at all, sir.

Felix Frankfurter:

Pardon me.

Philip Elman:

It may be, it may be that where there is a gift, there’s an —

Felix Frankfurter:

That’s why — that’s why your remarks about gift do not (Voice Overlap) —

Philip Elman:

Our difficulty —

Felix Frankfurter:

(Inaudible)

Philip Elman:

Our difficulty is that which was expressed by Mr. Justice Harlan.

We don’t see how the intention to convey property to give the employee a proprietary stake in the business is inconsistent with — with compensation any more than it’s inconsistent with gift.

Felix Frankfurter:

Well, that’s what I understand as the category, compensation, gift as proprietary interest.

Philip Elman:

We find compensation and gift in the statute, but we don’t find proprietary interest.

Felix Frankfurter:

All right.

Philip Elman:

And if the right questions have been asked here, was there an intention to compensate, was there an intention to make a gift, this case would not be here.

Thank you very much.