In Uncategorized on 03/14/2012 at 18:16

That’s the problem with exercising unqualified stock options on restricted stock, as is made clear to Patrick J. Sheedy and Karen J. Sheedy, 2012 T.C. Mem. 69, filed 3/14/12 (happy pi day).

Pat was a mortgage lender and a senior official in a subprime loan packager. When the corporation for which he worked restructured, Pat got what looked like a juicy stock option. There were the usual hooks: the stock was restricted by SEC regulations, could not be sold for a year, and could only be sold to accredited investors. The option deal was shown in the S-11 filed with SEC, but Pat never introduced that at trial. Pat also signed an accredited investor letter: he stated he was sophisticated, understood the risks, knew he couldn’t easily sell, and had all the necessary information he needed to make a reasoned investment decision.

Pat exercised the option, and got a W-2 showing that he did. Pat tried to unload the stock. The corporation never went public, so the only market was run by FBR Capital Markets, Inc. FBR, formerly Friedman, Billings, Ramsey & Co., Inc., is an investment adviser offering investment banking, sales, and trading services. At the material dates FBR was a registered broker-dealer that was a member of the NASD and NASDAQ. Moreover, it was the leading bookrunner (bid and ask broker) for restricted stock like what Pat was trying to unload.

Pat tried to unload via FBR, but no dice. Finally, overwhelmed by the subprime market meltdown, the corporation cratered, went into liquidation and sank without trace. Pat lost everything but the Section 83(a) deficiency based on the difference between FMV of the stock at exercise (as shown by FBR’s trading reports) and the exercise price (minuscule). Pat claimed a theft loss based on the deterioration of the corporation.

Pat claims IRS has to prove the validity of the W-2, based on Section 6201(d). But Pat and IRS stipulated the W-2 and the FBR sales figures, so IRS did introduce proof. Pat introduces none to prove the FBR sales numbers were wrong.

Now where property received in exchange for services has no market value, it need not be recognized under Section 83. But property has no value only in rare and exceptional circumstances. In short, there’s almost always a buyer for anything–at the right price.

The stock may have been restricted when it came to sale to the public at large, but Pat had ownership, control, benefits and burdens; there was no substantial risk of forfeiture.

Pat owned the stock outright, and there was a market, albeit restricted, for the stock.

But here, as in many other cases, Tax Court has to decide a case in the absence of careful lawyering (and both parties had counsel here). Judge Laro: “We begin our discussion of the fair market value of … stock by noting an evidentiary void caused by each party’s failure to call an expert witness on the matter. Expert witness testimony, while certainly not determinative of value, may prove helpful in assisting the Court to understand areas requiring specialized knowledge, experience, training, or judgment. See Fed. R. Evid. 702. Petitioners bear the burden of proving the fair market value of … stock, see Morris v. Commissioner, 70 T.C. 959, 988 (1978), and that burden is steepened in the absence of reliable and reasonable expert opinion on the point in question.” 2012 T. C. Mem. 69, at pp. 18-19.

Judge Laro goes on: “Whereas isolated stock sales may not be a reliable measure of fair market value in the face of contrary evidence, see Duncan Indus., Inc. v. Commissioner, 73 T.C. 266, 278 (1979), petitioners have not introduced evidence casting doubt on the sales which FBR facilitated other than petitioner’s self-serving trial testimony. We scrutinize carefully unsubstantiated testimony of interested parties. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). In this case, we decline to credit petitioner’s testimony absent corroborating evidence. Petitioners have offered no expert opinion evidence on the matter. They did not introduce a copy of the Form S-11 registration statement filed with the SEC in June 2006 establishing the primary offering price, though petitioner testified that his decision to exercise the options was based in part on the fact that the form was filed.” 2012 T.C. Mem. 69, at pp. 20-21.

Deficiency sustained. However, IRS generously gives Pat and Karen a $750,000 short-term capital loss on their worthless stock, based on  the value thereof as determined by Tax Court. Pat and Karen can take that at the rate of $3,000 per year. Those guys are all heart.


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