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US Supreme Court Declares Railroad Stock Options Not Taxable
Many San Diego and California businesses offer their employees stock options as a form of compensation. Sometimes (rarely) the stock option is without cost; more often, the option is a right to purchase company stock at a set price. Assuming there is a liquid market for the stock, if the option price is lower than the prevailing market rate, the employee can “cash out” the stock and pocket the proceeds. Employers offer stock options for several reasons, including:
- Provides a cash-free method of compensating employees — good for company cash flow
- Gives employees some ownership in the company which, in theory, incentivizes them to work harder for the company
- Increases — in theory — the value of the company by virtue of having incentivized employees to work hard to maximize the market price of the company’s stock
Generally, the federal Internal Revenue Service deems stock options to be taxable income, particularly when the option is “cashed out.” The sales proceeds are considered income.
Interestingly enough, the US Supreme Court held to the contrary in a case decided in June 2018. See Wisconsin Central Ltd. v. United States, Case No. 17-530 (US Supreme Court June 21, 2018). The case decision is limited to railroad companies, but it is an interesting look at how some stock options work in practice. Of note is the use of a so-called “cashless option” for railroad employees.
Taxable to the employee or not, stock options and other equity/ownership units offered as compensation are a useful tool for San Diego businesses. If your company wants to explore possibilities, call a good San Diego securities lawyer.
San Diego Corporate Law: Facts and Holding of Wisconsin Central
Wisconsin Central concerned stock options under the Railroad Retirement Tax Act of 1937 (“TTRA”). During the Great Depression, the RRTA federalized railroad pensions. Under the RRTA, railroad employees are taxed and, upon retirement, the government provides a pension. The railroad employees are taxed on all “compensation” which, under the TTRA, is defined as “any form of money remuneration.” See 26 U.S.C. §3231(e)(1). For the five Justices in the majority, the word “money” excluded the idea of non-money stock options. Thus, for those Justices, railroad stock options were not “compensation” and, thus, were not taxable.
Four Justices dissented for various reasons. One objection was the reality that a high percentage of railroad employees used what is called a “cashless option” when exercising their stock options. Under this procedure, the railroads offered a box for the employees to check off on a railroad form that asked the company to buy the stock at the option price for the employee and then immediately sell the stock at the higher market price, with the proceeds deposited into the employee’s bank account. For the four dissenting Justices, this was clearly “money remuneration” and to say otherwise was promoting form over substance. For some private railroads, the percentage of employees using this option exceeded 90%, or 93% in the case of CSX, 90% to 95% in the case of BNSF.
In addition, the dissenting Justices noted that various amendments to the RRTA excluded from taxation various “qualified stock option plans.” For those Justices, if all stock option plans were already excluded under the original RRTA, why separately exclude “qualified” plans in later amendments?
In any event, the majority controls. As a result, expect private railroads to offer more stock options as compensation and expect many more railroad employee to exercise those options.
Contact San Diego Corporate Law
For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for San Diego and California businesses including use of stock options, equities, and ownership units as compensation. Mr. Leonard can help ensure any stock option plan complies with Federal and California laws including securities laws. Mr. Leonard has been named a “Rising Star” three years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Mr. Leonard can be reached at (858) 483-9200 or via email.
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