The court rejected Gail Racine’s argument that her loan to finance the payment of taxes to complete the exercise of options was a second option replacing the first and therefore the shares still had not been transferred to her.
From March through July 2000, Racine exercised options to purchase 25,257 shares of Allegiance Telecom’s stock. The exercise price was $58,810.79, and the market value of the shares at the time of exercise was $1,972,705.63 (an average of $78.10 per share). Allegiance Telecom remitted about $625,000 in income tax on Racine’s gain and demanded reimbursement before it would give Racine clear title to the shares, the opinion said.
Racine borrowed about $684,000 on margin from CIBC Oppenheimer, a market-maker in Allegiance Telecom, to finance the exercise price and tax reimbursement. The market price of Allegiance Telecom’s stock began to decline soon after she exercised the options, and CIBC Oppenheimer issued margin calls in order to ensure that the stock was worth at least the minimum ratio required by the Federal Reserve Board’s Regulation T.
In November 2000 Racine sold 18,921 shares at an average price of $15.61 per share, and in May 2001 she sold 1,836 shares at $20.41 per share. That left her with 4,500 shares. Racine’s capital loss could not be offset against capital gains because she had none since the gain from the options’ exercise was ordinary income and her basis in the shares was $1.97 million.
According to the court, Racine claimed a $368,000 refund (plus interest) on her 2000 tax return, asserting that the shares had not been transferred to her during the first half of 2000 when they traded for more than $78 apiece, but instead had been transferred in November 2000 when they were sold. Additionally, Racine claimed on her return the shares held into 2001 were not yet transferred and not subject to tax until they were sold.
Racine received her refund, but after an audit the Internal Revenue Service demanded the money back. The Tax Court ordered Racine to pay $514,000 in back taxes and interest, finding that a transfer occurred when the options were exercised because Racine acquired full legal and beneficial ownership of the shares – she could sell them, vote them, hypothecate them, and so on, satisfying the regulation’s definition of a “transfer.”
The appellate court affirmed the tax court’s decision, adding that a transfer occurs when options are exercised because the owner of the shares is subject to market risk from that time forward.
The opinion in Racine v. Commissioner of Internal Revenue is here .