Stock Options, Tax Court

Stock received on option exercise was taxable event even though it became worthless in about six months: OUCH!

Patrick Sheedy worked for People’s Choice Financial Corporation (“PCFC”) from October 2001 through June 2006.  In 2004 he received nonqualified stock options to purchase 271,067.30 shares of PCFC common stock for $0.0221347 per share.  The options expired three months after Sheedy’s termination with his employer.

Sheedy left his employer in June 2006 and exercised most of his options on September 22, 2006, purchasing 250,000 shares that were “restricted securities” if the company went public.  As set forth in the option agreement, the compensation committee of the board of directors set the fair market value of the shares of privately held PCFC on the date of exercise.  The committee determined the value to be $3.00 per share, a price at which shares had changed hands infrequently in the last several months before the sale through an investment adviser who acted as an intermediary for trades of PCFC shares.  Sheedy signed a typical “accredited investor” letter stating that he knew what he was doing and knew about the company’s business and financial condition.

Sheedy paid PCFC a total of $225,278:  $5,534 for the purchase price of the shares and withholding tax of $ 219,744.  In March 2007, PCFC declared bankruptcy.

Let’s summarize.  Sheedy recognized almost $750,000 of ordinary income and was out of pocket almost $250,000 in taxes on stock that was worthless six months later.

Sheedy filed an original return for 2006 reporting the income.  He filed an amended return claiming a theft loss in the amount of the income recognized.  Nice try.

The law is clear, but punitive in the instant case.  The Tax Court got it right.  Sheedy was taxable on the difference between the $3.00 per share purchase price and the purchase price of $0.0221347 per share; no refund for 2006 for Sheedy.

As a consolation prize, the IRS awarded Sheedy a worthless stock loss in the form of a short-term capital loss.  If Sheedy lives an exceptionally long life and his investing acumen does not improve, he’ll recoup his money in 250 years.

Back in the 1980s, I witnessed this same phenomenon strike a number of employees of a client of mine.  These good folks were featured in a Fortune magazine article that trumpeted their sudden wealth when their employer went public and they held very valuable stock following the IPO.  Only a six-month restriction period kept them from being cash rich:  sort of an East Texas and low-tech version of Facebook millionaires.  During that six months the stock tanked.  They could not pay their taxes, even if they sold all their stock.  I and my colleagues from around the country tried to find a solution.  There was no way out.

So, let Sheedy be a cautionary tale if you get a chance to get in on the ground floor through nonqualified stock options.  Be sure that you understand the price you pay and the risks you take for the opportunity.