ADOPTED SEPTEMBER 20, 2005
CALIFORNIA STATE BOARD OF EQUALIZATION
PERSONAL INCOME TAX APPEAL
DECISION
Appellants
Year
Proposed
Assessment
Richard R. and Mari J. Cower
Case No. 294394
2000
$63,635
Representing the Parties:
For Appellants:
For Franchise Tax Board:
Counsel For Board of Equalization:
Richard R. and Mari J. Cower
Jeanne M. Sibert, Tax Counsel
Carl Bessent, Tax Counsel III
QUESTIONS: (1) Whether the taxable gain realized on the exercise of appellant-husband’s
nonqualified stock options received as an employee of Intel Online Services
constitutes employee compensation – a portion of which must be sourced to
and taxed by California – or in the alternative, gain derived form “intangible
property” that must be sourced to appellants’ out-of-state domicile.
(2) Whether respondent’s determination not to abate additional interest amounts
to an abuse of discretion.
FINDINGS AND DETERMINATION
Background
Appellants timely filed their 2000 California nonresident or part-year resident
return. Appellants’ reported total California wages on their form W-2 was $1,061,366, from
Intel Online Services. On appellants’ Schedule CA, they reported California-source income of
$129,635. Appellants indicated that they became California nonresidents on March 26, 2000,
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when they moved to Idaho. Appellants’ reported total California income tax was $11,714, and
they claimed a refund of $51,595, which was refunded by respondent.
Subsequently, respondent requested additional information and appellants
provided documents, including a Merrill Lynch statement for January 1, 2000, to December 29,
2000, for the Intel Corporation Stock Option Program. According to appellants’ documents, on
January 11, 2000, appellants exercised 1,000 nonqualified stock options (NQSO’s) that were
granted on April 12, 1994. Appellants included the gain from these NQSO’s ($81,937.10) in
their reported California taxable income because they exercised the NQSO’s while they were
California residents. On April 11, 2000, after moving to Idaho, appellants exercised 7,800
NQSO’s that had previously been granted, which resulted in total income (before taxes) of
$931,731.06. Appellants excluded the income for California tax purposes from the NQSO’s
exercised on April 11, 1995, because they exercised the stock options after they moved out of
California.
Appellants also provided their calculation of California workdays (862 days), and
total workdays (1,126 days) from the grant to exercise period of the NQSO’s.
After further correspondence, respondent issued a Notice of Proposed Assessment
(NPA), dated December 15, 2003. The NPA increased California AGI by $713,240, which
respondent indicated was the California-source income from the NQSO’s. The revision of
appellants’ California AGI increased the apportionment factor from .1228 to .7901. 1 Thus,
respondent revised appellants’ apportioned California income tax from $11,711 to $75,346, plus
the $3 additional tax reported on their form 3805P, minus the previously assessed tax of $11,714,
for additional tax due of $63,635, plus interest.
Appellants protested the NPA and requested a protest hearing. Later, appellants
waived their right to an oral hearing. The Protest Hearing Officer reviewed the provided
documents and concluded that a Notice of Action (NOA) should be issued. Respondent
issued a NOA on October 14, 2004, affirming the NPA. 2 Appellants filed this appeal.
Contentions
On appeal, appellants state that they had no rights to any portion of appellanthusband’s disputed stock options during their residency in California. Appellants contend that
when they exercised the NQSO’s about 16 days after leaving California, the income cannot be
sourced to California. Appellants assert that Revenue and Taxation Code (R&TC) section 17952
1
The “apportionment factor” calculation determines what portion of a taxpayer’s total income was sourced in
California. (See Rev. & Tax. Code, § 17041.)
2
On the NOA, respondent suspended interest from October 16, 2002, to December 29, 2003, pursuant to Revenue
and Taxation Code section 19116.
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is the applicable statute and it requires the income from the NQSO’s (the sale of stock) be
sourced to Idaho. Appellants allege that delayed actions of respondent added eight months
to the process with respondent, which appears to be a request for interest abatement.
Respondent contends that although appellants were not residents of California
when they exercised the disputed NQSO’s, appellants were granted the NQSO’s as California
residents. Appellant-husband performed services both inside and outside California after the
grant of the NQSO’s; therefore, a portion of the gain from the exercise of the NQSO’s (and the
resulting stock sale) was California-source income. Respondent applied a workday allocation to
the NQSO gain and calculated appellants’ California-source income from the exercise of their
NQSO’s on April 11, 2000. Respondent asserts that it applied the California method and
correctly calculated appellants’ California income tax. Additionally, respondent argues that
appellants did not meet the requirements for interest abatement.
Discussion
Exercise of the NQSO’s
Respondent’s determination is presumed correct and appellants have the burden
of proving it to be wrong. (Todd V. McColgan (1949) 89 Cal.App.2d 509; Appeal of Myron E.
and Alice Z. Gire, 69-SBE-029, Sept. 10, 1969; Appeal of Ismael R. Manriquez, 79-SBE-077,
Apr. 10, 1979.)
In general, a “stock option” is an employee’s unexercised right to buy stock of the
corporation employing him or her for a fixed price (which may be nominal) at some fixed time in
the future – regardless how much the stock price may have increased during the time period from
the date it was granted. Typically, stock options are given to employees as consideration for
their services to the corporation. The employee, however, technically does not own the stock
option granted to him or her prior to vesting, which typically is tied to a set number of years of
continued employment with the corporation. Once options vest, they must be exercised
within a range of time established by the plan.
R&TC section 17081 incorporates Internal Revenue Code (IRC) section 83 which
provides authority for the treatment of nonstatutory stock options, also known as NQSO’s.
Where stock options given by a corporation to any employee were not
transferable and the employee’s right to buy stock under them was contingent upon his
remaining an employee of the company until they were exercised, it was held by the United
States Supreme Court in Commissioner v. LoBue (1956) 351 U.S. 243 (LoBue) that the taxable
gain to the employee should be measured as of the time the options were exercised and not the
time they were granted.
Initially, the United States Supreme Court rejected LoBue’s – the taxpayer’s –
argument that a stock option transaction should be treated as a mere purchase of a proprietary
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interest in the corporation to which no taxable gain was realized in the year of the purchase. In
so holding, the court stated that a stock option given to an employee as compensation was not a
mere purchase of an interest or an arm’s length transaction between strangers, but an
arrangement by which an employer transferred valuable property to its employees in recognition
of their services; thus, it should be treated as taxable compensation, not the mere acquisition of a
property interest.
The LoBue court went on to acknowledge that, “it is of course possible for the
recipient of a stock option to realize an immediate taxable gain” where the option has a readily
ascertainable market value and the recipient is free to sell it, but noted that, “this is not such a
case. These three options were nontransferable and LoBue’s right to buy stock under them was
contingent upon his remaining an employee of the company until they were exercised.” (Ibid, at
249.) Furthermore, the court noted that, “the uniform Treasury practice since 1923 has been to
measure the compensation to employees given stock options subject to contingencies of this sort
by the difference between the option price and the market value of the shares at the time the
option is exercised . . . . And in its 1950 Act affording limited tax benefits for restricted stock
option plans, Congress adopted the same kind of standard for measurement of gains . . . . Under
these circumstances, there is no reason for departing from the Treasury practice. The taxable
gain to LoBue should be measured as of the time the options were exercised and not the time
they were granted.” (Commissioner v. LoBue, supra, at 249.) Thus, under the holding in LoBue,
the taxable gain to an employee who has received a restricted stock option in one year and then
sold it at a profit in a subsequent year should be measured as of the time the option was
exercised and not the time it was granted.
In the Appeal of Charles W. and Mary D. Perelle (58-SBE-057), decided by this
Board on December 17, 1958 (Perelle), the taxpayer entered into an employment contract in
which he agreed to work exclusively for his employer corporation for a period of five years. In
addition to a salary, he received a five-year option to purchase 10,000 shares of stock in the
corporation at any market price designated by him within one year from October 1, 1944. He
immediately selected the price existing on October 1, 1944. Subsequently – in 1946 – upon
leaving the employment of the corporation, the taxpayer sold his stock option back to the
corporation for $250,000. On its books, the corporation treated this sum as compensation. The
Board characterized the issue posed as follows: “[W]hether the amount realized on the sale of the
option is includible in California income for the year 1946.” While the respondent argued that
the $250,000 constituted compensation for services rendered in California, the taxpayer argued
that the option was not intended as compensation, but merely to give the taxpayer a proprietary
interest to insure his loyalty to the business.
Relying upon the United States Supreme Court’s decision in LoBue, the Board
found for the respondent and against the taxpayer, holding as follows: “Accepting [the
taxpayer’s] statement that the company’s purpose in giving the option was to insure loyalty,
that is tantamount to a purpose of securing better services as in the LaBue decision. It must be
concluded that the option itself or the gain on its sale was compensation for services.” (Appeal
of Charles W. and Mary D. Perelle, supra.)
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Although appellants were nonresidents when they exercised the stock options,
these options were compensation for services provided in California; therefore, a portion of the
gain is taxable California-source income. In Perelle, the taxpayers were California residents
when they were granted an option to purchase stock, but then they sold this option after
becoming Michigan residents. As stated above, in reliance on citing LoBue, the Board held that
the gain on the sale of the option was compensation for services. Because the services were
performed in California, the gain was taxable by California regardless of the taxpayers’ status
as Michigan residents at the time they sold their option.
R&TC section 17951 provides that for purposes of computing California taxable
income, the gross income of nonresidents includes only their gross income from sources within
California. California Code of Regulations, title 18, section 17951-5, subdivision (b)
(Regulation 17951-5), provides that, “If nonresident employees are employed in this State at
intervals throughout the year . . . between this State and other states . . . and are paid on a daily,
weekly or monthly basis, the gross income from sources within this State includes that portion of
the total compensation for personal services which the total number of working days employed
within the State bears to the total number of working days both within and without the State
[referred to herein as the “workday” apportionment method] . . . . If the employees are paid on
some other basis, the total compensation for personal services must be apportioned between this
State and other States and foreign countries in such a manner as to allocate to California that
portion of the total compensation which is reasonably attributable to personal services performed
in this State.”
What constitutes a reasonable apportionment method so as to properly limit a
taxpayer’s gross income to that earned “from sources within this State” pursuant to the dictates
of R&TC section 17951 must be based upon the facts and circumstances of each case. (Appeal
of James B. and Linda Pesiri, 89-SBE-027, Sept. 26, 1989.)
R&TC section 17952 provides that, “Income of nonresidents from stocks, bonds,
notes, or other intangible personal property is not income from sources within this State unless
the property has acquired a business situs in this State . . . .” R&TC section 17951 is a more
specific statute than 17952 and the more specific statue governs over the less specific statute.
R&TC section 17951 provides specific instructions for how a nonresident taxpayer should treat
his or her California-source income. IRC section 83 provides that gain from stock options is
compensation for services and, in accordance with Regulation 17951-5, compensation for
services must be allocated based on a reasonable allocation method, i.e., the pro rata “workday”
allocation.
Here, respondent relied upon the number of appellant-husband’s California
workdays and total workdays as provided by appellants. Based on this information, appellants
calculated 862 California workdays and 1,126 total workdays from the grant date to the exercise
date, for a ratio of .7655. Then respondent multiplied the total disputed stock option gain
($931,731) by the ratio (.7655) which equals $713,240 in California-source income.
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California Taxation of a Part-Year Resident
R&TC section 17041, subdivision (a), imposes a tax upon the entire income, from
all sources, of every California resident. R&TC section 17041, subdivision (b), imposes a tax
upon the California-source income of part-year residents and nonresidents. The tax on part-year
residents and nonresidents is determined first by calculating the tax on all income, regardless of
source, as though the taxpayer were a full-year resident. (Appeal of Louis N. Million, 87-SBE036, May 7, 1987.) The actual California tax liability is then factored out by applying the ratio
of California AGI to total AGI from all sources. (Id.) The purpose of the method is to apply the
graduated tax rates to all persons -–not just those who live in California for the full year; the
method does not tax out-of-state sources of income, but merely takes the out-of-state income into
consideration in determining the tax rate that should apply to California-source income. (Id.) 3
After examining the record, we conclude that respondent properly calculated
the tax on appellants’ California-source income under R&TC section 17041, subdivision (b).
California has not imposed tax on appellants’ non-California source income; the non-Californiasource income was simply considered in determining the tax rate applicable to appellants’
California-source income.
Interest
Interest is required to be assessed from the date when payment of tax is due,
through the date that it is paid. (Rev. & Tax. Code, 19101.) 4 Imposition of interest is
mandatory; it is not a penalty, but is compensation for appellant’s use of money after it should
have been paid to the state. (Appeal of Amy M. Yamachi, 77-SBE-095, June 28, 1977; Appeal
of Audrey C. Jaegle, 76-SBE-070, June 22, 1976.)
To obtain relief from interest, appellants must qualify under one of three statutesR&TC sections 19104, 19112 or 21012. R&TC section 21012 is not applicable, because there
3
The fundamental fairness and constitutionality of the above-described method of taxing the California-source
income of part-year residents and nonresidents has been upheld by New York’s highest court, and the United States
Supreme Court refused to hear an appeal from the New York decision. (Brady v. New York (1992) 80 N.Y.2d 596,
cert. den. (1993) 509 U.S. 905.) The Brady court reasoned that similarly situated taxpayers were those with the
same total income. For example, a nonresident earning $20,000 in New York, but with $100,000 reported total
income, should be taxed on the $20,000 New York-source income at the same rate as a New York resident with
$100,000 total income (and not at the same rate as a New York resident with $20,000 total income).
4
R&TC section 19101, subdivision (a), provides:
“If any amount of tax imposed by Part 10 (commencing with Section 17001) or Part 11
(commencing with Section 23001), is not paid on or before the last date prescribed for payment,
interest on that amount at the adjusted annual rate established under Section 19521 shall be paid
for the period from that last date to the date paid.”
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has been no reliance on any written advice requested of respondent. R&TC section 19112
requires a showing of extreme financial hardship caused by significant disability or other
catastrophic circumstance, which appellants have not alleged. We will therefore consider
appellants’ interest abatement request under the provisions of R&TC section 19104.
For tax years beginning on or after January 1, 1998, this Board may abate or
refund interest on appeal:
“[T]o the extent that interest is attributable in whole or in part to any unreasonable
error or delay by an officer or employee of the Franchise Tax Board (acting in his
or her official capacity) in performing a ministerial or managerial act.” (Rev. &
Tax. Code, § 19104, subd. (a)(1).)
Such an error or delay can be taken into account only if no significant aspect of
the error or delay is attributable to the taxpayer, and only after respondent contacted the taxpayer
in writing as to the underlying deficiency or payment. (Rev. & Tax. Code, § 19104, subd.
(b)(1).)
Respondent’s determination not to abate additional interest is presumed correct,
and the burden is on appellants to prove error. (Todd v. McColgan supra, 89 Cal.App.2d 509;
Appeal of Michael E. Myers, 2001-SBE-001, May 31, 2001.) Our jurisdiction in an interest
abatement case is limited by statute to a review of respondent’s determination for an abuse of
discretion. (Rev. & Tax. Code, § 19104, subd. (b)(2)(B).) To show an abuse of discretion,
appellants must establish that in refusing to abate interest respondent exercised its discretion
arbitrarily, capriciously, or without sound basis in fact or law. (Woodral v. Commissioner (1999)
112 T.C. 19, 23.) Interest abatement provisions are not intended to be routinely used to avoid
the payment of interest, thus abatement should be ordered only “where failure to abate interest
would be widely perceived as grossly unfair.” (Lee v. Commissioner (1999) 113 T.C. 145, 149.)
The mere passage of time does not establish error or delay that can be the basis of an abatement
of interest. (Id. at p. 150.)
It is clear from the foregoing authorities that respondent’s examination of
appellants’ 2000 return, and respondent’s determination of a deficiency and timely issuance of
an NPA does not constitute either a ministerial or managerial act for which interest may be
abated. Furthermore, appellants have not met their burden to show that respondent’s
determination not to abate interest amounts to an abuse of discretion. We note that there is no
statutory authority for the abatement of mandatory interest that accrued prior to respondent’s
first written contact with appellants regarding the tax deficiency (the initial contact letter sent by
respondent on January 17, 2003.) And, respondent suspended interest for periods from October
16, 2002, to December 29, 2003, under the provisions of R&TC section 19116. 5 Thus, the only
5
As relevant here, R&TC section 19116 provides that under certain conditions, if respondent does not issue an
NPA within 18 months of a timely filed return, interest will be suspended beginning on the first day after the 18
month period after the return was filed, and ending 15 days after the NPA is issued. Appellant’s 2000 return was
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interest legally in dispute is the interest that accrued after December 29, 2003. We find that
appellants have not shown any unreasonable error or delay by respondent in performing a
ministerial or managerial act, with respect to that interest.
Conclusion
For the foregoing reasons, respondent’s action is sustained.
Cower_cb
filed on or about March 29, 2001; 18 months after that is October 2002; respondent has apparently found that the
return was filed on April 15, 2001, as interest suspension begins October 16, 2002. The NPA was issued on June
16, 2003; 15 days after that is July 1, 2003.
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