Mr. Beane obviously did not hire a very good bean counter.
Mr. Beane was founder and chief-executive of AAVID Engineering. In 1992, Mr. Beane was granted 1,518,000 nonstatutory stock options. The stock options were scheduled to vest 25% per year over a four-year period. In 1996, AAVID went public. Between 1997 and 2000, Mr. Beane exercised all his options and sold the underlying stock.
A nonstatutory stock option (or nonqualified) is any option that does not meet the qualification criteria found in section 422. If a stock option meets the requirements of section 422 the employee is given preferential treatment pursuant to section 421. Generally, an employee must include in gross income compensation in cash and in-kind for services rendered. Under section 421, the employee will generally have income only after she has exercised the options and sold the underlying stock.
Nonstatutory stock options, on the other hand, result in gross income when the option is granted or upon exercise pursuant to section 83. In the latter instance (upon exercise), the difference between the fair market value of the stock and the price paid to exercise the options is treated as compensation in the year of exercise. Depending on the fair market value of the stock, this can result in a huge tax bill to the employee without a lot of money to pay it with (although, the employee could immediately sell the stock or take a loan against the stock to pay the tax bill).
When Mr. Beane exercised his stock options he made a myriad of errors in reporting his gain. For each of the three years Mr. Beane exercised the options, he reported the gain three different ways.
- In 1997 he reported income from exercised options as ordinary income.
- In 1998 he reported the income as trade or business income. He also reported the income subject to self-employment taxes.
- In 1999, he reported income for exercised options as self-employment income.
The IRS issued Mr. Beane a notice of deficiency for his 1998 tax return because he not only reported his gain incorrectly but he also reported less than 100% of it. His total gain on exercised options in 1998 was $21,886,688. But he only reported $13,511,014. Moreover, he reported this amount as trade or business income and paid self-employment taxes.
In 1999, Mr. Beane’s gain from exercised options was $4,938,543, but this time he reports $10,139,696. Again, he reported it as self-employment income and paid self-employment taxes.
The resources spent here trying to unwind Mr. Beane’s 1998 and 1999 tax returns appear to frustrate the Tax Court. And for good reason. The case here is a fairly simple. AAVID should have included the gain on Mr. Beane’s annual W2 as compensation. This would subject the gain to backup withholding and employment taxes. This is all spelled out rather clearly in IRS’s publication 525. Instead, Mr. Beane underreports one year, overreports the next, and pays self-employment taxes to boot.