Supreme Court Reverses Seventh Circuit; No Railroad Tax on Stock Options

(Parker Tax Publishing June 2018)

The Supreme Court reversed the Seventh Circuit and held that the term "money," as used in Code Sec. 3231, unambiguously excludes "stock" and thus the railroad companies were entitled to refunds of taxes they paid on their employees' exercise of stock options. According to the Court, when Congress enacted Code Sec. 3231 in the Railroad Retirement Tax Act (RRTA) in 1937, the term "money" was understood to mean currency issued by a recognized authority and used as a medium of exchange and, while stock can be bought or sold for money, it isn't usually considered a medium of exchange. Wisconsin Central LTD v. U.S., 2018 PTC 182 (S. Ct. 2018).

Background

In 1996, Wisconsin Central Ltd., Illinois Central Railroad Co., and Grand Trunk Western Railroad Co. ("the Railways"), all subsidiaries of the Canadian National Railway Company, began including stock options in the compensation plans of a number of employees. The options were nonqualified stock options, meaning that they were not incentive stock options as defined in Code Sec. 422(b) or part of an employee stock purchase plan as defined in Code Sec. 423(b), which in turn means that they were not "qualified stock options" as defined in Code Sec. 3231(e)(12).

Each option gave the employee the right to purchase one share of Canadian National stock at a fixed price equal to the stock's publicly traded price on the date of the option grant ("exercise price"). If an option was not exercised within a ten-year term, or possibly earlier if an employee retired or died, it expired. Twenty-seven percent of the options exercised from 2006-2013 were "performance" options, exercisable only if Canadian National attained certain financial performance benchmarks in a given year, while the remaining 73 percent were exercisable without regard to corporate financial performance or other constraints.

The Railroad Retirement Tax Act (RRTA) enacted Code Sec. 3201 through Code Sec. 3241. The RRTA was passed in 1937 and requires a railroad to pay an excise tax equal to a specified percentage of its employees' wages, and also to withhold a specified percentage of its employees' wages as their share of the tax. The RRTA is to the railroad industry what social security taxes paid by non-railroad employers and employees under the Federal Insurance Contributions Act (FICA) is to other industries: the imposition of an employment or payroll tax on both the employer and the employee, with the proceeds used to pay pensions and other benefits.

Under Code Sec. 3231(e)(1), the RRTA subjects to taxation "compensation," defined as "any form of money remuneration paid to an individual for services rendered as an employee to one or more employers." On the other hand, FICA, in Code Sec. 3121(a), taxes "wages," which are "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash."

The railroad retirement tax rates are much higher than the social security tax rates. Unlike FICA, the RRTA imposes two tiers of taxes under Code Sec. 3201, with Tier 1 providing benefits and taxes in a manner almost identical to FICA, and Tier II functioning like a private pension plan, tying its benefits to any individual employee's earnings and career service.

In their initial tax payments for the years at issue, the Railways treated each exercised option as income for federal income tax purposes and compensation for the purposes of the RRTA, in the amount by which the publicly traded share price of Canadian National on the exercise date exceeded the exercise price for each option exercised, and paid taxes on those amounts. The Railways subsequently came to believe that paying the tax was a mistake and that no RRTA tax should have been paid on the exercised nonqualified stock options as the options did not qualify under the RRTA as "any form of money remuneration." The Railways filed for a tax refund, which the IRS rejected. The Railways then filed suit against the IRS in district court.

The Railways' Arguments

The Railways argued that the particular non-qualified stock options at issue were not compensation under the RRTA because the phrase "money remuneration" is a specific limitation in the RRTA that distinguishes RRTA compensation from FICA wages.

According to the Railways, the absence of a statutory definition for "money" in the RRTA and the Internal Revenue Code implies that the word must have a commonly understood meaning outside the context of the Internal Revenue Code, and that its common definition and usage should apply throughout the Code, in the absence of any specific modification for a particular provision. The common understanding of money, the Railways said, is that it has a constant amount or denomination representing a specific stored value that can be applied to a future transaction. They contrasted that with non-money property, which has no fixed value but is susceptible to varying valuations over time and subjectively in the hands of different holders. According to the Railways, income from the exercise of the nonstock options given to employees is not a form of "money remuneration" to them and is therefore not taxable to the railway as compensation under Code Sec. 3231(e)(1).

District Court and Seventh Circuit Agree with IRS

In Wisconsin Central Ltd v. U.S., 2016 PTC 248 (N.D. Ill. 2016), the district court sided with the IRS and denied the Railways refund claim after finding that the phrase "any form of money remuneration" included nonqualified stock options.

The Railways appealed to the Seventh Circuit which, in 2017 PTC 216 (7th Cir. 2017), affirmed the district court. The Seventh Circuit noted that the value of a company's stock is a function of the company's profitability, whereas the size of a cash bonus, once it is given, is unaffected by the company's future business successes or failures. Underscoring the point, the court noted that the railway's stock-option plans are performance-based: they can be exercised only if the company achieves specified goals. According to the court, the fact that cash and stock are not the same things doesn't make a stock-option plan any less a "form of money remuneration" than cash. Indeed, the court said, the Railway offers its employees a choice to have an agent exercise an employee's stock option, sell the shares of stock obtained by that exercise of the option, reserve part of the money received in the sale for taxes and administrative costs, and deposit the balance in the employee's bank account. An employee who uses this method, the court said, will thus experience the stock option as a cash deposit.

The Seventh Circuit concluded that the equivalence of stock to cash is actually signaled in the statutory exception for qualified stock options, explicitly divorced from "money remuneration" by Code Sec. 3231(e)(12). To the court, that exception, by virtue of its narrowness, supported an inference that non-qualified stock options are covered by the term "money remuneration" and are therefore taxable.

The Railways then appealed to the Supreme Court which granted certiorari.

Supreme Court Reverses Lower Courts

On June 21, in a 5-4 decision, the Supreme Court reversed the district court and Seventh Circuit decisions and held that employee stock options are not taxable "compensation" under the Railroad Retirement Tax Act because they are not "money remuneration." When Congress adopted the Act in 1937, the Court said, "money" was understood as currency issued by a recognized authority as a medium of exchange. It was obvious to the Court that stock options do not fall within that definition. While stock can be bought or sold for money, it isn't usually considered a medium of exchange. As the Court observed, few people value goods and services in terms of stock, or buy groceries and pay rent with stock. Adding the word "remuneration" also does not alter the meaning of the phrase, the Court said.

The Court found that, when the statute speaks of taxing "any form of money remuneration," it indicates Congress wanted to tax monetary compensation in any of the many forms an employer might choose. It does not prove, the Court said, that Congress wanted to tax things, like stock, that are not money at all. According to the Court, the broader statutory context pointed to this conclusion. For example, the 1939 Internal Revenue Code, adopted just two years after Code Sec. 3231, also treated "money" and "stock" as different things. And a companion statute enacted by the same Congress, the Federal Insurance Contributions Act (FICA), taxes "all remuneration," including benefits "paid in any medium other than cash." The Congress that enacted both of these pension schemes, the Court said, knew well the difference between "money" and "all" forms of remuneration and its choice to use the narrower term in the context of railroad pensions alone, the Court said, required respect, not disregard.

According to the Court, even the IRS seemed to have understood all this back in 1938 because shortly after the RRTA's enactment, the IRS issued a regulation explaining that the RRTA taxes "all remuneration in money, or in something which may be used in lieu of money (scrip and merchandise orders, for example)." The regulation said the RRTA covered things like salaries, wages, commissions, fees, and bonuses. But, the Court observed, the regulation nowhere suggested that stock was taxable. In light of these textual and structural clues and others, the majority of the Supreme Court thought it was clear enough that the term "money" unambiguously excludes "stock."

For a discussion of the RRTA taxes on compensation, see Parker Tax ¶213,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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