Stock options exercised by railroad employees are a form of monetary compensation taxable to the employer and employee under the Railroad Retirement Tax Act, according to the Seventh Circuit Court of Appeals (Wisconsin Central Ltd., et al. v. United States, No. 16‐3300 (7th Cir. 2017)).
In 1996, three Midwestern railroad subsidiaries of the Canadian National Railway Company began including stock options in their employees’ compensation plans. In its appeal from a district court ruling, the railway argued that income from the exercise of stock options that a railroad gives its employees is not a form of “money remuneration” to them and is therefore not taxable to the railway under the Act, which defines “compensation” as “any form of money remuneration paid to an individual for services rendered as an employee… .”
The Railroad Retirement Tax Act of 1937 is the railroad industry’s version of the Social Security Act; it imposes a payroll tax on both employer and employee to pay for pensions and other benefits.
The question before the Seventh Circuit was whether the tax should be levied on the value of stock options exercised by employees when the market price reaches a certain level. The Internal Revenue Service argued that it should, and in a 2-1 decision, the court agreed.
Writing for the majority, Judge Richard Posner stated: “Stock has so well‐defined a monetary value in our society that there is no significant economic difference between receiving a $1,000 salary bonus and a share or shares of stock having a market value of $1,000.”
Posner reasoned that the value of a company’s stock is a function of its profitability and gives employees incentive to work harder so the company does well, making it remuneration for services rendered.
“The railway’s stock‐option plans are performance‐based: they can be exercised only if the company achieves specified goals. … 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.”
To illustrate this, Posner noted that the stock plan allows railroad employees to sell their shares of stock and have the after-tax proceeds deposited directly to their bank accounts, thereby receiving the option as a cash deposit.
Posner rejected the railroads’ argument that the drafters of the Act did not intend to include stock as taxable compensation. “Maybe stock [in 1935] wasn’t a form of money remuneration, but there is no reason to think that the framers and ratifiers of the Act meant money remuneration to be limited to cash even if, as was eventually to happen, stock became its practical equivalent.”
The Act’s exception for “qualified” stock options, along with other statutory exceptions for noncash employee benefits, supported the inference that the non‐qualified stock options at issue were covered by the term “money remuneration” and therefore taxable, Posner concluded.
“The government’s position also makes good practical sense by avoiding the creation of a tax incentive that might distort the ways in which employers structure compensation packages for their managers,” Posner wrote, noting that other federal circuits have recognized non‐qualified stock options as money remuneration under the Act.
In a lengthy dissenting opinion, Judge Manion argued that because the Act’s plain language did not include stock or stock options in the definition of taxable compensation, and the Act differs from the statute governing Social Security contributions in defining what is taxable, the court should have found for the plaintiffs.
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