NEW! What is the significance of the US Supreme Court's 2018 decision about stock options?
In Wisconsin Central Ltd. v. United States, the US Supreme Court issued a ruling involving stock options. While initially it appears that the application of the decision is narrow and applies only to employee stock options at railroad companies (also perhaps RSUs and other types of stock compensation), its implications are broader. The decision also provides some insights into what the justices in our highest court know about equity compensation.
In short, by a 5–4 margin, the Supreme Court ruled that options are not taxable compensation under the Railroad Retirement Tax Act (RRTA) because they are not "money remuneration" as meant by the term in the statute, which was written in 1937. Significantly, when Congress adopted the RRTA it also enacted the Federal Insurance Contributions Act (FICA), which taxes "all remuneration," including benefits "paid in any medium other than cash." Therefore, according to Justice Neil Gorsuch, who wrote the majority opinion, "the Congress that enacted both of these pension schemes 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 requires respect, not disregard."
The RRTA provides funding for pension-like benefits to railroad employees instead of Social Security retirement benefits. The spread at exercise would still be subject to the standard income tax rules, as the NASPP confirmed in a blog commentary on the decision. For railroad companies, a commentary from PwC provides some guidance on the decision. Of course, for those not working on the railroads, the spread at the exercise of nonqualified stock options (NQSOs) remains subject to Social Security and Medicare taxes.
Does The Supreme Court Understand Stock Options?
The vote on the court followed the conservative-versus-liberal pattern of many 5–4 decisions. Therefore, in our view, the majority opinion and the dissenting opinion (by Justice Breyer, joined by Ginsberg, Sotomayor, and Kagan), represent an argument over two points:
- the approach the Supreme Court should take in interpreting statutory language
- the ability of government agencies, such as the Treasury Department and the IRS, to issue regulations when terms of a statute are ambiguous
Like any well-written Supreme Court decision, this case can be analyzed on many different levels. It is interesting to see how well the Supreme Court justices understand and explain stock options and equity compensation. They seem to know how stock options work, they recognize the differences in the taxation of ISOs and NQSOs, and they comprehend the underlying purpose of equity compensation for employers. Justice Gorsuch succinctly states that the goal of options is "to encourage employee performance and align employee and corporate goals" and describes in his own way the various exercise methods. In his dissent, Justice Breyer discusses how companies use stock options to compensate employees—in part, "hoping that by doing so they will provide an incentive for their employees to work harder to increase the value of the company."
For Justice Gorsuch, the author of the majority opinion, it didn't seem to matter as much that stock options can be easily exercised and the shares sold for money. Yet in the minority opinion, Justice Breyer elucidates in detail the procedure for cashless exercises and provides data on how a large percentage of employees at railroad companies use this exercise method. He also notes that many of the country's "top executives are compensated in both cash and stock or stock options," with stock-based compensation often exceeding cash salary. The strongest argument in his dissenting opinion is that cashless exercise makes options almost identical to money remuneration. The summary of the justices' inquiries during the oral argument and the lawyers' replies does suggest that the decision may have hinged on whether the justices who supported the majority opinion fully understand how cashless exercises really work. Given the past debates as to whether stock options should be expensed on the income statement (they have been since 2006), it is odd that the decision does not mention the accounting rules, even in its discussion of whether options have a "readily discernible value."