Michaelsen v. New York State Tax Commission, 67 N.Y.2d 579 (1986)

When a nonresident exercises stock options granted by a New York employer, the taxable gain in New York is the difference between the option price and the stock’s fair market value on the exercise date; subsequent stock sale gains are not taxable in New York.

Summary

James Michaelsen, a Connecticut resident, challenged a New York State income tax assessment on gains from exercising stock options granted by his New York employer, Avon. The Tax Commission argued both the gain from exercising the option and the later stock sale were taxable in New York. The Court of Appeals held that only the gain realized at the time of exercising the options (difference between option price and fair market value at exercise) was taxable in New York. The gain from the later sale of the stock was not taxable because it was considered investment income and not derived from New York sources.

Facts

James Michaelsen, a senior executive at Avon in New York City, received stock options in 1968. In 1972 and 1973, he exercised these options while working in New York, purchasing 6,000 shares of Avon stock. In 1973, while a resident of Connecticut, Michaelsen sold all the shares, realizing a gain of $179,761. He did not report this gain on his New York State nonresident income tax return.

Procedural History

The New York Tax Commission assessed additional income tax liability of $19,017.12. Michaelsen challenged this in an Article 78 proceeding. Special Term dismissed the petition. The Appellate Division remitted the case to the Tax Commission to recompute the tax based on the difference between the stock’s fair market value when the options became exercisable and the option price. The Tax Commission appealed to the Court of Appeals.

Issue(s)

Whether gains derived from the exercise of stock options granted to a nonresident by a New York employer, and the subsequent sale of stock acquired through those options, constitute income derived from or connected with New York sources for income tax purposes under Tax Law § 632.

Holding

Yes, in part, because the gain derived from the exercise of the option is taxable in New York, calculated as the difference between the option price and the fair market value of the stock on the date the option is exercised. No, in part, because the gain from the subsequent sale of the stock is not considered income derived from New York sources and is therefore not taxable in New York.

Court’s Reasoning

The Court considered Tax Law § 632 (a)(1) and (b)(1)(B), noting that New York’s income tax law conforms to federal authority where possible. Referencing Commissioner v. LoBue, 351 U.S. 243 (1956), the Court acknowledged that federal tax law taxes the compensation an employee receives by purchasing stock at below market value via options. However, the court distinguished between the *realization* and *recognition* of income. The gain is *realized* when the option is exercised but *recognized* when the stock is disposed of. Citing Treasury Regulations, the court emphasized that the value of an option includes not only the difference between the exercise price and the stock’s value at exercise but also the opportunity to benefit from future appreciation. The Court rejected the Appellate Division’s formula, stating it undervalued the options and conflicted with federal law. The proper method is to subtract the option price from the fair market value of the stock when the option is exercised. The court stated, “Plainly the option on the date it becomes exercisable is worth more than merely the difference between the fair market value of the stock at that time and the option price.” The court found that taxing the gain from the stock’s increased value after purchase improperly taxed intangible personal property not derived from a New York source, stating, “Any gain petitioner realized from an increase in the market value of Avon stock between the time the option was exercised and the time the stock was sold is clearly investment income rather than compensation and, as a nonresident, petitioner cannot be taxed on this amount.” The case was remitted for tax assessment based on the stock value at the time of option exercise.