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Court rules that underwriters’ commissions paid upon the sale of stock in an IPO cannot be treated as a reduction of ordinary income

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In Hann v. U.S., 120 AFTR 2d 2017-5518 (2017), the taxpayer, an individual, exercised stock options in his employer’s stock that were immediately sold after the exercise as part of an initial public offering of the employer’s stock. The underwriters charged a commission that was deducted from the taxpayer’s cash proceeds upon sale of the stock. This case in the U.S. Court of Federal Claims addressed the tax treatment of the commission.

The taxpayer’s employer issued a Form W-2 that included compensation income related to the stock option exercise. The amount included on the Form W-2 was equal to the fair market value of the stock at the time of exercise, minus the exercise price. The stock was sold immediately upon exercise, so the fair market value of the stock at the time of exercise was equal to the gross sales proceeds the taxpayer received when his stock was sold in the initial public offering.

On his original federal income tax return, the taxpayer treated the commission as a capital loss. The taxpayer later amended his return to reflect the commission as a reduction of his gross income. This resulted in a refund claim due to the difference between ordinary and capital gain rates, and due to the $3,000 annual limit on the amount by which short-term capital losses can offset ordinary income. The IRS refused to issue the refund, so the taxpayer sued.

The taxpayer put forth several arguments for treating the commission as a reduction of gross income. For example, he argued that the commission was an ordinary and necessary expense incurred in a trade or business. He also argued that because the commission was paid to generate ordinary income (referring to the income generated upon exercising the options), it should be deductible from ordinary income.

The court rejected all of the taxpayer’s arguments and held that commissions are properly treated as a reduction in the amount realized on the sale of stock. The taxpayer had basis in the stock equal to his exercise price plus the amount reported as income on his Form W-2. The amount reported as income on his Form W-2 was based on gross sales proceeds, but his actual proceeds reflected a reduction for the commission. Thus, he had a capital loss equal to the amount of the commission.

The stock was sold immediately upon acquisition, so the loss associated with the commission was a short-term capital loss. The court held that the taxpayer properly treated the commission as a short-term capital loss on his original return, and denied the refund reflected on his amended return.

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Eddie Adkins
Partner, Washington National Tax Office
T +1 202 521 1565

Jeffrey Martin
Partner, Washington National Tax Office
T +1 202 521 1526

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