37 T.C. 988">*988 Respondent determined deficiencies in income taxes of petitioners1962 U.S. Tax Ct. LEXIS 185">*186 as follows:

The sole issue presented is whether or not the exercise of stock options by petitioners in 1956 to purchase stock of U.S. Polymeric Chemicals, Inc., gave rise to taxable income to petitioners to the extent of the difference between the fair market value of the stock and the option price thereof at the time the options were exercised.

FINDINGS OF FACT.

Some of the facts are stipulated and are incorporated herein by this reference.

Petitioner William S. Thornhill has been a resident at all times material hereto of Riverside, Connecticut. He and his wife, Margaret M. Thornhill, filed their joint income tax return for the taxable year 1956 with the district director of internal revenue, Lower Manhattan District, New York, New York.

Petitioner Maarten W. J. Oudegeest has been a resident at all times material hereto of Riverside, Connecticut. He and his wife, Carol T. Oudegeest, filed their joint return for the taxable year 1956 with the district director for the district of Connecticut.

1962 U.S. Tax Ct. LEXIS 185">*187 The significant facts relate to the husbands, who are herein sometimes referred to as petitioners.

In 1950 petitioners and a third party, A. J. Fisher, Jr. (sometimes herein referred to as the promoters), entered into negotiations with 37 T.C. 988">*989 the investment banking firm of Dominick & Dominick for the raising of capital to organize and operate a corporate manufacturing enterprise. Being impressed with the talents of the promoters and the merits of their proposed enterprise, Dominick & Dominick took the proposition up with a limited group of investors with a view to a financing program.

While Dominick & Dominick judged the promoters to be skilled chemists and salesmen, the latter appeared too untested as a management team to warrant placing in their hands immediate control of the projected business. Hence, the plan of organization worked out among the parties in interest contemplated that initial common stock voting control remain for the time being in the hands of the investors with Dominick & Dominick as their representatives, but that the promoters would have the opportunity of assuming voting control of the business after they had succeeded in building a going concern with 1962 U.S. Tax Ct. LEXIS 185">*188 sufficient substance to pay off the initial investment which was to be furnished by the investors in the form of subscriptions to preferred stock.

As a result of these negotiations, the promoters entered into a written agreement dated October 3, 1950, with a group of investors and Dominick & Dominick representing the investors, entitled "U.S. Polymeric Chemicals, Inc., Memorandum of Corporate Structure and Financing" (sometimes referred to as the "October 3, 1950, Subscription Agreement").

The October 3, 1950, subscription agreement provided that Fisher, Oudegeest, and Thornhill would be the corporation's initial executive officers and that they would enter into employment contracts with the corporation for a period of 5 years. The first meeting of the board of directors of U.S. Polymeric Chemicals, Inc., held on October 16, 1950, elected A. J. Fisher, Jr., M. W. J. Oudegeest, and W. S. Thornhill as officers and approved a 5-year employment contract dated October 17, 1950, which provided for a minimum yearly salary for each of $ 9,500. The minimum salary was subject to change.

In accordance with the provisions of the October 3, 1950, subscription agreement, the investors pledged 1962 U.S. Tax Ct. LEXIS 185">*189 $ 100,000 of capital represented by their subscriptions to 1,000 shares of no-par-$ 6 preferred stock (nonvoting) at $ 99.26 1/2 per share and 1,470 shares of 50-cent-par-value common stock (voting) at its stated par value of 50 cents per share. The promoters were allotted and subscribed for collectively 1,380 shares of common stock, or 460 shares each, and Dominick & Dominick were allotted 150 shares of common stock for their services. Out of the total 3,000 shares of common stock to be initially issued, 37 T.C. 988">*990 the investor group were to acquire 49 percent of voting control, the promoters 46 percent thereof, and Dominick & Dominick 5 percent thereof, thus lodging in the latter the balance of voting power as between the promoters and the investor group.

To carry out the plan whereby the promoters were to have an opportunity to acquire voting control, each of the promoters was to have an option to purchase 100 additional shares of common stock (or a total of 300 shares) at the same price upon retirement of all of the preferred stock.

The certificate of incorporation of the new enterprise under the name of U.S. Polymeric Chemicals, Inc., a Delaware corporation (the company), embodied1962 U.S. Tax Ct. LEXIS 185">*190 the capital structure contemplated in the October 3, 1950, subscription agreement, and specified the option rights of the three promoters, together with provisions protecting them against dilution of their potential voting rights in case the company should issue shares of its common stock in excess of the initial issue of 3,000 shares. Such common stock provisions were as follows:

3. Three hundred (300) shares of unissued Common Stock shall be set aside and held in reserve for issuance under an option agreement to be given by the Corporation to A. J. Fisher, Jr., M. Oudegeest and W. S. Thornhill for the purchase by each of them at par of one hundred (100) shares within one year after the retirement of all issued and outstanding shares of $ 6 Preferred Stock, provided that, if, prior to the exercise of such option, Common Stock shall be issued in excess of 3,000 shares, then in addition to the said 300 shares so set aside under option, there shall be set aside and reserved under such option, shares of Common Stock at the rate of one share for each ten shares of Common Stock of the Corporation issued in excess of 3,000 shares, but the purchase price of such additional optioned 1962 U.S. Tax Ct. LEXIS 185">*191 shares, if any, shall be the same per share as the issuing price per share of the shares of Common Stock issued in excess of 3,000 shares by which such additional optioned shares shall be respectively measured as aforesaid.

4. Holders of Common Stock shall have the pre-emptive right to subscribe for any issue of shares of Capital Stock of the Corporation of any class in excess of 1,000 shares of $ 6 Preferred Stock and 3,000 shares of Common Stock plus such number of shares of Common Stock as shall have been set aside and held in reserve under the aforementioned option agreement, and no such pre-emptive right shall apply to the issue of said 1,000 shares of $ 6 Preferred Stock and said 3,000 shares of Common Stock plus said number of shares of Common Stock so reserved under option.

At the first organizational meeting of the company's board of directors on October 16, 1950, the details of the October 3, 1950, subscription agreement were carried out, including authorization of the company to enter into a stock option agreement with the promoters, which as executed was in the following terms:

37 T.C. 988">*991 U.S. Polymeric Chemicals, Inc.

New York, N.Y.

Mr. Arthur1962 U.S. Tax Ct. LEXIS 185">*192 J. Fisher, Jr.

West Road

New Canaan, Conn.

Mr. Maarten W. J. Oudegeest

60-01 D -- 194th Street

Flushing, N.Y.

Mr. W. S. Thornhill

Warwick Road

Colonia, N.J.

Dear Sirs:

Reference is made to the pre-organization memorandum subscription agreement dated October 3, 1950 (a copy of which is on file in this corporation's minute book, as identified by the incorporators at their first meeting held previously today) pursuant to which the undersigned corporation was organized, and to the provisions set forth in this corporation's Certificate of Incorporation relating to an option to be granted by this corporation to each of you to purchase, at par, 100 shares of the corporation's Common Stock (or a total of 300 shares) within one year after all of the $ 6 Preferred Stock of this corporation shall have been retired.

It is the mutual understanding between you and this corporation that such option is to afford you an opportunity to acquire in the aggregate a sufficient number of shares of Common Stock which together with your combined holdings of Common Stock, as contemplated in said pre-organization memorandum subscription agreement, will amount to a majority of such Common Stock and voting1962 U.S. Tax Ct. LEXIS 185">*193 control of the corporation, after the retirement of all of the said $ 6 Preferred Stock.

In consideration of the terms of said pre-organization memorandum subscription agreement and the sum of one dollar paid by each of you, receipt of which is hereby acknowledged, the undersigned corporation hereby grants to each of you an option to purchase 100 shares of this corporation's Common Stock at the price of fifty cents per share, which option, however, may be exercised only after the retirement of all outstanding shares of this corporation's $ 6 Preferred Stock, and within one year of such complete retirement of said $ 6 Preferred Stock; provided, however, that, so long as any of the corporation's $ 6 Preferred Stock shall remain outstanding, such option shall terminate in respect of any one or more of you who shall cease to be employed by this corporation if and when such employment ceases, in which event, the shares theretofore held under option for such one or more of you who shall cease to be employed shall be available for purchase under option by such one or more of you as shall remain in the Company's employ, pro rata, under the same terms and conditions herein set forth.

In1962 U.S. Tax Ct. LEXIS 185">*194 order to protect the shares under option from dilution of their potential relative voting rights, it is further agreed that if, prior to the exercise of such option, Common Stock of this corporation shall be issued in excess of 3,000 shares, then in addition to the said 300 shares set aside under option, there shall be set aside and reserved under such option, shares of Common Stock at the rate of one share for each ten shares of Common Stock of this corporation issued in excess of 3,000 shares, but the purchase price of such additional optioned shares, if any, shall be the same per share as the issuing price per share 37 T.C. 988">*992 of the shares of Common Stock issued in excess of 3,000 shares by which the number of such additional optioned shares shall be measured; and each of you shall have pro rata right to purchase such additional optioned shares on the terms aforesaid.

You and each of you represent to this corporation that any shares you acquire hereunder will be acquired for investment and not for resale.

So long as any of said $ 6 Preferred Stock shall remain outstanding, the option rights hereunder shall not be assignable except among yourselves.

This letter is to be executed1962 U.S. Tax Ct. LEXIS 185">*195 in four counterparts (each counterpart being deemed an original) one of which counterparts is to be delivered to each of you and the fourth counterpart is to be retained by this corporation and lodged among its corporate records.

Very truly yours,

U.S. Polymeric Chemicals, Inc.

By W. S. Thornhill

Attest:

Arthur J. Fisher, Jr.

On October 17, 1950, all subscriptions to company's capital stock were paid in full and stock certificates were issued to the following persons in the amounts listed:

Effective January 31, 1955, Arthur J. Fisher, Jr., one of the three promoters, resigned as an officer and director of the company. On January 25, 1955, he sold his 460 shares of common stock to the company. As specified in the foregoing October 1962 U.S. Tax Ct. LEXIS 185">*196 16, 1950, option agreement, Fisher's option rights on 100 shares of common stock became vested in Thornhill and Oudegeest so that each of the latter then held options on 150 shares instead of 100 shares.

In the latter part of 1955, due to business growth, the company needed additional capital of approximately $ 100,000. Of this amount, the board of directors, at its December 19, 1955, meeting, determined to raise $ 50,000 through a term bank loan and the balance through the sale of 500 additional shares of $ 6 preferred stock at $ 100 per share, accompanied by rights to the purchasers thereof to buy 3 additional shares of common stock at $ 20 per share for each 5 shares of preferred stock so purchased.

37 T.C. 988">*993 The contemplated sale of 300 additional shares of common stock at $ 20 per share automatically brought into operation the antidilution provisions of the company's charter and the stock option agreement, so that the 300 shares of common stock then under option to Thornhill and Oudegeest were increased by 10 percent or 30 shares, but at a price of $ 20 per share for the additional 30 shares.

A feature of the situation which commanded the attention of the board at its December1962 U.S. Tax Ct. LEXIS 185">*197 19, 1955, meeting was that the use of preferred stock as a continuing vehicle for the company's capital expansion by the issuance from time to time of additional shares of such stock would unfairly prejudice the optionees by postponing indefinitely their rights of exercise, out of context with the intent that these rights should accrue upon the retirement of initial 1,000 shares of preferred stock issued in 1950.

By December 19, 1955, over 28 percent of the original 1,000 shares had already been retired.

In consequence, the board authorized a modification of the option agreement to the extent of permitting the exercise thereof in equal annual installments over a 3-year period commencing in 1956, as follows:

U.S. Polymeric Chemicals, Inc.

Stamford, Conn.

Mr. Maarten W. J. Oudegeest

6 Meadow Lane

Old Greenwich, Conn.

Mr. W. S. Thornhill

109 Hendrie Avenue

Riverside, Conn.

Dear Sirs:

Reference is made to the terms of a certain option agreement under this Company's letter dated October 16, 1950, addressed to each of you and to Arthur J. Fisher, Jr., duly accepted by you and him, whereby you and the said Mr. Fisher were granted an option to purchase in the aggregate, 1962 U.S. Tax Ct. LEXIS 185">*198 300 shares of this Company's Common Stock at 50 cents per share, pro rata, after the retirement of all of the Company's $ 6 Preferred Stock, plus 1 additional share for each 10 shares of Common Stock issued by the Company in excess of 3,000 shares prior to the exercise of the option.

Mr. Fisher having withdrawn from the Company, it is recognized that the shares formerly available to him under said option are now available to each of you pro rata.

In view of the Company's expansion plans and need for more capital through the proposed issue and sale of 500 additional shares of $ 6 Preferred Stock and 300 additional shares of Common Stock, the consequent changed outlook for the early retirement of all of the $ 6 Preferred Stock, and in consideration of the foregoing and the lower percentage of voting rights in the Company that your present stock holdings, plus shares under option, will represent after 37 T.C. 988">*994 the new financing presently contemplated, the Company agrees to modify the terms of said October 16, 1950, option agreement so as to provide as follows:

Each of you shall have an option to purchase 150 shares of this Company's Common Stock at the price of 50 cents per share, 1962 U.S. Tax Ct. LEXIS 185">*199 plus 15 additional shares of Common Stock at $ 20 per share (such additional shares under option aggregating 30 shares, equal to 10% of the 300 additional shares presently to be issued at $ 20 per share in connection with the new financing). Said option shall be exercisable in three equal installments by each of you as follows: Between January 1 and April 1 in each of the years 1956, 1957, and 1958, each of you shall have the right to purchase 50 shares of Common Stock at 50 cents per share and 5 shares of Common Stock at $ 20 per share.