22 T.C. 440">*440 This proceeding involves deficiencies in income tax as follows:

The issues to be determined are: (1) Whether the exercise of stock options by petitioner resulted in taxable compensation to him in 1946 and 1947; and (2) if so, in what amounts. Other adjustments made in the deficiency notice have not been contested, and will be taken into account under a Rule 50 computation.

Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein.

The petitioner is a resident of Leonia, New Jersey, and filed his Federal income tax returns for the years in question with the collector of internal revenue for the fifth district of New Jersey.

The petitioner was employed by the Michigan Chemical Corporation (hereinafter referred to as the corporation) as manager of the New York sales division from September 1941 to February 28, 1947, at which time his employment terminated. There was no written contract covering the terms and conditions of his employment. His salary was $ 500 per month in 1944 and 1945, 1954 U.S. Tax Ct. LEXIS 193">*195 and $ 550 per month in 1946 and 1947. The nature and extent of his duties remained the same throughout his employment.

The corporation was organized in 1935, and was engaged in the business of producing and selling chemical products. One T. C. Davis had been a director and executive vice president of the corporation since 1941. In 1946 he became president, and in 1949 chairman of the board. From 1944 through 1947, he was the company's chief executive officer. Prior to 1944, Davis felt that the corporation should 22 T.C. 440">*441 provide some means to give its key employees a proprietary interest in it, because of his longstanding belief that both the company and employees profited from employee stock ownership. Davis discussed his ideas with the directors and officers of the corporation, and proposed at a stockholders' meeting on March 21, 1944, that key employees be given an option to purchase stock. On that date the shareholders of the corporation approved a plan of its board of directors, whereby 10,000 shares of its common stock were to be made available to certain key employees of the corporation over the ensuing 3 years. The option price was $ 5 per share, and the fair market1954 U.S. Tax Ct. LEXIS 193">*196 value of the stock at that time was $ 4.50. The sale of the stock to the employees was authorized by the Michigan Corporation and Securities Commission on June 15, 1945.

On June 29, 1944, the executive vice president of the corporation addressed a letter to petitioner advising him of the action of the stockholders and board of directors in March of that year. The letter stated:

The purpose of this is to provide an incentive to key employees and especially to permit such men to participate in the success of the Company. This is a method or plan which has been followed by many of the leading American corporations.

* * * *

The letter further stated that petitioner was to be tentatively allotted an option to purchase 10 shares of stock; that the option could not become definite until January 1, 1945, depending upon the company's profitable operations for the remainder of the year 1944. The letter further stated that receipt of the option was contingent upon petitioner's being employed by the company on June 30, 1945.

On January 18, 1945, another letter from the executive vice president of the corporation to petitioner granted him an option to purchase 150 shares of stock on June1954 U.S. Tax Ct. LEXIS 193">*197 30 of that year. The rights to subscribe to the stock were not transferable. The letter also stated:

As you know, we must continue to contribute our every effort toward the success of Michigan Chemical Corporation. There is much yet to be done to bring the Company along towards the attainment of our goal. This will require the most intensive work on the part of all of us during the current year. That we have a great opportunity is, I am sure, well known to you.

* * * *

On May 1, 1945, petitioner gave the corporation his promissory note for $ 750, covering the purchase price of the 150 shares allotted to him. The corporation had granted similar option rights to 36 other key employees in 1945.

A letter from the executive vice president of the corporation, dated January 1, 1946, granted petitioner an option to purchase an additional 150 shares of stock. The letter stated:

I am sure you recognize that there is much waste in most of our operations. Waste of materials, steam, water and of still greater importance the waste of 22 T.C. 440">*442 time and labor. You should make every effort to correct these faults and where you know them to exist in parts of the plant beyond your control, 1954 U.S. Tax Ct. LEXIS 193">*198 you should not hesitate to point them out to those responsible.

* * * *

On January 3, 1946, petitioner gave the corporation his promissory note, in the amount of $ 750, covering the purchase price of the 150 shares. In 1946 the corporation granted similar option rights to 47 other key employees. On May 24, 1946, petitioner paid his 2 notes in the total amount of $ 1,500 and received 300 shares of stock.

On January 2, 1947, the president of the corporation advised the petitioner that he had been granted the option to purchase 40 additional shares of the Corporation's stock. The president's letter stated:

Again I wish to call your attention to the fact that these allocations afford you an opportunity to become a stockholder and thus participate in the future earnings of the corporation. The future progress and earnings of the corporation are largely dependent upon the loyal cooperation and efforts of each of its employees. The corporation's plans for 1947 include further expansion which should bring to you greater opportunities for participation in the future of your company both as an employee and stockholder. Incidentally, an employee should feel a certain amount of pride 1954 U.S. Tax Ct. LEXIS 193">*199 in also being a stockholder.

* * * *

The corporation, in 1947, granted additional option rights to 75 other key employees. On February 3, 1947, petitioner paid the corporation $ 200 and received a certificate for 40 shares of its stock.

No deduction was taken by the corporation on its income tax return for the year ending December 31, 1945, for the difference in the fair market value and the option price of stock options granted to employees in that year.

On its income tax returns for the years ending December 31, 1946, and December 31, 1947, the corporation deducted an amount described as the excess of market value at exercise date over option price of 3,900 shares of stock sold to employees in 1946 and 5,665 shares sold to employees in 1947.

The fair market value of the corporation's stock at certain times during the 3-year period, 1944-1947, was as follows:

The number of stockholders, from 1940 to 1947, was as follows:

1954 U.S. Tax Ct. LEXIS 193">*200 22 T.C. 440">*443 In his deficiency notice, the respondent determined that petitioner received additional unreported compensation in the amount of $ 8,100 from the exercise of the option in 1946 and $ 580 from the exercise of the option in 1947.

The options granted to petitioner in 1945, 1946, and 1947 were to give him a proprietary interest in the corporation, and not as compensation for services.

OPINION.

Petitioner argues that the stock options given to him in 1945, 1946, and 1947 were granted by the corporation for the purpose of providing him with a proprietary interest in the business, and were not intended as additional compensation to be received when he exercised them.

If the options were intended as additional compensation, the excess of the fair market value over the option price is taxable income to him when the option is exercised. Commissioner v. Smith, 324 U.S. 177">324 U.S. 177 (1945). If the options were granted to provide him with a proprietary interest in the business, no taxable gain is recognized when the options are exercised. Abraham Rosenberg, 20 T.C. 5 (1953); Norman G. Nicholson, 13 T.C. 690 (1949).1954 U.S. Tax Ct. LEXIS 193">*201 This is a question of fact. Abraham Rosenberg, supra.We have found that the stock options were granted to petitioner for the purpose of providing him with a proprietary interest in the business. We shall elaborate presently on our findings.

The respondent recognizes the factual nature of the question presented with respect to the option granted to petitioner in January 1945. He argues, however, with respect to the options granted in January 1946 and 1947, that T. D. 5507, 1946-1 C. B. 18, and I. T. 3795, 1946-1 C. B. 15, automatically require the excess of the fair market value of the stock over the option price paid for it to be taxed as compensation.

T. D. 5507, supra, provides that if property is transferred by an employer to an employee, for an amount less than its fair market value, the difference between the amount paid for the property and the amount of its fair market value is in the nature of compensation, and shall be included in the gross income of the employee.

I. T. 3795, supra, further provides that if an employee receives an option, on or after February 26, 1954 U.S. Tax Ct. LEXIS 193">*202 1945, to purchase the stock of his employer corporation and the employee exercises that option, he realizes taxable income by way of compensation to the extent that the fair market value of the stock when received exceeds the option price paid for it.

In essence, respondent's argument with respect to the mandatory effect of T. D. 5507, supra, and I. T. 3795, supra, is to say that we 22 T.C. 440">*444 may not consider the factual question of whether the options granted to petitioner in 1946 and 1947 were or were not intended as compensation. In Harley v. McNamara, 19 T.C. 1001 (1953), reversed on other grounds 210 F.2d 505 (C. A. 7, 1954), involving an option granted after February 26, 1945, we did consider the factual question whether the option was intended as compensation; but, since we determined that it was so intended, we found it unnecessary to consider whether T. D. 5507, supra, and I. T. 3795, supra, were justified by 324 U.S. 177">Commissioner v. Smith, supra, or were otherwise valid.

The Commissioner1954 U.S. Tax Ct. LEXIS 193">*203 promulgated the rulings in question on the assumption that the Smith case held that any economic or financial benefit conferred on an employee was compensation, regardless of the form or mode by which the benefit was conferred. The Smith case does not so hold. Therein the Supreme Court upheld a finding of fact by this Court that a stock option was intended as additional compensation and in doing so stated, page 181:

Section 22 (a) of the Revenue Act is broad enough to include in taxable income any economic or financial benefit conferred on the employee as compensation, whatever the form or mode by which it is effected. * * *

This language does not support the Commissioner's amendment to the regulations that any stock option granted to an employee after February 26, 1945, results in taxable compensation, when exercised, to the extent that the fair market value of the stock at that time exceeds the option price paid. ¹

1954 U.S. Tax Ct. LEXIS 193">*204 Determination of whether a stock option is granted to an employee as additional compensation, or to give him a proprietary interest in the corporation, thus remains a question of fact. In reaching that conclusion, we think the criteria set forth by this Court in Delbert B. Geeseman, 38 B. T. A. 258 (1938), are still the most reliable guide to be followed. In the Geeseman case, we said, at page 264:

as a prerequisite to the conclusion sought by the respondent it should definitely and clearly appear that a transaction, which in form is nothing more than a purchase and to an obvious and substantial extent is unquestionably a purchase, 22 T.C. 440">*445 is in fact to some extent the payment of compensation for services rendered or to be rendered.

Here it "definitely and clearly" appears that the granting of the options to petitioner in 1945, 1946, and 1947 was not intended as additional compensation for his services.

The essential purpose of the corporation's action in initially authorizing the allocation of 10,000 shares to be sold to employees, as indicated by the vice president's letter of June 29, 1944, and as amplified by his testimony at the trial, 1954 U.S. Tax Ct. LEXIS 193">*205 was to provide the key employees with an incentive to promote the growth of the company by permitting them to participate in its success. The annual report of the corporation for the year ended December 31, 1947, emphasizes the growth in the number of shareholders after the employee-purchase option plan was adopted. In the 4-year period, 1944 to 1947, inclusive, the number of shareholders more than doubled.

The vice president's and president's letters to petitioner, notifying him of the granting of the stock options, emphasized the corporation's problems and encouraged his cooperation and help in their solution. The tenor of these letters bespeaks appeal to a proprietary interest in the corporation's welfare and growth rather than to a mere employee's interest.

The fact that the purchase price initially specified by the directors in granting the option rights slightly exceeded the then fair market value of the stock negates the idea that the rights were authorized with compensation in mind.

We observed in Delbert B. Geeseman, supra, page 263, that in practically all such cases as the one before us, both the element of additional compensation and the1954 U.S. Tax Ct. LEXIS 193">*206 granting of a proprietary interest are present. We said, however, that decision would be impossible "if the absence of one or the other is essential thereto."

The respondent attaches considerable significance to the fact that the corporation, in 1946 and 1947, claimed a deduction on its income tax returns for the difference in the fair market value and the option price at which the stock was purchased by the employees in those years. The corporation did not claim a deduction in 1945, but did in 1946 and 1947. We do not think the deductions in the latter years are binding on petitioner, and do not change the essential purpose which motivated the granting of the option rights. Abraham Rosenberg, supra;Estate of Lauson Stone, 19 T.C. 872 (1953), affd. 210 F.2d 33 (C. A. 3, 1954); and Delbert B. Geeseman, supra.

Decision will be entered under Rule 50.