* * *

6. Conditions Precedent to the Obligation of Royal.

* * *

(e) Royal shall have obtained a definitive permit from the Commissioner to issue the options to purchase Royal shares referred to in paragraph 5(b) hereof, and R. B. Mitchell, Gordon Bagne and C. L. Mitchell shall have surrendered the options to purchase Amerco Shares which they presently hold, and shall have agreed to accept the options to purchase Royal1976 U.S. Tax Ct. LEXIS 148">*154 shares.

* * *

7. Conditions Precedent to the Obligations of the Amerco Shareholders. * * *

65 T.C. 1099">*1103 * * *

(c) Royal shall have obtained a definitive permit from the Commissioner to issue the options to purchase Royal shares referred to in paragraph 5(b) hereof, and R. B. Mitchell, Gordon Bagne and C. L. Mitchell shall have surrendered the options to purchase Amerco Shares which they presently hold, and shall have agreed to accept the options to purchase Royal shares.

Exhibit "F" referred to in paragraph 5(b) of the May 3 agreement is an unexecuted copy of the Royal stock option subsequently granted to petitioner. It is this 10,000-share nonstatutory stock option, ³ executed on June 15, 1966, which forms the foundation of the controversy between the parties in this litigation. The pertinent provisions of the Royal option are set out as follows:

Royal Industries, Inc.

1976 U.S. Tax Ct. LEXIS 148">*155 Stock Option Agreement

This Agreement, made this 15th day of June, 1966, by and between Royal Industries, Inc., a California corporation, herein called the "Company," and R. B. Mitchell, herein called the "Grantee."

Witnesseth:

In consideration of the mutual convenants herein contained and other good and valuable consideration, the parties hereto do agree as follows:

1. The Company hereby grants to the Grantee, as a matter of separate inducement and agreement in connection with his employment by the Company or a subsidiary of the Company, and not in lieu of any salary or compensation for his services, the right and option to purchase, at a price of $ 12.00 per share, an aggregate of 10,000 shares of the authorized, but unissued Common Stock of the Company. This option may be exercised by the Grantee only in accordance with the terms and conditions of this agreement.

2. This agreement and the option granted hereunder shall expire five (5) years after the date hereof and to the extent not exercised prior thereto shall lapse.

3. This option may be exercised at any time in whole or in part between the date hereof and June 14, 1971, by giving written notice to the Company specifying the1976 U.S. Tax Ct. LEXIS 148">*156 number of shares then to be purchased pursuant to such exercise of option, accompanied by payment in cash or by certified or cashiers check of the full purchase price of the shares to be purchased.

* * *

5. During the lifetime of the Grantee, this option may be exercised only by the Grantee. This option shall be binding upon and shall inure to the benefit of the administrators, executors, heirs and legatees of the Grantee.

6. The Company shall not be required to issue or deliver any certificate or certificates for the shares of its Common Stock purchased upon the exercise of this option prior to the admission of such shares to listing on notice of issuance 65 T.C. 1099">*1104 of any stock exchange on which stock of the same class is then listed. The Company shall use its best efforts to take such steps as may be required by law and applicable regulations, including the rules and regulations of the Securities and Exchange Commission, and of any stock exchange on which the stock is then listed, in connection with the issuance or sale of any shares purchased upon the exercise of said option or the listing of said shares on said exchange.

7. No shares issuable upon exercise of this option shall1976 U.S. Tax Ct. LEXIS 148">*157 be issued unless a permit of the Commissioner of Corporations of the State of California is in effect with respect thereto, and this option shall be exercised, and the shares delivered, at the Company's then principal executive offices.

* * *

11. Grantee, in consideration of the granting to him of this option, hereby agrees to remain in the employ of the Company or one of its subsidiaries unless prevented by death for a period of one (1) year from the granting of this option with such duties and at such compensation (at a rate not less than the Grantee's present compensation) as shall be determined from time to time by the Board of Directors or pursuant to its authority. Nothing herein contained shall be deemed to limit or restrict the right of the Company to terminate the Grantee's employment at any time, with or without cause, or to increase or decrease the compensation of the Grantee from the rate in existence at the date hereof.

1976 U.S. Tax Ct. LEXIS 148">*158 As a result of its tender offer to all Amerco shareholders, Royal acquired approximately 98 percent of the outstanding Amerco stock. Following the Royal takeover, petitioner continued to be employed as president of the Mitchell Rubber Division of Amerco; albeit at a salary some $ 6,000 less than he had been earning. ⁴ This salary reduction was part of the negotiated agreement between the parties, and more particularly was part of the consideration going to Royal in exchange for the Royal option. ⁵

1976 U.S. Tax Ct. LEXIS 148">*159 Petitioner terminated his employment with Amerco in October 1967, having remained with Royal beyond the 1 year agreed upon. Shortly thereafter, he sold his 10,000-share Royal option to Mr. M. E. Singleton, Jr., as follows: one-half of the option (i.e., an option in 5,000 shares) was sold on December 29, 65 T.C. 1099">*1105 1967, for $ 95,000, and the remaining half was sold on January 16, 1968, for another $ 95,000.

The terms of the first assignment between petitioner and Mr. Singleton called for payment in three installments to be made over a 3-year period with the first payment of $ 27,550 due in 1968. The terms of the second assignment were almost identical to the first, with the result that petitioner received no payments in 1967 and a total of $ 55,100 in 1968, representing the first installments on the two option sales.

Following both sales, Royal Industries, Inc., entered into an amended stock option agreement with Mr. Singleton acknowledging the assignment of options from petitioner to Mr. Singleton. We note that this last agreement contains a paragraph identical to paragraph 11 of the Royal option granted to petitioner, requiring Mr. Singleton to work for Royal, or one of its subsidiaries, 1976 U.S. Tax Ct. LEXIS 148">*160 for a period of 1 year. Apparently this paragraph was never enforced against Mr. Singleton, and petitioner contends that this makes the paragraph meaningless in his own option. But merely because it may not have been enforced in one instance does not mean the clause is meaningless wherever it appears, and we decline to so find.

On his joint income tax return for 1967 petitioner reported the sale of one-half of the Royal option as a sale of 5,000 shares of Royal Industries common stock. He elected to be taxed on the income from such sale under the installment method of reporting income, and because no payments were received in 1967, no income was reported by him on his return. For 1968, petitioner reported $ 55,100 as "collections" in that year on the sale of 10,000 shares of Royal Industries stock "reported 1967." The entire $ 55,100 was reported as long-term capital gain income in 1968.

Respondent determined, in his notice of deficiency, that petitioner received $ 95,000 of ordinary income, both in 1967 and in 1968, as compensation from the stock option sales occurring in each of those years. Respondent now concedes, however, that petitioner did not realize any income from such1976 U.S. Tax Ct. LEXIS 148">*161 sales in 1967, but rather realized ordinary income from such sales only as payments were received, beginning in 1968.

65 T.C. 1099">*1106 OPINION

In 1966 Royal Industries, Inc., acquired all of petitioner's stock in Amerco, Inc., for $ 4 per share and, in addition, acquired petitioner's 22,137-share Amerco stock option. Petitioner remained in the employ of Amerco after the Royal takeover at a reduced salary and received a nonstatutory stock option to purchase 10,000 shares of Royal stock.

The issues remaining to be decided are whether the Royal option granted to petitioner in 1966 was granted in exchange for petitioner's Amerco option or in lieu of salary, whether extrinsic evidence is admissible to show the consideration given for the Royal option, whether the gain on sale of the Royal option was ordinary income or capital gain, and whether the Royal option had a readily ascertainable fair market value on the date of grant.

Petitioner contends that since the Royal option was received in exchange for the Amerco option, the subsequent transfer of the Royal option to Mr. Singleton should be governed by section 1234 of the Internal Revenue Code of 1954, ⁶ and give rise to capital gain. Furthermore, 1976 U.S. Tax Ct. LEXIS 148">*162 petitioner argues the option-for-option exchange was a taxable event and gain was realized in 1966 (a year not before the Court). Respondent, on the other hand, contends section 1234 is inapplicable because the Royal option was compensatory in nature (whether granted in lieu of salary or in exchange for the Amerco option), and any gain realized from the transfer of the Royal option to Mr. Singleton was ordinary income. Respondent adds that no taxable event occurred in 1966 with respect to the above transactions.

Section 61(a)(1) provides that gross income includes compensation for services. Section 1.61-15, Income Tax Regs., states that: "If any person receives an option in payment of an amount constituting compensation of such person * * *, such option is subject to the rules contained in § 1.421-6 for purposes of determining when income is realized in connection with such option1976 U.S. Tax Ct. LEXIS 148">*163 and the amount of such income."

To determine whether the provisions of section 1.421-6, Income Tax Regs., apply to the stock option granted by Royal to petitioner, we must decide whether that option was granted as compensation within the meaning of section 61(a)(1).

65 T.C. 1099">*1107 However, initially we note that we do not subscribe to petitioner's contention that we are precluded from looking beyond the written documents entered into evidence by the parole evidence rule as enunciated in Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), or Clark v. United States, 341 F.2d 691 (9th Cir. 1965). In our case, none of the documents expressly declares the sole consideration given for the Royal stock option. The option agreement itself refers to "other good and valuable consideration" without delineating just what that consideration is. Parole evidence, therefore, is not being admitted to vary the terms of the contract, but rather to explain what those terms mean. Estate of Leon Holtz, 38 T.C. 37">38 T.C. 37, 38 T.C. 37">41 (1962). See also Estate of Richard F. O'Brien, Jr., 57 T.C. 27">57 T.C. 27, 57 T.C. 27">30 (1971);1976 U.S. Tax Ct. LEXIS 148">*164 S. E. Brown, 52 T.C. 50">52 T.C. 50, 52 T.C. 50">59-60 (1969).

Additionally, the documents themselves are ambiguous on the issue of whether the option was compensatory. Paragraph 1 of the Royal option agreement states that the option was issued to the grantee "as a matter of separate inducement and agreement in connection with his employment by the Company or a subsidiary of the Company, and not in lieu of any salary or compensation for his services."

This Court is hard pressed to envision situations where the grant would be "in connection with" one's employment yet not constitute compensation. But even if paragraph 1 could be read as petitioner desires, to indicate the option was not granted as compensation, paragraph 11 of the option suggests otherwise: "Grantee, in consideration of the granting to him of this option, hereby agrees to remain in the employ of the Company * * * unless prevented by death for a period of one (1) year from the granting of this option." This latter paragraph tends to show that the option was indeed granted as compensation and thus conflicts with paragraph 1. We must, therefore, look beyond the written agreement to the entire record to decide1976 U.S. Tax Ct. LEXIS 148">*165 whether the Royal option granted to petitioner was compensatory in nature. Jack F. Morrison, 59 T.C. 248">59 T.C. 248, 59 T.C. 248">256 (1972).

Robert C. Sherbourne, an executive of Royal, testified that a key factor in determining the number of shares subject to the option granted to petitioner was petitioner's reduction in salary from $ 44,000 per year to $ 38,000 per year after the Royal takeover. Petitioner himself acknowledged that a salary reduction was discussed in connection with the consideration he 65 T.C. 1099">*1108 was to receive from Royal in exchange for his Amerco stock option. He argues, however, that the option agreement, as finally constituted in writing, differed from the negotiations leading up to the agreement, in that the final agreement did not contemplate a reduction in salary. We disagree. As stated previously, the stock option agreement refers to "other good and valuable consideration" without stating just what that consideration is. A reasonable inference to be drawn from the record is that a salary reduction was indeed part of the consideration given for the stock option granted to petitioner. Indeed, Mr. Sherbourne so testified and a letter from Mr. 1976 U.S. Tax Ct. LEXIS 148">*166 Sherbourne to petitioner, dated April 6, 1966, corroborates his testimony. This letter indicates that 40 percent of the 10,000-share nonstatutory stock option offered to petitioner (i.e., 4,000 of the 10,000 shares subject to the offer) was granted in exchange for petitioner's salary reduction of $ 6,000 per year for 5 years. This 40 percent of the Royal option clearly represented compensation for future services. Petitioner has failed to carry his burden to show that "from an examination of all the surrounding circumstances, there was no reason for the option to have been granted as the payment of an amount constituting compensation." Sec. 1.61-15(b)(2), Income Tax Regs. The disposition of this 40 percent of the Royal option is governed by section 1.421-6, Income Tax Regs., and gives rise to ordinary income in the manner discussed later.

Petitioner has persuaded us, however, that the remaining 60 percent of the Royal option was granted in exchange for petitioner's old Amerco option. Much of the evidence adduced at trial indicates that Royal wished to retire all outstanding Amerco options and issue its own options in their place. Petitioner's evidence shows an option-for-option1976 U.S. Tax Ct. LEXIS 148">*167 exchange was contemplated by the parties, at least in part, and the testimony of Mr. Sherbourne confirms this. But this is not to say, as petitioner argues, that the exchange causes the income realized on the subsequent sale of the Royal option to be characterized as capital gain. In our view, all the gain is ordinary income.

Section 1234(a) states:

Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, a privilege or option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as 65 T.C. 1099">*1109 the property to which the option or privilege relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).

Petitioner contends that this section governs his sale of the Royal option to Mr. Singleton, and that since the stock subject to the option would be a capital asset in his hands, the gain realized by him on sale is capital gain. However, subsection (d) of section 1234 provides exceptions to the general rule:

This section shall not apply to --

* * *

(2) in the case of gain attributable to the sale or exchange of a privilege1976 U.S. Tax Ct. LEXIS 148">*168 or option, any income derived in connection with such privilege or option which, without regard to this section, is treated as other than gain from the sale or exchange of a capital asset;

The regulations interpret this exception to make section 1234 inapplicable in the area of employee stock options issued as compensation. Section 1.1234-1(e), Income Tax Regs., states:

Section 1234 does not apply to gain resulting from the sale or exchange of an option --

(1) To the extent that the gain is in the nature of compensation (see sections 61 and 421, and the regulations thereunder, relating to employee stock options);

Section 1234 is clearly not applicable to that 40 percent portion of the Royal option granted in lieu of petitioner's salary. As to the remaining 60 percent, it is our opinion that section 1234 is again not applicable. But to determine whether the gain on the sale of this latter portion of the Royal option represents compensation, we must look first at the nature of the Amerco option for which it was exchanged.

Petitioner testified that the Amerco option was a restricted stock option identical to the Western Rubber option granted him in 1961 except for price and number1976 U.S. Tax Ct. LEXIS 148">*169 of shares. ⁷ Paragraph 1 of the stock option plan, incorporated into all Western Rubber options, indicates that the options were issued to retain the services of key employees. Paragraph 5(a)(1) of the plan requires that the options may not be exercised until the employee has worked for 6 months following the date of grant. Since these terms were also in the Amerco option, we think this shows the Amerco option granted to petitioner was a compensatory, 65 T.C. 1099">*1110 restricted stock option. As stated in Commissioner v. LoBue, 351 U.S. 243">351 U.S. 243, 351 U.S. 243">247 (1956):

When assets are transferred by an employer to an employee to secure better services they are plainly compensation. It makes no difference that the compensation is paid in stock rather than in money. * * * LoBue received a very substantial economic and financial benefit from his employer prompted by the employer's desire to get better work from him. This is "compensation for personal service" within the meaning of [sec. 61(a)] * * *

1976 U.S. Tax Ct. LEXIS 148">*170 Since the Amerco option was a compensatory stock option, section 1234 was not applicable to its disposition. Donald H. Kunsman, 49 T.C. 62">49 T.C. 62 (1967). Similarly, such disposition was not controlled by the provisions of section 421, because in order for a taxpayer to obtain capital gain treatment under section 421, the option must be exercised, the stock held for the requisite period and then sold according to the provisions of the statute. Where the option itself is transferred or canceled prior to exercise, section 421 is not applicable, and the gain realized on such cancellation or transfer is compensation. 49 T.C. 62">Donald H. Kunsman, supra.See also Rank v. United States, 345 F.2d 337 (5th Cir. 1965); Dugan v. United States, 234 F. Supp. 7">234 F. Supp. 7 (S.D. N.Y. 1964); Nathan Putchat, 52 T.C. 470">52 T.C. 470, 52 T.C. 470">477 (1969).

Therefore, the disposition of the Amerco stock option prior to exercise gave rise to compensation in the amount of the gain realized. The 60-percent portion of the Royal option received by petitioner in exchange for his Amerco option was that1976 U.S. Tax Ct. LEXIS 148">*171 compensation. As in LoBue: "It makes no difference that the compensation is paid in stock rather than in money." 351 U.S. 243">351 U.S. at 247. In our case, the compensation took the form of a stock option, and even though granted in exchange for another option, it was, nonetheless, compensation.

There is no reason to presume that this exchange of options does not give rise to the realization of income under section 1001. Indeed, petitioner contends the exchange was a taxable event (although he did not report it as such on his income tax return for 1966). However, we think that if the Royal option had no readily ascertainable fair market value on the date of exchange, it is inappropriate to compute petitioner's tax at that time. Rather, the tax is imposed when the Royal option is later transferred or exercised. The Court stated in 351 U.S. 243">Commissioner v. LoBue, supra:

It is of course possible for the recipient of a stock option to realize an immediate taxable gain. * * * The option might have a readily ascertainable 65 T.C. 1099">*1111 market value and the recipient might be free to sell his option. But this is not such a case. * * * Under these1976 U.S. Tax Ct. LEXIS 148">*172 circumstances there is no reason for departing from the Treasury practice. The taxable gain to LoBue should be measured as of the time the options were exercised and not the time they were granted. [351 U.S. 243">351 U.S. at 249.]

Since both portions of the Royal option represented compensation to petitioner, the gain on sale of the entire option is taxed according to principles set out in the LoBue decision. Those principles are codified in respondent's regulations. Section 1.421-6(c), Income Tax Regs., provides in part:

(1) * * * If an option to which this section applies does not have a readily ascertainable fair market value at the time the option is granted, the time when the compensation is realized and the amount of such compensation shall be determined under paragraph (d) of this section.

(2) Although options may have a value at the time they are granted, that value is ordinarily not readily ascertainable unless the option is actively traded on an established market. * * *

(3)(i) When an option is not actively traded on an established market, the fair market value of the option is not readily ascertainable unless the fair market value of the option can1976 U.S. Tax Ct. LEXIS 148">*173 be measured with reasonable accuracy. For purposes of this section, if an option is not actively traded on an established market, the option does not have a readily ascertainable fair market value when granted unless the taxpayer can show that all of the following conditions exist:

(a) The option is freely transferable by the optionee;

(b) The option is exercisable immediately in full by the optionee;

(c) The option or the property subject to the option is not subject to any restriction or condition (other than a lien or other condition to secure the payment of the purchase price) which has a significant effect upon the fair market value of the option or such property; and

(d) The fair market value of the option privilege is readily ascertainable in accordance with subdivision (ii) of this subparagraph.

Subdivision (ii) states that the fair market value of the option is not readily ascertainable unless the value of the option privilege can be measured with reasonable accuracy. To ascertain the value of the option privilege consideration must be given to the following:

(a) Whether the value of the property subject to the option can be ascertained;

(b) The 1976 U.S. Tax Ct. LEXIS 148">*174 probability of any ascertainable value of such property increasing or decreasing; and

(c) The length of the period during which the option can be exercised.

No evidence appears in the record showing Royal options were actively traded on an established market. We must decide then whether the fair market value of the Royal option granted to 65 T.C. 1099">*1112 petitioner can be determined with "reasonable accuracy" using the test of section 1.421-6(c)(3), Income Tax Regs.

Paragraph 6 of the option states that no certificates for Royal's shares of common stock may be acquired prior to the admission of such shares to listing on notice of issuance of any stock exchange on which stock of the same class is listed. The record gives no indication whether this condition was met at the time of grant and we will not so presume.

A further restriction appears in paragraph 11 of the option requiring petitioner to remain in the employ of Royal for at least 1 year. Just what impact this requirement has on the value of the option is not presented in the evidence, but because the restriction is significant, it casts doubt over the value of the option, and renders us unable to ascertain the option's value1976 U.S. Tax Ct. LEXIS 148">*175 with reasonable accuracy.

Petitioner has also failed to establish the value of the Royal option privilege. At trial, petitioner testified the option privilege on the Amerco option was worthless to him, the Amerco option itself was worth $ 36,744, and the Royal option was worth the same. Petitioner does not, however, claim to be an expert in the valuation of stock options. Furthermore, his opinion of what the Amerco option or the Amerco option privilege is worth to him is not persuasive to us on the fair market value of the Royal option privilege. Cf. Frank L. Shamburger, 61 T.C. 85">61 T.C. 85, 61 T.C. 85">94 (1973).

Petitioner argues that pursuant to the principles enunciated in United States v. Davis, 370 U.S. 65">370 U.S. 65 (1962), the value of the option received (the Royal option) should be presumed to be the value of the option given in exchange (the Amerco option). See also Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184 (Ct. Cl. 1954). In Philadelphia Park the court was trying to determine the taxpayer's basis in a 10-year franchise (to operate a passenger railway) received in exchange for 1976 U.S. Tax Ct. LEXIS 148">*176 a bridge. Ordinarily, the basis in the franchise would be its fair market value on the date of transfer, but that value was not ascertainable. The court concluded that the fair market value of the bridge given in exchange should be presumed to be the fair market value of the franchise. However, the court noted that if the fair market value of the property given up also could not be ascertained then no taxable event occurred. See Gould Securities Co. v. United States, 96 F.2d 780 (2d Cir. 1938). Such is our case.

65 T.C. 1099">*1113 We recognize "it is only in rare and extraordinary cases that the value of the property exchanged cannot be ascertained with reasonable accuracy." Philadelphia Park Amusement Co. v. United States, supra at 189. Sec. 1.1001-1(a), Income Tax Regs. But we think the value of stock options (which are not traded on an established market) can be particularly difficult to ascertain. The Supreme Court recognized this in 351 U.S. 243">Commissioner v. LoBue, supra, and respondent has incorporated this notion in his regulations. Sec. 1.421-6(c), Income Tax Regs.

In the present case, we have1976 U.S. Tax Ct. LEXIS 148">*177 only petitioner's testimony of a value of $ 36,744 for the Amerco option. We think petitioner has failed to accurately value the Amerco option privilege or take into consideration the restrictions contained in the Amerco option in reaching his conclusions of value. Moreover, petitioner has failed to take into account Royal's willingness to pay more for the Amerco option (as it did for the Amerco stock) than the option could have been sold for on the open market. ⁸ In short, we are not convinced by petitioner's testimony that the Amerco option had a readily ascertainable fair market value in June 1966. Consequently, we cannot assign any fair market value to the Royal option received in the exchange.

1976 U.S. Tax Ct. LEXIS 148">*178 Since the Royal option had no readily ascertainable fair market value on the date it was granted to petitioner, its disposition is governed by the provisions of section 1.421-6(d)(3), Income Tax Regs., which provides:

If the option is not exercised by the person to whom it was granted, but is transferred in an arm's length transaction, the employee realizes compensation in the amount of the gain resulting from such transfer of the option, and such compensation is includible in his gross income in accordance with his method of accounting.

Under this regulation petitioner realized ordinary income from the transfer of his Royal option to Mr. Singleton in December 65 T.C. 1099">*1114 1967 and January 1968. However, since no payments were received in 1967, and petitioner reported his income on the cash receipts and disbursements method of accounting, respondent has conceded that petitioner realized ordinary income only as payments were received, beginning in 1968.

Because of concessions,

Decision will be entered under Rule 155.