Rev. Rul. 74-243

Advice has been requested whether a disposition of stock occurred under section 425(c) of the Internal Revenue Code of 1954 under the circumstances described below.

The taxpayer was a corporate executive and acquired stock in the corporation pursuant to his exercise of qualified stock options under section 422 of the Code. A few months after his acquisition of this stock, the taxpayer resigned from employment as a corporate executive to accept a five-year assignment in government service. In order to remove himself completely from participation in, or knowledge of, certain of his financial affairs during the period of his government service, the taxpayer transferred the above stock and other property to an irrevocable trust, the term of which was to last until his separation from government service, or his death, whichever occurred first.

Under the terms of the trust agreement, the trustees were required to pay monthly from the trust net income and, to the extent necessary from principal, such amounts of money as the taxpayer would request in writing from time to time. To effect the taxpayer's insulation from the administration of the trust, the trustees were given broad powers to manage all the property in the trust, including the power to exchange or sell the trust property, and were not permitted to furnish, directly or indirectly, any information to the taxpayer about the trust assets, any changes therein, any distributions made in kind, or any liabilities assumed or discharged.

The trust agreement provided that upon termination of the trust the trustees would deliver the entire principal and any accumulated income to the taxpayer.

Section 422(a) of the Code provides, in part, that in general, section 421(a) shall apply with respect to the transfer of a share of stock to an individual pursuant to his exercise of a qualified stock option if no disposition of such share is made by the employee within the three-year period beginning on the day after the day of the transfer of such share and if at all times during the period beginning with the date of the granting of the option and ending on the day three months before the date of such exercise, the individual was an employee of either the corporation granting the option or a subsidiary thereof. Section 421(a)(1) provides, with an exception not involved here, that if a share of stock is transferred to an individual in a transfer in respect of which the requirements of section 422(a) are met, no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share.

Under section 1.421-8(b) of the Income Tax Regulations, the disposition of a share of stock, acquired by the exercise of a statutory option before the expiration of the applicable holding period makes section 421 of the Code inapplicable to the transfer of such share. The income attributable to such transfer shall be treated by the individual as income received in the taxable year in which such disposition occurs.

Section 425(c) of the Code provides that the term "disposition" includes a sale, exchange, gift, or a transfer of legal title, but does not include an exchange to which section 1036 applies.

Section 1036 of the Code states that no gain or loss shall be recognized if common stock in a corporation is exchanged solely for common stock in the same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the same corporation.

In Rev. Rul. 57-451, 1957-2 C.B. 295, it is noted that for purposes of section 1036 of the Code, a "simultaneous delivery is not essential to an exchange." The transferee, however, must be under an obligation to replace transferred shares with shares of the same kind and amount. In the instant case, the trustee to whom the stockholder transferred the stock was under no such obligation. Thus, the transaction is not an exchange within the meaning of section 1036.

The phrase "transfer of legal title" is not defined in either section 425 of the Code or in the regulations under that section. However, the phrase has been frequently considered in connection with Federal and State stock transfer taxation, and, in the absence of a definition of "transfer of legal title" in section 425, the construction placed upon the phrase by courts in the area of stock transfer taxes has been relied upon. Rev. Rul. 57-451.

In Selected American Shares, Inc. v. United States, 196 F. 2d 473 (7th Cir. 1952) the court viewed a mere custodian of stock as the alter ego of the true owner and as taking no legal title to stock deposited with it for safekeeping where the stock, accompanied by a blank assignment, was not reissued in the custodian's name so as to necessitate a retransfer by the custodian in the event of a subsequent sale by the true owner.

On the basis of the foregoing, Rev. Rul. 57-451 held that where certificates representing shares of stock received by an optionee under a restricted stock option are endorsed or assigned in blank by such optionee and are deposited with a custodian, such as a bank or trust company or a broker, under a written agreement between the parties providing that such stock is to be held or disposed of by such custodian for, and subject at all times to the instructions of, the optionee, who remains the registered owner of such certificates on the books of the corporation, such deposit is not a "disposition" of the stock.

However, in the instant case, when the taxpayer transferred the stock to the trust, it was not a transfer of the stock to a mere custodian but was a transfer of legal title in the stock to the trustee. The trustee acquired the power to sell the stock, and so long as the trustee holds the stock in trust he may transfer by sale all the incidents of ownership in the stock to a third party.

Accordingly, a disposition of the taxpayer's stock occurred within the meaning of section 425(c) of the Code at the time the taxpayer transferred his stock to the trust, and the income attributable to such transfer is treated as income received in the taxable year in which the disposition occurred.

Compare Rev. Rul. 73-30, 1973-1 C.B. 207, where the delivery of option stock to an agent with a power-of-attorney for the period of a taxpayer's government service is held not to be a disposition under section 425(c) of the Code.