NIKOLAOS I. TSOUROS, LL.M.

On February 13, 2008, the Commonwealth Court of Pennsylvania, in the Case of In Re: Appeal of Whitpain Township Board of Supervisors, Commonwealth Court Docket No. 2059 C.D. 2006, held that non-qualified stock options granted to the chief executive officer of a company located in Whitpain Township, Pennsylvania, but exercised after the taxpayer had retired and moved to another state, were not subject to the township's earned income tax. If you have been granted non-qualified stock options, which you have not yet exercised, you'll want to know the outcome of this case.

Case Facts

A local company employed the taxpayer from 1980-1998. From 1990-1998, the taxpayer served as the chief executive officer. The taxpayer's main office during his employment was in Whitpain Township, Montgomery County, Pennsylvania. During the years of his employment, the taxpayer received non-qualified stock options from the company, which he did not exercise on the dates they were granted. Additionally, none were exercised on the dates that they vested. After the taxpayer retired in 1998, he moved from Pennsylvania to Arizona. He previously had lived in Lower Merion Township, Montgomery County, Pennsylvania. After he retired and had moved to Arizona, the taxpayer exercised his stock options, whereby he received a capital gain of $38,792,548. After the taxpayer exercised these options, the company withheld earned income tax from the gains for Whitpain Township earned income tax purposes in the amount of $97,977.

Procedure

The taxpayer filed a request for refund from Berkheimer & Associates, the tax collector for Whitpain Township's earned income tax. The taxpayer based his refund request upon the fact that the township had no authority to impose a tax upon him because he was no longer employed within the township and never resided there. Berkheimer & Associates issued a notice in June, 2002 which granted the refund petition conditionally and concluded that the taxpayer was neither a resident nor employed within the township when he exercised his stock options, therefore, the township did not have the authority to impose the tax.

The township appealed this decision to the Court of Common Pleas of Montgomery County, arguing that there was an error of law and that Berkheimer & Associates incorrectly concluded that the stock options were not taxable to the taxpayer, which was contrary to the definition of earned income under the township earned income tax ordinances. Additionally, the township argued that the Case of Marchlen v. Township of Mt. Lebanon, 560 Pa. 453, 746 A.2d 566 (2000) supported the township's position. Additionally, the township argued that the stock options were compensation earned and received when granted and valued for tax purposes when exercised.

The trial court affirmed the decision of the hearing officer from Berkheimer, concluding that the case of Marchlen was controlling and, therefore, because the taxpayer exercised the options after he retired, the township clearly had no authority under the Local Tax Enabling Act ("LTEA") to impose its earned income tax upon the income derived from the exercise of the options.

Issue

On appeal, the Commonwealth Court was faced with one issue, whether non-qualified stock options when granted to the non-resident taxpayer during his employment within a township, but exercised after the taxpayer had ceased his employment, are subject to the township's earned income tax.

Court's Holding

The Commonwealth court disagreed with the township's argument regarding Marchlen and regarding the argument that the taxpayer both earned and received compensation when he was granted the stock options, holding that Marchlen suggests that recognition of income should occur when the value of the options can be ascertained, i.e., when exercised. Additionally, the court held that the regulations enacted shortly after the events at issue clearly indicate that the Department of Revenue considers compensation in the form of options to be received when exercised.

The township's other argument regarding the LTEA, which provides that tax returns and payments are due by April 15th of the year following receipt of earned income, the court held that unless the options were exercised in the same year in which they were granted, or before April 15th of the following year, the court reasoned that it would be impossible to file a timely return under the township's analysis. According to the court, it was obvious that the legislature must have intended taxable income attributable to stock options to be deemed received at such time as value could be determined for purposes of filing a tax return the following April 15th.

Conclusion/Practical Affects of this Case

This case is favorable to the taxpayer due to the fact that if non-qualified stock options are received by an employee and not exercised until the employee retires or moves out of the township which has a local earned income tax, such stock options are not deemed compensation and subject to the local earned income tax in the Commonwealth of Pennsylvania.

If you have any questions regarding the tax implications of exercising stock options, the State and Local Tax Department of MacElree Harvey has experienced tax attorneys who can advise you.

MacElree Harvey
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Post Office Box 660
West Chester, PA 19381–0660
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