## Facts

- Western Cooperage Co. contracted to manage and reorganize Hawley Pulp & Paper Co., with Western to receive Hawley stock as compensation if it reduced Hawley’s indebtedness by specified amounts.
- Smith, a longtime Western employee, worked on the Hawley reorganization.
- In December 1934, Western’s president gave Smith an oral option, as compensation for services, to buy part of the Hawley stock Western would later receive.
- At grant, the option had no readily ascertainable market value, and the parties contemplated that Smith’s compensation would occur if the stock later increased in value above the option price.
- In two later tax years, Smith exercised the option and acquired large blocks of Hawley stock at the option price when the stock’s market value was higher.

## Issues

1. Whether, under § 22(a) of the Revenue Act of 1938 and the Internal Revenue Code, the spread between market value and option price when an employee acquires stock through a compensatory option is taxable compensation income in the year of acquisition.
2. Whether the transaction should instead be treated as a noncompensatory purchase of a capital asset with taxable gain only upon later sale.

## Decision

- The Supreme Court reversed the Ninth Circuit and reinstated the Commissioner’s treatment sustained by the Tax Court.
- The Court held that Smith received taxable compensation in each year he effectively exercised the option and acquired stock.
- The amount includable in income each year equaled the difference between the stock’s market value at acquisition and the option (purchase) price.
- Because there was no certainty the employee would receive the stock until delivery, the taxable event occurred upon effective exercise resulting in delivery/acquisition, not at grant.

## Legal Principles

- “Gross income” under § 22(a) includes compensation for personal services in whatever form paid, including property and economic benefits tied to employment.
- When an employee receives a stock option as compensation and the option lacks ascertainable value at grant, the compensatory benefit is realized when the employee acquires the stock at a bargain, not when the option is granted.
- The bargain element (market value at acquisition minus option price) constitutes taxable compensation upon acquisition, even if the employee pays a substantial purchase price.
- Appellate courts should respect the Tax Court’s supported findings characterizing the option and resulting stock acquisition as compensation for services.

## Conclusion

An employee who acquires stock through a compensatory option realizes taxable compensation when the stock is acquired, measured by the spread between the stock’s market value at that time and the option price, rather than deferring taxation until a later sale.


Commissioner v. Smith, 324 U.S. 177 (1945)