## Facts

- Pagel, Inc., a stock brokerage firm, received a nonqualified stock option in 1977 as partial compensation for underwriting a stock offering for Immuno Nuclear Corp.
- The option allowed Pagel to buy Immuno shares at scheduled prices but barred Pagel from exercising or disposing of the option for 13 months after grant.
- The option was not publicly traded at grant, and no market existed to readily determine its value.
- In 1981, Pagel sold the option and reported the resulting gain as capital gain on its federal return.
- The IRS determined the option had no readily ascertainable fair market value at grant and treated the 1981 proceeds as ordinary income under I.R.C. § 83; the Tax Court sustained the deficiency.

## Issues

1. Whether I.R.C. § 83 taxed as ordinary income the gain from disposing of a compensatory nonqualified stock option that lacked a readily ascertainable fair market value at grant.
2. Whether § 83(e)(3), which excludes § 83 from applying to the grant of such an option, also prevents § 83 from applying at the later sale.
3. Whether Treas. Reg. § 1.83-7’s rules for determining “readily ascertainable fair market value” and for taxing at exercise or disposition are consistent with § 83.

## Decision

- The court affirmed the Tax Court.
- Because the option was nonpublic and restricted from immediate exercise or disposition, it had no readily ascertainable fair market value at grant under Treas. Reg. § 1.83-7(b)(2).
- Under § 83 and Treas. Reg. § 1.83-7, taxation was deferred from grant to the time of exercise or disposition; therefore, the 1981 sale produced ordinary income rather than capital gain.
- Section 83(e)(3) did not eliminate § 83’s application at disposition; read with § 83(e)(4), it established a timing framework to avoid taxing both at grant and again at exercise/disposition.
- The court treated the regulation as a reasonable interpretation of the statute, noting long-standing regulatory treatment and congressional inaction as supporting its validity.

## Legal Principles

- Property transferred in connection with services generally produces ordinary income to the extent fair market value exceeds any amount paid, under I.R.C. § 83(a).
- A compensatory stock option that is not publicly traded and is subject to restrictions on immediate exercise or disposition lacks a readily ascertainable fair market value at grant under Treas. Reg. § 1.83-7(b)(2).
- When a compensatory option lacks a readily ascertainable fair market value at grant, § 83 does not apply at grant but applies upon the option’s exercise or disposition; the amount realized (net of any basis) is ordinary income.
- Statutory exclusions in § 83(e)(3) and § 83(e)(4) must be read together; they allocate when § 83 applies to compensatory options rather than creating permanent immunity from § 83.

## Conclusion

The Eighth Circuit held that a restricted, nonpublic compensatory option with no readily ascertainable fair market value at grant is taxed under I.R.C. § 83 when later exercised or disposed of, and the resulting proceeds are ordinary income, not capital gain.


Pagel, Inc. v. Commissioner of Internal Revenue, 905 F.2d 1190 (8th Cir. 1990)