Article

Newbrey and Marchlen: Option Gains Not Taxable by Pennsylvania Municipalities
Compensation & Benefits Update

Kirkpatrick & Lockhart LLP

Spring 1998

In decisions of interest to Pennsylvania residents who hold stock options and to their employers, Pennsylvania's Commonwealth Court recently decided two cases holding that Pennsylvania municipalities cannot tax gains on stock options as "earned income." See Newbrey v. Township and School District of Upper St. Clair, et al., __ A.2d __ (Pa. Cmwlth., No. 2132 C.D. 1997, filed March 24, 1998) and Marchlen v. Township of Mt. Lebanon, __ A.2d __ (Pa. Cmwlth., No. 1133 C.D. 1997, filed February 20, 1998). The Township of Mt. Lebanon has requested that the Pennsylvania Supreme Court review the Marchlen case. The Supreme Court has discretion whether to hear the appeal and its decision should be announced in a few months. Although the cases are not final, Pennsylvania residents who have exercised options and paid earned income tax within the most recent three tax years (in most municipalities) and/or employers who have withheld earned income tax on option exercises during that period should consider filing for refunds as promptly as possible. Each municipality's ordinance may differ and should be specifically reviewed.

In each of these cases, Pennsylvania's Commonwealth Court, applying its earlier decision in Pugliese v. Township of Upper St. Clair, 660 A.2d 155 (Pa. Cmwlth. 1995), held that gains on the exercise of a non-qualified stock option are investment income and not earned income as defined in Pennsylvania's Local Tax Enabling Act, as amended, 53 P.S. 6901, et seq. (the "LTEA"). The Court reasoned that, when the option was granted, it had no ascertainable value and, therefore, even if the grant was intended to be compensatory, there is no amount earned at grant for purposes of the LTEA. The Court attributed subsequent increases in option value to market forces affecting the underlying stock and not to actions performed by the optionees. Newbrey adds the interesting twist that, since Upper St. Clair advanced the same arguments unsuccessfully to the Court two years earlier in Pugliese, the Commonwealth Court determined that Upper St. Clair should pay some portion of Newbrey's cost of appeal.

As a practical matter, these decisions change the playing field for Pennsylvania residents holding stock options. Previously, optionees who exercised non-qualified stock options or had disqualifying dispositions of incentive stock options were faced with the choice of paying the earned income tax to their municipalities or resisting the assessments which were virtually certain to follow since the gain must be reported as "income" for Pennsylvania income tax purposes, and state income tax information is or can be available to the municipal tax collector. Most optionees chose to pay the tax because it was less expensive than contesting the assessment. However, with precedents of state-wide applicability (assuming the Pennsylvania Supreme Court allows them to stand), an optionee has no earned income as defined in the LTEA and, therefore, no municipal earned income tax. If the municipality attempts collection, the optionee can expect to have some amount of attorneys' fees paid by the municipality.

Newbrey, Marchlen and Pugliese are cases of statutory construction. Under Pennsylvania's Constitution, the power to tax resides solely in the General Assembly, except to the extent the General Assembly specifically permits its "political subdivisions" (a term which includes cities, boroughs, townships and school districts but excludes the state itself) to levy taxes. The delegation of taxing power is generally through the LTEA. The LTEA permits political subdivisions to levy, among others, a tax of not more than 1% (shared between overlapping subdivisions such as a township and a school district) on "earned income." Other limitations apply for Philadelphia and certain "home rule" municipalities. The LTEA defines earned income as follows:

" ... [s]alaries, wages, commissions, bonuses, incentive payments, fees, tips and other compensation received by a person ... for services rendered. whether in cash or property."

The introductory language to the earned income tax portion of the LTEA states:

"The definitions contained in this section shall be exclusive for any tax upon earned income and net profits levied and assessed pursuant to this act, and shall not be altered or changed by any political subdivision levying and assessing this tax."

The definition of earned income in the LTEA is very different from the definition of income for either Pennsylvania or federal income tax purposes. Moreover, the method of taxing incomes is different at the state and federal levels. Since the LTEA was in effect for many years before the current state income tax was instituted, that is, following the 1970's litigation over the uniformity clause of Article 8 of the Pennsylvania Constitution, and both the LTEA and the state income tax were adopted many years after Section 61 of the Internal Revenue Code, it is not surprising that time and the political process left inconsistencies among statutory definitions.

Substantially all Pennsylvania municipalities have ordinances levying taxes on earned income. These ordinances also require reporting by residents and tax withholding by employers operating in the municipality. If the employer does not operate in the municipality, the employee must pay earned income tax directly. Municipalities have traditionally taken the position that earned income includes gains on options recognized for federal and state income tax purposes. Some municipalities have gone so far as to draft ordinances to specifically include gains on options as earned income.

Mt. Lebanon and Upper St. Clair argued in their respective cases that (1) federal and state income tax rules treat gains on options as taxable income and (2) the options were granted to provide compensation to the optionee for services rendered or to be rendered. However, the Commonwealth Court determined that, even if the options were granted as compensation, a point on which they did not rule, the options had no value when granted. Subsequent increases in the value of the options were attributable not to services rendered by optionees but, instead, by market forces affecting the underlying stock. More central to the Court's decision is that the LTEA does not specifically empower municipalities to tax option gains and, therefore, it is beyond the capacity of municipalities to tax option gains. This result applies even though the operative ordinances purported to tax such gains.

The recent cases make clear that, in the Commonwealth Court's view, municipalities cannot extend the definition of earned income beyond that set forth in the LTEA either by tax administration policy or by ordinance. The power to tax will be strictly construed.

Supreme Court review may not be the end of the issue as a practical matter. Since optionees with significant gains must be among the smallest constituencies in Pennsylvania, the General Assembly may change the LTEA to permit taxation of gains on stock options. The General Assembly's action, however, can have only prospective application.

There is a window of opportunity for optionees who have exercised or intend to exercise options . Each municipal ordinance has some sort of refund procedure. Procedures and times may vary from ordinance to ordinance. However, as a general rule, refunds may be requested for only the three most recent tax years. Accordingly, if an optionee exercised options within the last three years and paid or had earned income tax withheld, a request for refund should be made promptly to preserve the years in question. It is unlikely that any municipality would process the refund until the Supreme Court rules in Marchlen. However, on the other hand, it would appear reasonable for the municipality to stipulate that the refund would be granted if the Supreme Court rules for the taxpayer, and the refund request would be dropped if the Supreme Court ruled for the municipalities. Accordingly, if reason prevails, the refund process should have little risk of litigation. If the cases stand as decided and the General Assembly subsequently amends the LTEA, the amendment can apply only to option exercises after the legislative action. Therefore, if the cases stand, the refund request is viable for those who exercised options, no matter what action is taken by the General Assembly.

-- William T. Cullen
(412) 355-8600

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Copyright 1998 by Kirkpatrick & Lockhart LLP. Permission to reproduce is granted provided Kirkpatrick & Lockhart LLP is acknowledged as the source of this document. Reprinted on BenefitsLink by permission.