Rail-Stock Options Aren’t Taxable Pay, Justices Rule

(CN) – In a win for railroads, the Supreme Court ruled Thursday that money earned by a railroad employee’s exercise of stock options should not be treated as compensation for the purposes of paying payroll taxes.

The issue boils down to whether stock options should be considered “monetary remuneration.”

For former U.S. Circuit Judge Richard Posner of the Seventh Circuit, the matter was clear.

“A $10 bill is paper; so is a stock certificate that can be sold for $10,” Posner said in one of his last opinions published before his retirement. “The dictionary definition of money may remain constant while the instruments that comprise it change over time: sheep may have once been a form of money; now stock is.”

Under the Railroad Retirement Tax Act of 1937, railroad employees are entitled to railroad retirement benefits in lieu of Social Security benefits.

Just like other employers pay a payroll tax to cover a portion of an employee’s Social Security dues, railroads pay an excise tax equal to a certain percentage of its employees’ wages to cover retirement costs.

In 1996, subsidiaries of the Canadian National Railway Co. – Wisconsin Central Ltd., Illinois Central Railroad Co., and Grand Truck Western Railroad Co. – began including stock options in their employee compensation plans, which can only be exercised if the company achieves certain goals.

The IRS classified these stock options as employee compensation, and ordered the railroads to pay the excise tax on the value of stock options as if they were wages.

On the railroads’ challenge, a federal judge ruled for the government, and a divided Seventh Circuit panel affirmed last July.

“The government’s position makes good practical sense by avoiding the creation of a tax incentive that might distort the ways in which employers structure compensation packages for their managers,” Posner wrote at the time.

The judge admitted that the legislators who wrote the Railroad Retirement Tax Act, enacted in the middle of the Great Depression when the value of corporate stock was quite low, may not have considered stock to be a form of monetary compensation.

But today, “the equivalence of stock to cash is actually signaled in the statutory exception for qualified stock options, explicitly divorced from ‘money remuneration’ by 26 U.S.C. § 3231(e)(12),” Posner wrote.

That exception implies that non-qualified stock options, which are the kind at issue in this case, are taxable, the Seventh Circuit opinion states.

However, the U.S. Supreme Court reversed and ruled 5-4 Thursday that employee stock options are not taxable compensation under the Railroad Retirement Tax Act.

Justice Neil Gorsuch delivered the majority opinion, finding the stock options are not monetary remuneration.

“Our case arises from a peculiar feature of the statute and its history. At the time of the Act’s adoption, railroads compensated employees not just with money but also with food, lodging, railroad tickets, and the like,” he wrote. “Because rail­roads typically didn’t count these in-kind benefits when calculating an employee’s pension on retirement, neither did Congress in its new statutory pension scheme. Nor did Congress seek to tax these in-kind benefits.”

The majority found that new applications to the meaning of old laws “may arise in light of changes in the world.”

“So ‘money,’ as used in this stat­ute, must always mean a ‘medium of exchange.’ But what qualifies as a ‘medium of exchange’ may depend on the facts of the day,” Gorsuch wrote.

He continued, “Take electronic transfers of paychecks. Maybe they weren’t common in 1937, but we do not doubt they would qualify today as ‘money remu­neration’ under the statute’s original public meaning. The problem with the government’s and the dissent’s position today is not that stock and stock options weren’t common in 1937, but that they were not then—and are not now—recognized as mediums of exchange.”

Justice Stephen Breyer wrote a dissenting opinion and was joined by Justices Ruth Bader Ginsburg, Sonia Sotomayor and Elena Kagan.

Breyer backed the government’s interpretation of the Railroad Retirement Tax Act that stock options are a form of money remuneration paid to employees for their services.

“In respect to stock options, the Act’s language has a degree of ambiguity. But the statute’s purpose, along with its amendments, argues in favor of including stock options,” he wrote. “The government has so interpreted the statute for decades, and Congress has never suggested it held a contrary view, despite making other statutory changes.”

Breyer also said the majority’s ruling suggests that the statute at issue will be “trapped in a monetary time warp, forever limited to those forms of money com­monly used in the 1930’s.”

The railroads were represented in the case by Thomas H. Dupree, Jr. with Gibson, Dunn & Crutcher. The federal government was represented by Solicitor General Noel J. Francisco.

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