Nield and Linda Montgomery v. Commissioner , 127 T.C. No. 3 ( 2006 )

127 T.C. No. 3
UNITED STATES TAX COURT
NIELD AND LINDA MONTGOMERY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 633-05. Filed August 28, 2006.
P-H, president and CEO of MGC Communications, Inc.
(MGC), received incentive stock options (ISOs) from MGC
between April 1996 and March 1999. In November 1999,
P-H resigned as president and CEO of MGC and entered
into an employment contract with MGC which included
provisions accelerating the vesting dates of his ISOs.
In early 2000, P-H exercised many of his ISOs. P-H
subsequently sold shares of MGC stock in 2000 and 2001
at prices above and below the exercise prices that he
paid for the shares.
Ps filed a joint Federal income tax return for
2000 reporting total tax of $2,831,360, including
alternative minimum tax (AMT). Ps subsequently
submitted to R an amended return for 2000 in which they
claimed (1) they were not subject to AMT, and (2) they
overpaid their taxes. R rejected Ps’ claimed
overpayment and issued to Ps a notice of deficiency for
2000. R determined Ps failed to report wages, capital
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gains, and additional alternative minimum taxable
income (AMTI) arising from the exercise of P-H’s ISOs.
Held: P-H’s rights to the MGC shares he acquired
upon the exercise of his ISOs were not subject to a
substantial risk of forfeiture within the meaning of
sec. 83, I.R.C., and sec. 16(b) of the Securities
Exchange Act of 1934. Held, further: R’s
determinations Ps failed to report wages, capital
gains, and AMTI arising from the exercise of P-H’s ISOs
are sustained in that (1) R properly applied the
$100,000 annual limit imposed on ISOs under sec.
422(d), I.R.C., (2) Ps are not entitled to carry back
capital losses to 2000, and (3) Ps are not entitled to
carry back alternative tax net operating losses to
2000. Held, further: Ps are not liable for an
accuracy-related penalty for 2000 under sec.
6662(b)(2), I.R.C.
Duncan C. Turner and Brian G. Isaacson, for petitioners.
Kirk M. Paxson, Julie L. Payne, and William C. Schmidt, for
respondent.
HAINES, Judge: Respondent determined a deficiency of
$417,601 in petitioners’ Federal income tax for 2000 and an
accuracy-related penalty of $83,520 under section 6662(b).1 All
references to petitioner in the singular are to petitioner Nield
Montgomery.
1
Unless otherwise indicated, section references are to the
Internal Revenue Code, as amended, and Rule references are to the
Tax Court Rules of Practice and Procedure.
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After concessions,2 the issues remaining for decision are:
1. Whether petitioner’s rights in shares of stock acquired
upon the exercise of incentive stock options (ISOs) in 2000 were
subject to a substantial risk of forfeiture within the meaning of
section 83(c)(3) and section 16(b) of the Securities Exchange Act
of 1934)3 (the Exchange Act). We hold petitioner’s rights were
not subject to a substantial risk of forfeiture.
2. Whether respondent properly determined that petitioner’s
options exceeded the $100,000 annual limit imposed on ISOs under
section 422(d). We hold respondent correctly applied section
422(d) in this case.
3. Whether petitioners may carry back capital losses to
reduce the amount of their alternative minimum taxable income for
2000. We hold they may not.
4. Whether petitioners may carry back alternative tax net
operating losses to reduce the amount of their alternative
minimum taxable income for 2000. We hold they may not.
5. Whether petitioners are liable for an accuracy-related
penalty under section 6662(b)(2) for 2000. We hold petitioners
2
The parties filed a stipulation of settled issues in
which they agreed to the amounts of deductions petitioners are
entitled to claim for charitable contributions made during 2000.
3
The Securities Exchange Act of 1934, ch. 404, sec. 16(b),
48 Stat. 896, codified at 15 U.S.C. sec. 78p(b) (2000). For
convenience, all citations are to sections of the Securities
Exchange Act of 1934.
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are not liable for the accuracy-related penalty under section
6662(b).
FINDINGS OF FACT
Some facts have been stipulated and are so found. The
parties’ stipulations of facts, with attached exhibits, are
incorporated herein by this reference. At the time the petition
was filed, petitioners (husband and wife) resided in Las Vegas,
Nevada.
A. MGC Communications, Inc.
In 1995, petitioner cofounded NevTEL, Inc., subsequently
renamed MGC Communications Inc. (MGC),4 to engage in the business
of providing local telephone service in Nevada. Petitioner
served as MGC’s president and chief executive officer from 1995
to November 1999. During the period in question, MGC’s common
stock was publicly traded on the NASDAQ market system, and MGC
was subject to the reporting requirements of the Exchange Act.
MGC shares were subject to a 6-for-10 reverse stock split in
May 1998 and a 3-for-2 stock split in August 2000. Unless
otherwise indicated, all data (including tables) set forth below
reflect these stock splits.
1. MGC Communications, Inc. Stock Option Plan
In 1996, MGC adopted the MGC Communications, Inc. Stock
4
Although MGC Communications, Inc., was subsequently
renamed Mpower Communications, Inc., we shall refer to the
corporation as MGC.
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Option Plan (the MGC stock option plan) which provided in
pertinent part: (1) The plan would be administered by a
committee of no fewer than two “disinterested persons” (the
committee), who would be appointed by MGC’s board of directors
(MGC board) from its membership or, in the absence of such
appointments, by the entire MGC board; (2) the committee would
have the sole discretion to (a) select the persons to be granted
options, (b) determine the number of shares subject to each
option, (c) determine the duration of the exercise period for any
option, (d) determine that options may only be exercised in
installments, and (e) impose other terms and conditions on each
option as the committee in its sole discretion deemed advisable.
The MGC stock option plan expressly contemplated that the
committee would grant to MGC employees ISOs within the meaning of
sections 421 and 422.
2. Petitioner’s Incentive Stock Options
On April 1, 1996, September 4, 1998, and March 1, 1999,
petitioner executed a series of share option agreements under
which he was granted ISOs from MGC. Each of the share option
agreements stated that if petitioner were considered an “insider”
subject to section 16(b) of the Exchange Act, petitioner “shall
be restricted from selling any Option Shares acquired by him
through exercise of the Options or any portion thereof during the
six (6) month period following the date of grant of the Option.”
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Table 1 sets forth the dates on which petitioner’s ISOs were
granted and the number of MGC shares petitioner was entitled to
purchase under each ISO.
Table 1
Grant Grant date Shares
1 4/1/96 540,000
2 9/4/98 22,500
3 9/4/98 45,000
4 3/1/99 15,000
5 3/1/99 22,500
Petitioner’s ISOs provided for exercise prices, i.e., the price
petitioner would pay for each MGC share, ranging from $0.55 to
$5.33. Petitioner’s ISOs originally were scheduled to vest on
various dates between 1997 and 2003.
Petitioner was not granted any additional MGC stock options
after March 1, 1999. During the period in question, petitioners
owned less than 10 percent of the total combined voting power of
all classes of MGC’s stock.
Petitioner unilaterally determined the specific terms and
conditions of the ISOs that he received under the share option
agreements. The MGC board did not appoint a committee to
administer the MGC stock option plan, and the MGC board did not
play any role in consummating the share option agreements
described above.
B. Petitioner’s 1999 Employment Agreement With MGC
On November 1, 1999, petitioner entered into a comprehensive
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agreement with MGC governing his employment status with MGC and
his ISOs (the 1999 employment agreement). Pursuant to the 1999
employment agreement: (1) Petitioner resigned as president, chief
executive officer, and director of MGC, and he resigned as an
officer and director of MGC’s subsidiaries; (2) petitioner agreed
to assist MGC’s new chief executive officer “in order to provide
for a smooth transition for the Company”; (3) MGC agreed to make
a lump-sum payment of $360,000 to petitioner; (4) MGC and
petitioner agreed to accelerate the vesting dates of petitioner’s
ISOs; and (5) petitioner and MGC agreed that petitioner would
continue to be employed by MGC through April 1, 2001, for the
purpose of providing advice regarding regulatory developments,
testimony at legal, regulatory, and administrative proceedings as
necessary, and other mutually agreed duties.
After November 1, 1999, MGC never requested petitioner to
prepare any formal reports for the company, and petitioner did
not prepare any formal reports for MGC.
Table 2 sets forth (1) the fair market value of MGC shares
as of the dates petitioner’s ISOs were granted, and (2) the total
fair market value of all shares as to which petitioner’s ISOs
were exercisable for the first time during each of the years 1997
to 2001 (taking into account the accelerated vesting schedule
that MGC and petitioner agreed to on November 1, 1999):
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Table 2
Year ISO
first
exercisable FMV of MGC shares as of ISO grant date Total
Grant 1 Grant 2 Grant 3 Grant 4 Grant 5 FMV
1997 $60,000 -- -- -- -- $ 60,000
1998 60,000 -- –- –- –- 60,000
1999 60,000 $96,000 $240,000 $20,298 -– 416,298
2000 60,000 24,000 -- 20,298 $91,350 195,648
2001 60,000 -- -- 20,304 -- 80,304
C. Petitioner’s SEC Filings
In February 2000, petitioner filed with the Securities and
Exchange Commission (SEC) a Form 5, Annual Statement Of Changes
In Beneficial Ownership of Securities, in which he reported
owning 736,500 shares of MGC common stock and options to purchase
430,000 additional shares of MGC common stock.5 A cover letter
accompanying petitioner’s Form 5 stated that the report would be
petitioner’s last because he was no longer subject to the
reporting requirements of section 16(a) of the Exchange Act.
Petitioner did not file any further Forms 5 with the SEC.
During 2000 and 2001, petitioner remained in contact with
certain MGC executive officers and was privy to material, non-
public information regarding MGC’s operations and financial
matters.
D. Petitioner’s Acquisitions and Dispositions of MGC Shares
Table 3 sets forth the ISOs that petitioner exercised,
5
Adjusted for MGC’s August 2000 stock split, petitioner
held options to purchase 645,000 shares of MGC common stock. See
supra Table 1.
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identified by grant, exercise date, numbers of MGC shares
acquired, total exercise price, and total fair market value (FMV)
of the MGC shares acquired as of each exercise date:
Table 3
Grant Exercise date Shares acquired Exercise price FMV
1 1/11/00 324,000 $179,982 $10,773,000
2 1/11/00 18,000 96,000 598,500
3 1/11/00 45,000 240,000 1,496,250
4 1/11/00 5,000 20,300 166,250
4 3/9/00 5,000 20,300 237,050
5 3/9/00 22,500 91,350 1,066,725
1 3/29/00 108,000 59,994 4,733,640
Petitioner subsequently disposed of a number of the MGC
shares he had acquired upon the exercise of his ISOs (as
described in Table 3 above). In particular, on May 4, 2000,
petitioner transferred 2,250 shares of MGC stock by way of a
gift. In addition, petitioner sold a number of MGC shares during
2000 and 2001, as set forth in the following table:
Table 4
Gain or loss
(Difference between
exercise price and
Grant Sale date Shares sold Sale proceeds sales proceeds)
1 9/29/00 175,000 $1,480,729 $1,383,517
1 12/8/00 50,000 209,991 182,216
1 12/20/00 42,000 140,121 116,790
1 12/20/00 13,000 43,371 36,149
1 12/21/00 41,750 151,486 128,294
2 12/21/00 9,750 35,377 (16,623)
2 12/21/00 8,250 29,934 (14,066)
3 12/21/00 10,250 37,191 (17,475)
3 12/28/00 6,000 28,947 (3,053)
3 12/29/00 19,000 82,196 (93,037)
3 3/13/01 5,000 19,122 (7,544)
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3 3/14/01 4,740 18,297 (7,036)
4 3/14/01 250 963 (52)
4 3/15/01 4,750 18,215 (1,070)
4 3/15/01 998 3,827 (225)
4 3/15/01 4,002 15,346 (902)
5 3/14/01 250 963 (52)
5 3/16/01 10,000 39,496 (1,104)
5 3/19/01 5,000 19,278 (1,022)
5 3/20/01 7,500 27,275 (2,160)
Petitioners have never been in the trade or business of
trading stocks. Petitioners held their MGC shares for investment
purposes and not as traders or dealers.
MGC never requested that petitioner disgorge any profits
from his sales of MGC shares, petitioner was never sued by MGC or
one of its shareholders pursuant to section 16(b) of the Exchange
Act, and petitioner never paid over to MGC any part of the
proceeds from his sales of MGC common stock.
E. Petitioners’ Tax Return and Amended Return
On or about October 18, 2001, petitioners filed a joint
Federal income tax return for the taxable year 2000 reporting
total tax of $2,831,360 (including AMT described below).
Petitioners reported total payments of $2,636,723, leaving a
balance due of $196,006 (including an estimated tax penalty of
$1,369). Petitioners submitted Form 6251, Alternative Minimum
Tax--Individuals, with their tax return for 2000. On Form 6251,
line 10, petitioners reported $3,988,180 of alternative minimum
tax income (arising from the exercise of petitioner’s ISOs) in
excess of regular taxable income, a total of $10,665,935 of
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alternative minimum taxable income (AMTI), and AMT of $526,679.
Petitioners’ tax return was prepared and signed by a tax return
preparer employed at Deloitte & Touche LLP.
Petitioners failed to remit the full amount of tax due with
their tax return. Respondent accepted petitioners’ tax return as
filed and assessed the tax reported therein, as well as statutory
interest and a late-payment penalty.
Respondent issued to petitioners a Final Notice of Intent to
Levy and Notice of Your Right to a Hearing with regard to their
unpaid taxes for 2000. Petitioners submitted to respondent an
amended return for 2000 and a request for an administrative
hearing under section 6330. In their amended return, petitioners
claimed that they overstated the amount of tax due on their
original return, and they claimed they were due a refund of
$519,087. Contrary to their original return, petitioners
submitted a Form 6251 with their amended return in which they
reported $850,534 of alternative minimum taxable income in excess
of regular taxable income, a total of $7,148,666 of AMTI, and
zero AMT.
Respondent declined to consider petitioners’ refund claim
and issued to petitioners a Notice of Determination Concerning
Collections Actions for 2000. Petitioners filed a petition for
lien or levy action with the Court at docket No. 16864-02L. Upon
review of the matter, the Court remanded the collection case to
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respondent’s Office of Appeals for consideration of petitioners’
amended return. During the remand, respondent audited
petitioners’ original and amended returns and issued to
petitioners a Supplemental Notice of Determination under section
6330 and a notice of deficiency under section 6213(a).6
In the notice of deficiency, respondent determined (1)
petitioners failed to report the correct amount of wages and
capital gains arising from the exercise of petitioner’s ISOs, (2)
petitioners were not entitled to certain itemized deductions, (3)
petitioners were liable for AMT in excess of that reported on
their original return, and (4) petitioners were liable for an
accuracy-related penalty. Specifically, respondent determined
that petitioners’ correct tax liability for 2000 totaled
$3,248,961--a sum comprising regular tax of $2,511,949 and AMT of
$737,012. Petitioners filed a petition for redetermination in
this case challenging the notice of deficiency.
At the conclusion of the trial in this case, the Court
directed the parties to file seriatim briefs. After petitioners
filed their opening brief, respondent filed an answering brief
and a motion for leave to file amended answer seeking an
increased deficiency and an increased accuracy-related penalty to
conform the pleadings to testimony offered by petitioner at
6
Petitioners’ collection review case at docket No. 16864-
02L was stayed pending the disposition of the instant case.
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trial. Respondent asserted that petitioner’s trial testimony
demonstrated that petitioner’s options were not ISOs as defined
in section 422(b). Respondent’s motion was denied by Order dated
May 10, 2006. Under the following analysis, petitioner’s options
are treated as ISOs (consistent with respondent’s position in the
notice of deficiency).
OPINION
I. Taxation of Stock Options
A. Incentive Stock Options
Generally, under section 421(a), a taxpayer is not required
to recognize income upon the grant or exercise of an ISO.7
Section 422(a) provides that section 421(a) shall apply with
respect to the transfer of a share of stock to a taxpayer
pursuant to the exercise of an ISO if (1) no disposition of such
7
Sec. 422(b) defines an incentive stock option (ISO) in
pertinent part as an option granted to a taxpayer by an employer
corporation (or a parent or subsidiary corporation) to purchase
stock of any such corporation but only if (1) the option is
granted pursuant to a plan which is approved by the stockholders
of the granting corporation, (2) such option is granted within
the earlier of 10 years from the date such plan is adopted or
approved by the stockholders, (3) such option is not exercisable
after 10 years from the date such option is granted, (4) the
option price is not less than the fair market value of the stock
at the time such option is granted, (5) such option is not
transferrable by the taxpayer other than by will or the laws of
descent and distribution and is exercisable during the taxpayer’s
lifetime only by the taxpayer, and (6) such taxpayer, at the time
the option is granted, does not own stock possessing more than 10
percent of the total combined voting power of all classes of
stock of the employer corporation or of its parent or subsidiary
corporation.
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share is made by the individual within 2 years from the date of
the granting of the option nor within 1 year after the transfer
of the share to the individual, and (2) the taxpayer remains an
employee of the corporation granting the option (or of a parent
or subsidiary corporation of such corporation) during the period
beginning on the date the option was granted and ending on the
day 3 months before the date the option was exercised. Any gain
or loss on a sale of shares acquired pursuant to the exercise of
an ISO that are held for the periods prescribed in section
422(a)(1) generally will qualify as a capital gain or loss.
Secs. 1001, 1221, 1222.
Section 421(b) provides that if a taxpayer disposes of any
shares of stock acquired pursuant to the exercise of an ISO
before the expiration of the holding periods prescribed in
section 422(a)(1), the taxpayer shall recognize an increase in
income in the taxable year in which such disqualifying
disposition occurs.8 Section 422(c)(2) provides in pertinent
part that if a taxpayer disposes of any shares of stock acquired
pursuant to the exercise of an ISO before the expiration of the
holding periods required in section 422(a)(1), and such
disposition is a sale or exchange with respect to which a loss
8
Sec. 424(c) provides that the term “disposition” as
related to shares of stock acquired pursuant to the exercise of
an ISO generally means “a sale, exchange, gift, or a transfer of
legal title”.
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(if sustained) would be recognized to such individual, the amount
includable in the taxpayer’s gross income shall not exceed the
excess (if any) of the amount realized on such sale or exchange
over the adjusted basis of such shares.
Section 422(d) imposes an annual limit on options that
qualify as ISOs. Section 422(d) provides:
SEC. 422(d). $100,000 Per Year Limitation.--
(1) In general.--To the extent that the
aggregate fair market value of stock with respect to
which incentive stock options (determined without
regard to this subsection) are exercisable for the 1st
time by any individual during any calendar year (under
all plans of the individual’s employer corporation and
its parent and subsidiary corporations) exceeds
$100,000, such options shall be treated as options
which are not incentive stock options.
(2) Ordering rule.--Paragraph (1) shall be
applied by taking options into account in the order in
which they were granted.
(3) Determination of fair market value.--For
purposes of paragraph (1), the fair market value of any
stock shall be determined as of the time the option
with respect to such stock is granted.
In sum, when the aggregate fair market value of stock that a
taxpayer may acquire pursuant to ISOs that are exercisable for
the first time during any taxable year exceeds $100,000, such
options shall be treated as nonqualified stock options (NSOs)
under section 83 (as discussed in detail below).
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B. Alternative Minimum Tax
1. In General
The Internal Revenue Code imposes upon taxpayers an AMT in
addition to all other taxes imposed by subtitle A. Sec. 55(a).
Although a taxpayer exercising an ISO may defer recognition of
income for regular tax purposes, the taxpayer nevertheless may
incur AMT liability. See sec. 56(b)(3). The AMT is imposed upon
the taxpayer’s AMTI, which is an income base broader than that
applicable for regular tax purposes. Allen v. Commissioner, 118
T.C. 1, 5 (2002); see also H. Conf. Rept. 99-841 (Vol. II), at
II-249, II-264 (1986), 1986-3 C.B. (Vol. 4) 1, 249, 264. AMTI is
defined as the taxable income of a taxpayer for the taxable year,
determined with adjustments provided in sections 56 and 58, and
increased by the amount of items of tax preference described in
section 57. Sec. 55(b)(2).
For purposes of computing a taxpayer’s AMTI, section
56(b)(3) provides that section 421 shall not apply to the
transfer of stock acquired pursuant to the exercise of an ISO as
defined by section 422. Therefore, under the AMT, the spread
between the exercise price and the fair market value of the
shares of stock on the date an ISO is exercised is treated as an
item of adjustment and is included in the computation of AMTI.
See sec. 56(b)(3); sec. 1.83-7(a), Income Tax Regs.; see also
Speltz v. Commissioner, 124 T.C. 165, 178-179 (2005), affd. 454
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F.3d 782 (8th Cir. 2006). Insofar as section 56(b)(3) provides
that section 421 shall not apply to the exercise of an ISO,
section 83 is applicable to the exercise of an ISO inasmuch as
the exclusion for ISOs set forth in section 83(e)(1) is negated.9
2. Section 83
Section 83(a) provides in pertinent part that if property is
transferred to a taxpayer in connection with the performance of
services (i.e., stock transferred to a taxpayer upon the exercise
of a stock option), the excess of the fair market value of the
stock (measured as of the first time the taxpayer’s rights in the
stock are not subject to a substantial risk of forfeiture) over
the amount, if any, paid for the stock (the exercise price) shall
be included in the taxpayer’s gross income in the first taxable
year in which the taxpayer’s rights in the stock are not subject
to a substantial risk of forfeiture. See Tanner v. Commissioner,
117 T.C. 237, 242 (2001), affd. 65 Fed. Appx. 508 (5th Cir.
2003); sec. 1.83-7(a), Income Tax Regs. As mentioned above, the
combined application of various provisions of sections 55, 56,
and 83, requires that, upon the exercise of an ISO, such income
be included in the computation of AMTI.
9
Sec. 56(b)(3) further provides, however, that sec.
422(c)(2) shall apply “in any case where the disposition and the
inclusion for * * * this part are within the same taxable year
and such section shall not apply in any other case.”
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Section 83(c) contains special rules related to recognition
of income under section 83(a). Section 83(c)(3) provides that a
taxpayer’s rights in property (stock) are subject to a
substantial risk of forfeiture and are not transferable so long
as the sale of the stock at a profit could subject the taxpayer
to suit under section 16(b) of the Exchange Act.
3. AMT Impact on Basis
As a result of the unique treatment of the exercise of ISOs
under the AMT regime, a taxpayer normally will have two different
bases in the same shares of stock. The taxpayer’s regular tax
basis is the exercise price or cost basis. See sec. 1012.
However, for AMT purposes, section 56(b)(3) provides that the
adjusted basis of any stock acquired by the exercise of an ISO
“shall be determined on the basis of the treatment prescribed by
this paragraph.” In other words, a taxpayer’s adjusted AMT basis
equals the exercise or cost basis in the shares increased by the
amount of income included in AMTI. See secs. 55(b)(2), 56(b)(3),
83(a).
The following example illustrates the general operation of
the ISO basis rules. Assume a taxpayer is granted an ISO giving
him the right to purchase 100 shares of ABC, Inc., common stock
at $1 per share. The taxpayer exercises the ISO at a time when
ABC, Inc. common stock is trading at $10 per share and the
taxpayer’s rights in such shares are freely transferrable. Under
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this example, the taxpayer’s basis for regular tax purposes is
$100--the total exercise price or cost incurred by the taxpayer
to purchase the 100 shares of stock. On the other hand, the
taxpayer’s adjusted basis solely for AMT purposes is $1,000--an
amount that comprises the taxpayer’s $100 cost basis plus the
$900 bargain purchase element of the transaction that is included
in the computation of the taxpayer’s AMT liability.
The anomaly in the ISO basis rules may create inequitable
results when a taxpayer has incurred AMT liability upon the
exercise of an ISO in one taxable year, only to have the shares
of stock decrease in value the following year. In this
situation, the AMT imposed on the bargain purchase element of the
ISO results in a payment of tax on income the taxpayer may never
actually receive.
II. The Parties’ Positions
A. Respondent’s Determinations
Respondent determined that the aggregate fair market value
of the stock with respect to which petitioner held ISOs that were
first exercisable in 1999 and 2000 exceeded the $100,000
limitation imposed under section 422(d). In connection with this
determination, respondent asserts that the aggregate value of
stock that a taxpayer may acquire pursuant to ISOs during a
taxable year is computed for purposes of the $100,000 limitation
of section 422(d) without taking into account any disqualifying
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dispositions; i.e., transfers or sales of stock prior to the
expiration of the holding periods required under section
422(a)(1). Taking into account the effects of section 422(d) and
petitioner’s disqualifying dispositions of MGC shares, respondent
determined that petitioners failed to report gross income (wages
and capital gains) subject to regular tax, and they failed to
compute properly their AMT for 2000.
B. Petitioners’ Contentions
Petitioners first contend they were not obliged to recognize
any income related to the shares of stock petitioner acquired
upon the exercise of his ISOs during the taxable year 2000
because petitioner’s rights in the MGC shares in question were
subject to a substantial risk of forfeiture during 2000.
Specifically, petitioner maintains he was a statutory insider of
MGC throughout 2000, and he could have been sued by MGC or
another MGC shareholder under section 16(b) of the Exchange Act
and forced to disgorge the profits he realized when he sold his
MGC shares. See sec. 83(c)(3).
In the alternative, petitioners assert they incurred
capital losses or alternative tax net operating losses (ATNOLs)
in years subsequent to the taxable year 2000, and such losses may
be carried back to reduce their AMTI for 2000. Petitioners
contend that for AMT purposes (1) capital losses are not subject
to the $3,000 limitation imposed under section 1211, and (2)
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imposing a $3,000 limitation on the amount of capital losses
petitioners may report would defeat Congress’s intent to tax only
the economic gain received by a taxpayer.
III. Whether Petitioner’s Rights in his MGC Shares Were Subject
to a Substantial Risk of Forfeiture Within the Meaning of Section
83(c)(3)
Section 16(a) of the Exchange Act requires the principal
stock holders of any class of equity security registered under
section 12 of the Exchange Act, and the directors and officers of
the issuer of such securities (hereinafter insiders), to file
periodic statements with the SEC disclosing the amount of equity
securities such insider owns, and purchases and sales made by
such insider, during the reporting period. Section 16(b) of the
Exchange Act provides in pertinent part:
(b) For the purpose of preventing the unfair use
of information which may have been obtained by such
beneficial owner, director, or officer by reason of his
relationship to the issuer, any profit realized by him
from any purchase and sale, or any sale and purchase,
of any equity security of such issuer (other than an
exempted security) or a security-based swap agreement
(as defined in section 206B of the Gramm-Leach-Bliley
Act) involving any such equity security within any
period of less than six months, unless such security or
security-based swap agreement was acquired in good
faith in connection with a debt previously contracted,
shall inure to and be recoverable by the issuer,
irrespective of any intention on the part of such
beneficial owner, director, or officer in entering into
such transaction of holding the security or security-
based swap agreement purchased or of not repurchasing
the security or security-based swap agreement sold for
a period exceeding six months.
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The remainder of section 16(b) provides that an issuer or any
shareholder of the issuer may bring suit against an insider to
recover any profit realized by the insider on any purchase and
sale, or any sale and purchase, of any equity security of such
issuer within any period of less than 6 months.
Section 16(b), the so-called short-swing profit recovery
provision, is a prophylactic and strict liability measure “under
which an insider’s short-swing profits can be recovered
regardless of whether the insider actually was in possession of
material, non-public information.” Ownership Reports and Trading
By Officers, Directors and Principal Security Holders (Ownership
Reports), Exchange Act Release No. 34-28869, 56 Fed. Reg. 7242,
7243 (Feb. 21, 1991); see Levy v. Sterling Holding Co., LLC, 314
F.3d 106, 109-111 (3d Cir. 2002); Magma Power Co. v. Dow Chem.
Co., 136 F.3d 316, 320 (2d Cir. 1998). Section 16(b) applies to
transactions involving derivative securities such as stock
options. At Home Corp. v. Cox Commcns. Inc., 446 F.3d 403 (2d
Cir. 2006); Magma Power Co. v. Dow Chem. Co., supra at 321; SEC
rule 16a-1(c) and (d), 17 C.F.R. sec. 240.16a-1(c) and (d)
(2006).
The elements of a claim under section 16(b) of the Exchange
Act are “(1) a purchase and (2) a sale of securities (3) by an
officer or director of the issuer or by a shareholder who owns
more than ten percent of any one class of the issuer’s securities
- 23 -
(4) within a six-month period.” Gwozdzinsky v. Zell/Chilmark
Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998).
The parties disagree whether petitioner was an insider
subject to liability under section 16(b) of the Exchange Act
during 2000. Respondent points out that, after petitioner’s
resignation as an officer and director of MGC in 1999, petitioner
no longer filed Form 4, Statement of Changes in Beneficial
Ownership, or Form 5, Statement of Changes in Beneficial
Ownership of Securities, with the SEC, he was not a 10-percent
shareholder, and he apparently no longer considered himself an
insider subject to the reporting requirements of section 16(a) of
the Exchange Act. Respondent also points out that no lawsuit was
ever filed against petitioner seeking disgorgement of the profits
he realized when he sold MGC shares during 2000 and 2001.
Petitioner counters that he remained an insider at MGC during
2000 and 2001 as an adviser to MGC’s executives. Although we are
doubtful petitioner was an insider subject to liability under
section 16(b) of the Exchange Act during 2000, we need not decide
the point. Assuming arguendo that petitioner was an insider
within the meaning of section 16(b) of the Exchange Act, we
conclude that petitioner was not subject to a substantial risk of
forfeiture during the taxable year 2000 because he exercised his
ISOs and acquired shares of MGC stock at a point in time outside
- 24 -
of the 6-month period which would give rise to a lawsuit under
section 16(b) of the Exchange Act.
It is well settled that it is the acquisition (grant) of a
stock option (as opposed to the exercise of a stock option) that
is deemed to be a purchase of a security for purposes of the 6-
month short-swing profit recovery provision under section 16(b)
of the Exchange Act.10 See Magma Power Co. v. Dow Chem. Co.,
supra at 321-322. The SEC made this point indelibly clear when
it adopted the regulatory framework governing insider
transactions involving derivative securities in 1991. The SEC
stated in pertinent part:
The functional equivalence of derivative securities and
their underlying equity securities for section 16
purposes requires that the acquisition of the
derivative security be deemed the significant event,
not the exercise. * * * The Rules correspondingly
recognize that, for purposes of the abuses addressed by
section 16, the exercise of a derivative security, much
like the conversion of a convertible security,
essentially changes the form of beneficial ownership
from indirect to direct. Since the exercise represents
neither the acquisition nor the disposition of a right
10
For the sake of completeness, we observe the exercise of
a stock option is treated as a purchase of the underlying
security for purposes of the insider reporting provisions under
section 16(a) of the Exchange Act. SEC rule 16a-1(b), 17 C.F.R.
sec. 240.16a-1(b) (2006) defines a “call equivalent position” as
“a derivative security position that increases in value as the
value of the underlying equity increases, including, but not
limited to, a long convertible security, a long call option, and
a short put option position.” SEC rule 16a-4(b), 17 C.F.R. sec.
240.16a-4(b) (2006), provides that the exercise of a call
equivalent position shall be reported on Form 4 and treated for
reporting purposes as (1) a purchase of the underlying security
and (2) a closing of the derivative security position.
- 25 -
affording the opportunity to profit, it should not be
an event that is matched against another transaction in
the equity securities for purposes of section 16(b)
short-swing profit recovery. [Emphases added; fn. ref.
omitted.]
Ownership Reports, supra, 56 Fed. Reg. at 7248-7249. The SEC
went on to state that “to avoid short-swing profit recovery, a
grant of an employee stock option by an issuer, absent an
exemption, must occur at least six months before or after a sale
of the equity security or any derivative security relating to the
equity security.” Id., 56 Fed. Reg. at 7251 n.120; see sec.
16(b) of the Exchange Act (last sentence authorizes the SEC to
adopt rules and regulations exempting transactions as not
comprehended within the purpose of the provision).
In Tanner v. Commissioner, 117 T.C. 237, 239 (2001), affd.
65 Fed. Appx. 508 (5th Cir. 2003), this Court held that the 6-
month period under which an insider is subject to liability under
section 16(b) of the Exchange Act begins on the date that a stock
option is granted. In Tanner v. Commissioner, supra, the
taxpayer, an officer, director, and owner of approximately 65
percent of an issuer’s stock, was granted an NSO in July 1993 to
purchase up to 182,000 of the issuer’s shares at an exercise
price of 75 cents per share. The taxpayer exercised the NSO in
September 1994, and the Commissioner determined the taxpayer was
obliged to report compensation income on his return for 1994
pursuant to section 83. The taxpayer challenged the
- 26 -
Commissioner’s determination and asserted he was not obliged to
report compensation income in 1994 because he had signed a lockup
agreement which purportedly extended for 2 years the period under
which he would he would remain liable under section 16(b) of the
Exchange Act. We rejected the taxpayer’s arguments and held (1)
the 6-month period under section 16(b) of the Exchange Act began
to run in July 1993 when the taxpayer was granted the NSO in
question, (2) the 6-month period was not extended by the 2-year
lockup agreement, and (3) the 6-month period expired long before
the taxpayer exercised the NSO in September 1994. Id. at 244-
246.
Petitioner contends the Court’s holding in Tanner v.
Commissioner, supra, is not controlling in this case. Petitioner
testified at trial that the MGC stock option plan was not
administered by the MGC Board nor by a committee as contemplated
under the plan, and he unilaterally granted the ISOs in question
to himself. Consistent with these points, petitioner maintains
(1) he obtained his ISOs pursuant to a “discretionary
transaction” within the meaning of SEC rule 16b-3(b)(1), 17
C.F.R. sec. 240.16b-3(b)(1) (2006); (2) his ISOs were not exempt
from the application of section 16(b) of the Exchange Act; and
(3) because he failed to report to the SEC that he exercised the
ISOs, and subsequently sold some of the shares so acquired, he
- 27 -
remained liable under section 16(b) of the Exchange Act until
approximately June 2003.
Petitioner’s reliance on the discretionary transaction
provisions contained in SEC rule 16b-3 is misplaced. A
discretionary transaction is defined in SEC rule 16b-3(b)(1) as a
transaction pursuant to an employee benefit plan that (1) is at
the volition of a plan participant; (2) is not made in connection
with the participant’s death, disability, retirement, or
termination of employment; (3) is not required to be made
available to a plan participant pursuant to the Internal Revenue
Code; and (4) results in either an intraplan transfer involving
an issuer equity securities fund, or a cash distribution funded
by a volitional disposition of an issuer equity security. SEC
rule 16b-3(f) provides that a discretionary transaction shall be
exempt from section 16(b) of the Exchange Act only if an election
effecting an acquisition (or disposition) is made at least 6
months following the date of the most recent disposition (or
acquisition), as the case may be.
A review of the SEC’s release adopting SEC rule 16b-3
reveals the exemption for discretionary transactions was targeted
at opportunities for abuse arising from so-called fund-switching
transactions effected within contributory employee benefit plans.
In particular, the SEC stated in pertinent part:
Many contributory employee benefit plans permit a
participant to choose one of several funds in which to
- 28 -
invest (e.g., an issuer stock fund, a bond fund, or a
money market fund). Plan participants typically are
given the opportunity to engage in ‘fund-switching’
transactions, permitting the transfer of assets from
one fund to another, at periodic intervals. Plan
participants also commonly have the right to withdraw
their investments in cash from a fund containing equity
securities of the issuer. Fund-switching transactions
involving an issuer equity securities fund and cash
distributions from these funds may present
opportunities for abuse because the investment decision
is similar to that involved in a market transaction.
Moreover, the plan may buy and sell issuer equity
securities in the market in order to effect these
transactions, so that the real party on the other side
of the transaction is not the issuer but instead a
market participant. [Fn. ref. omitted.]
Ownership Reports and Trading by Officers, Directors and
Principal Security Holders, Exchange Act Release No. 34-37260, 61
Fed. Reg. 30376, 30379 (June 14, 1996).
Although petitioner exercised discretion in granting ISOs to
himself, in exercising the ISOs, and in disposing of the
underlying shares, petitioner’s activities were not undertaken
under the auspices of an employee benefit plan as contemplated
under SEC rule 16b-3, nor did his activities result in an
intrafund transfer or a cash distribution from a plan.
Accordingly, we conclude the discretionary transaction provisions
are not relevant to the question whether petitioner was subject
to a suit under section 16(b) of the Exchange Act during 2000.
The period during which petitioner was subject to liability
under section 16(b) of the Exchange Act is directly addressed in
SEC rule 16b-3(d)(3) and SEC rule 16(b)-6(a) and (b), 17 C.F.R.
- 29 -
sec. 240.16b-6(a) and (b) (2006), which apply specifically to
derivative securities. Read together, these regulations provide
that (1) the establishment of a call equivalent position (grant
of a stock option) shall be deemed a purchase of the underlying
security for purposes of section 16(b) of the Exchange Act, (2)
the acquisition of underlying securities at a fixed price upon
the exercise of a call equivalent position shall be exempt from
the operation of section 16(b) of the Exchange Act, and (3) if 6
months elapse between the acquisition of a derivative security
and the disposition of the derivative security or its underlying
equity security, the transaction is exempt from the operation of
section 16(b) of the Exchange Act. Inasmuch as petitioner did
not sell any MGC shares within 6 months of March 1999--the last
date MGC granted petitioner an ISO--we conclude petitioner
qualified for the exemption set forth in SEC rule 16b-3(d)(3).
Consequently, we hold petitioner was not subject to a suit under
section 16(b) of the Exchange Act during 2000.
We would reach the same conclusion even if some technical
impediment precluded petitioner’s ISOs from qualifying for
exemption under SEC rule 16b. That rule merely provides
exemptions or a “safe-harbor” from the applicability of section
16(b) of the Exchange Act--it does not impose affirmative
liability. As previously discussed, because petitioner’s ISOs
were granted between April 1996 and March 1999, the 6-month
- 30 -
period during which petitioner would have been subject to suit
under section 16(b) of the Exchange Act expired in September
1999, several months before petitioner exercised his ISOs in
2000. Petitioner simply has not persuaded us that his liability
under section 16(b) of the Exchange Act extended beyond September
1999. Because petitioner was not subject to a suit under section
16(b) of the Exchange Act during 2000, we conclude petitioner’s
rights in his MGC shares were not subject to a substantial risk
of forfeiture within the meaning of section 83(c).11
IV. Whether Respondent Correctly Applied the $100,000 Annual
Limit on ISOs Imposed Under Section 422(d)
Section 422(d) provides stock options will be subject to
taxation as NSOs under section 83 if the aggregate fair market
value of stock a taxpayer may acquire pursuant to ISOs that are
exercisable for the first time during any taxable year exceeds
$100,000. Section 421(b) provides that if the transfer of a
share of stock to a taxpayer pursuant to the exercise of an
option would otherwise meet the requirements of section 422(a),
except there is a failure to meet a holding period requirement,
11
Petitioner contends sec. 1.83-3(j)(1), Income Tax Regs.,
is invalid insofar as the regulation fails to acknowledge that
the period during which an insider may remain subject to suit
under sec. 16(b) of the Exchange Act may extend beyond the normal
6-month period specified in that provision. Because we have
rejected petitioner’s argument that the period he was subject to
a suit under sec. 16(b) of the Exchange Act extended beyond the
6-month period beginning with the dates his ISOs were granted, we
need not address petitioner’s challenge to the validity of sec.
1.83-3(j)(1), Income Tax Regs.
- 31 -
any increase in the income of the taxpayer or deduction from
income of his employer corporation shall be recognized in the
taxable year in which such disposition occurs.
The fair market value of the MGC shares petitioner was
entitled to purchase under his ISOs, measured as of the dates
petitioner’s ISOs were granted and which were first exercisable
in 1999 and 2000, exceeded $100,000. The parties also agree that
during 2000 and 2001, petitioner engaged in disqualifying
dispositions of MGC shares that he acquired upon exercising his
ISOs.
Respondent determined that the value of the MGC shares
petitioner could acquire pursuant to his ISOs exceeded the
$100,000 limit imposed under section 422(d) by $316,298 and
$95,648 for 1999 and 2000, respectively.12 Petitioners contend,
without citation to any authority or any meaningful discussion,
that respondent erroneously applied section 422(d). As we
understand petitioners’ position, they assert the $100,000
limitation is only applied to shares that are not subject to a
12
Respondent determined the following shares were not
eligible to be treated as having been transferred to petitioner
pursuant to ISOs: (1) 10,499 of the 22,500 shares that were the
subject of option grant No. 2 dated Sept. 4, 1998; (2) all of the
45,000 shares that were the subject of option grant No. 3 dated
Sept. 4, 1998; (3) 6,057 of the 15,000 shares that were the
subject of option grant No. 4 dated Mar. 1, 1999; and (4) all of
the 22,500 shares that were the subject of option grant No. 5
dated Mar. 1, 1999.
- 32 -
subsequent disqualifying disposition during the same taxable year
in which the shares were acquired. We disagree.
Section 422(b), summarized supra note 7, sets forth the
definition of the term “incentive stock option”. Section 422(b)
does not impose a holding period requirement on shares of stock
acquired pursuant to the exercise of an ISO, nor does it cross-
reference section 422(a)(1) or otherwise exclude shares which are
later subject to disqualifying dispositions. Equally important,
although section 422(a) provides the general rule that section
421(a) shall apply with respect to the transfer of a share of
stock to an individual pursuant to an exercise of an ISO if,
among other requirements, certain holding periods are satisfied
under section 422(a)(1), section 422(a) does not state that a
violation of the holding period requirement will cause the option
to fail to qualify as an ISO. Along the same lines, although
section 421(b) describes the tax effects if a taxpayer receives
shares of stock pursuant to the exercise of an option which would
meet the requirements of section 422(a), except for a failure to
meet any of the holding period requirements of section 422(a)(1),
section 421(b) does not state that the option is not to be
considered an ISO. In contrast, section 422(d) unambiguously
states that options exceeding the $100,000 limitation “shall be
treated as options which are not incentive stock options.”
- 33 -
In the absence of any language in the controlling statutory
provisions suggesting a disqualifying disposition of stock will
cause the related option to be treated as something other than an
ISO, we reject petitioners’ argument on this point. We sustain
respondent’s interpretation and application of the $100,000 limit
imposed under section 422(d) in this case.
V. Whether Petitioners May Reduce Their AMTI in 2000 by AMT
Capital Losses Realized in 2001
Capital Losses Under Regular Tax and Alternative Minimum Tax
Sales of securities generally are subject to the capital
gain and loss provisions. Section 165(f) provides that capital
losses are permitted only to the extent allowed in sections 1211
and 1212.
Under section 1212(b), a noncorporate taxpayer is required
to offset capital losses against capital gains for a particular
taxable year. If aggregate capital losses exceed aggregate
capital gains for a taxable year, up to $3,000 of the excess may
be deducted against ordinary income.13 Sec. 1212(b). A
noncorporate taxpayer may carry forward unrecognized capital
losses to subsequent taxable years, but it does not allow such
13
For married individuals filing separately, $3,000 is
reduced to $1,500. Sec. 1211(b)(1). If the excess of capital
losses over capital gains is less than $3,000 (or $1,500), then
only that excess may be deducted. Sec. 1211(b)(2).
- 34 -
unrecognized capital losses to be carried back to prior taxable
years. Sec. 1212(b). The Internal Revenue Code does not
explicitly address the treatment of capital losses for AMT
purposes. See secs. 55-59 (and accompanying regulations).
Petitioners are not securities dealers, and they held their
MGC shares strictly as investors. There is no dispute the MGC
shares in question are capital assets under section 1221. The
record also shows petitioner sold MGC shares in 2001 and that he
realized capital losses as a result.14 However, the capital loss
limitations of sections 1211(b) and 1212(b) restricted
petitioners’ ability to deduct these regular capital losses.15
Petitioners also realized AMT capital losses in 2001 taking
into account petitioner’s adjusted AMT basis in his MGC shares.
Petitioners contend that they may carry back these AMT capital
losses to reduce their AMTI in 2000. Petitioners argue the
capital loss limitations of sections 1211 and 1212 do not apply
to bar the carryback of AMT capital losses for purposes of
calculating AMTI. We disagree.
14
To avoid confusion between petitioner’s capital losses,
we shall refer to his capital losses for regular tax purposes as
his “regular capital losses”, and we shall refer to his capital
loss for AMT purposes as his “AMT capital loss”.
15
The effect of the capital loss limitations of secs.
1211(b) and 1212(b) for regular tax purposes is not in issue and
thus, is not discussed in detail.
- 35 -
In Merlo v. Commissioner, 126 T.C. 205, 211-212 (2006), on
appeal to the U.S. Court of Appeals for the Fifth Circuit, the
Court recently rejected the argument that the capital loss
limitations of sections 1211 and 1212 do not apply for purposes
of calculating a taxpayer’s AMTI. In so holding, we cited
section 1.55-1(a), Income Tax Regs., which states in pertinent
part that, except as otherwise provided: “[A]ll Internal Revenue
Code provisions that apply in determining the regular taxable
income of a taxpayer also apply in determining the alternative
minimum taxable income of the taxpayer.” In the absence of any
statute, regulation, or other published guidance which purports
to change the treatment of capital losses for AMT purposes, we
held the capital loss limitations of sections 1211 and 1212 apply
in calculating a taxpayer’s AMTI. Id. at 212.
Like the taxpayer in Merlo v. Commissioner, supra,
petitioners argue the instructions to lines 9 and 10 of Form 6251
for 2000 do not mention section 1211, and, therefore, section
1211 does not apply for purposes of calculating petitioners’
AMTI. Petitioners’ reliance on these instructions is misplaced.
It is settled law that taxpayers cannot rely on Internal Revenue
Service instructions to justify a reporting position otherwise
inconsistent with controlling statutory provisions. Johnson v.
Commissioner, 620 F.2d 153, 155 (7th Cir. 1980), affg. T.C. Memo.
- 36 -
978-426; Graham v. Commissioner, T.C. Memo. 1995-114; Jones v.
Commissioner, T.C. Memo. 1993-358.
Consistent with Merlo v. Commissioner, supra, we conclude
petitioners may not carry back their AMT capital losses to reduce
their AMTI in 2000. See Spitz v. Commissioner, T.C. Memo. 2006-
168.
VI. Whether Petitioners May Carry Back Net Operating Losses and
Alternative Tax Net Operating Losses To Reduce Their AMTI for
2000
In a further attempt to carry back their AMT capital losses,
petitioners assert their AMT capital losses entitle them to an
ATNOL deduction under section 56. This, too, is an argument the
Court rejected in Merlo v. Commissioner, supra.
A taxpayer normally may carry back a net operating loss
(NOL) to the 2 taxable years preceding the loss, then forward to
each of the 20 taxable years following the loss.16 Sec.
172(b)(1)(A). Section 172(c) defines an NOL as “the excess of
the deductions allowed by this chapter over the gross income”, as
modified under section 172(d). In the case of a noncorporate
taxpayer, the amount deductible on account of capital losses
shall not exceed the amount includable on account of capital
gains. Sec. 172(d)(2)(A); sec. 1.172-3(a)(2), Income Tax Regs.
16
In the case of NOLs incurred in 2001 or 2002, sec.
172(b)(1)(H) creates a 5-year carryback. Petitioners argue they
are entitled to relief from the 5-year carryback. However,
because we conclude infra that petitioners are not entitled to an
ATNOL, petitioners’ argument is moot.
- 37 -
Consequently, the effect of section 172(d)(2)(A) is that net
capital losses are excluded from the NOL computation. See, e.g.,
Parekh v. Commissioner, T.C. Memo. 1998-151. In Merlo v.
Commissioner, supra, we stated in pertinent part:
For AMT purposes, section 56(a)(4) provides that
an ATNOL deduction shall be allowed in lieu of an NOL
deduction under section 172. An ATNOL deduction is
defined as the NOL deduction allowable under section
172 and is computed by taking into consideration all
the adjustments to taxable income under sections 56 and
58 and all the preference items under section 57 (but
only to the extent that the preference items increased
the NOL for the year for regular tax purposes). Sec.
56(d)(1).
Petitioner’s net regular capital loss is excluded
from computing his NOL deduction. See sec. 172(c),
(d)(2)(A); sec. 1.172-3(a)(2), Income Tax Regs. For
AMT purposes, petitioner’s ATNOL is the same as his
NOL, taking into consideration all the adjustments to
his taxable income under sections 56, 57, and 58. See
sec. 56(a)(4), (d)(1). No adjustments under those
sections modify the exclusion of net capital losses
from the NOL computation under section 172(d)(2)(A).
Therefore, petitioner’s AMT capital loss is excluded
for purposes of calculating his ATNOL deduction. As a
result, petitioner’s AMT capital loss realized in 2001
does not create an ATNOL that can be carried back to
2000 under sections 56 and 172(b).
Merlo v. Commissioner, supra at 212-213 (fn. ref. omitted).
Consistent with Merlo v. Commissioner, supra, we hold
petitioners may not claim an ATNOL carryback to reduce their AMTI
for 2000. See Spitz v. Commissioner, supra.
VII. Whether Petitioners Are Liable for a Substantial
Understatement Penalty Under Section 6662(b)(2)
Respondent determined petitioners are liable for a
- 38 -
substantial understatement penalty under section 6662(b)(2).17
Petitioners assert (1) respondent’s determination is invalid
because respondent did not consider “standardized exception
criteria” before imposing the penalty, and (2) the penalty is
inapplicable because petitioners acted in good faith and
reasonably relied upon tax professionals to prepare their tax
return for 2000.
While the Commissioner bears the initial burden of
production as to the accuracy-related penalty and must come
forward with sufficient evidence showing it is appropriate to
impose the penalty, the taxpayer bears the burden of proof as to
any exception to the accuracy-related penalty. See sec. 7491(c);
Rule 142(a); Higbee v. Commissioner, 116 T.C. 438, 446-447
(2001). One such exception to the accuracy-related penalty
applies to any portion of an underpayment if the taxpayer can
prove there was reasonable cause for the taxpayer’s position and
the taxpayer acted in good faith with respect to that portion.
Sec. 6664(c)(1); sec. 1.6664-4(b), Income Tax Regs. The
determination of whether a taxpayer acted with reasonable cause
17
There is a substantial understatement of tax if the
amount of the understatement exceeds the greater of either 10
percent of the tax required to be shown on the return, or $5,000.
Sec. 6662(a), (b)(1) and (2), (d)(1)(A); sec. 1.6662-4(a) and
(b)(1), Income Tax Regs. This threshold is satisfied in the
instant case.
- 39 -
and in good faith depends on the pertinent facts and
circumstances, including the taxpayer’s efforts to assess his or
her proper tax liability, the knowledge and experience of the
taxpayer, and the reliance on the advice of a professional. Sec.
1.6664-4(b)(1), Income Tax Regs. When a taxpayer selects a
competent tax adviser and supplies him or her with all relevant
information, it is consistent with ordinary business care and
prudence to rely upon the adviser’s professional judgment as to
the taxpayer’s tax obligations. United States v. Boyle, 469 U.S.
241, 250-251 (1985). Moreover, a taxpayer who seeks the advice
of an adviser does not have to challenge the adviser’s
conclusions, seek a second opinion, or try to check the advice by
reviewing the tax code himself or herself. Id.
Petitioners received professional assistance in preparing
their 2000 tax return. The return was prepared and signed by a
representative of Deloitte & Touche, and we are satisfied from a
review of the return petitioners supplied the return preparer
with all relevant information. We likewise conclude petitioners
relied on their return preparer to accurately and properly
prepare their return for 2000. We find nothing in the record to
indicate it was unreasonable for petitioners to accept the advice
of their return preparer. Our holding sustaining respondent’s
determinations on the substantive issues in dispute does not, in
and of itself, require holding for respondent on the penalty.
- 40 -
See Hitchins v. Commissioner, 103 T.C. 711, 719-720 (1994)
(“Indeed, we have specifically refused to impose * * * [a
penalty] where it appeared that the issue was one not previously
considered by the Court and the statutory language was not
entirely clear.”). Considering that the complex issues
underlying the deficiency in this case had yet to be litigated at
the time petitioners filed their return for 2000, we are
persuaded petitioners had reasonable cause and acted in good
faith in reporting their stock option transactions. See, e.g.,
Williams v. Commissioner, 123 T.C. 144 (2004) (declining to
impose a penalty involving an issue of first impression and the
interrelationship between complex tax and bankruptcy laws).
Consequently, we hold petitioners are not liable for an accuracy-
related penalty under section 6662(b)(2) for 2000.
To reflect the foregoing,
Decision will be entered
pursuant to Rule 155.