Moore v. Comm'r ( 2007 )

T.C. Memo. 2007-123
UNITED STATES TAX COURT
WALTER AND SUSAN MOORE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12106-05. Filed May 17, 2007.
Brian Isaacson and Duncan Turner (specially recognized), for
petitioners.
Kirk M. Paxson and Julie Payne, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Petitioners petitioned the Court to
redetermine respondent’s determination of a $810,805 deficiency
in their 2002 Federal income tax and a $162,161 accuracy-related
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penalty under section 6662(a).1 We decide primarily whether
Susan Moore (petitioner) realized income in 2002 when she
exercised stock options received from her employer Cell
Therapeutics, Inc. (CTI). We hold she did. We also decide
whether petitioners are liable for the accuracy-related penalty
determined by respondent under section 6662(a). We hold they are
not.
FINDINGS OF FACT
Some facts were stipulated or contained in the exhibits
submitted therewith. We find the facts accordingly. Petitioners
are husband and wife, and they resided in Hansville, Washington,
when their petition was filed.
A. Petitioner’s Relationship With CTI Before January 13, 2001
CTI hired petitioner as a compensation consultant in January
1993, and she continued to work for CTI as a full-time employee
through January 12, 2001. Before working for CTI, petitioner had
earned a bachelor’s degree in business administration, and she
had worked for more than 10 years in various capacities (e.g.,
compensation manager, director of human resources) for various
other employers. Petitioner is certified by the American
Compensation Society as a professional in the field of
compensation.
1
Unless otherwise indicated, section references are to the
applicable versions of the Internal Revenue Code.
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Two months after petitioner began working for CTI, CTI
promoted her to its office of vice president of human resources.
In 1995, CTI promoted her further to its office of executive vice
president of human resource development. In 1999, CTI expanded
petitioner’s responsibilities as executive vice president to head
CTI’s corporate communications department in addition to its
human resource department. Petitioner reported directly to CTI’s
chief executive officer (CEO), Dr. James Bianco (Dr. Bianco), and
she served on CTI’s strategic management team. The strategic
management team was the top level of CTI, and it consisted of the
CEO and all of the executive vice presidents of CTI’s major
functional areas.
CTI was a private corporation when petitioner first began
working for it, and it later became a public corporation while
she was affiliated with it. During each year that petitioner was
affiliated with CTI, CTI employed between 100 and 500
individuals.
1. Stock Option Grants
As part of her compensation package, CTI gave petitioner
options to purchase CTI common stock. Each option allowed
petitioner to purchase a specified number of shares of CTI common
stock at a specified price.
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a. First Options
Petitioner was granted options to purchase 20,000 shares and
10,000 shares of CTI common stock at $4.50 per share under the
CTI 1992 Stock Option Plan Incentive Stock Option Agreement
entered into as of December 20, 1993. The agreement pertaining
to these options contained the following recital:
Termination of Option.
A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:
(i) ten (10) years from the date of grant; or
12/20/03;
(ii) the expiration of ninety (90) days from the
date of Optionee’s termination of employment with the
Company for any reason other than death or disability
(as defined in the Plan), (unless the exercise period
is extended by the Plan Administrator until a date not
later than the expiration date of the Option) * * *
b. Second Options
Petitioner was granted options to purchase 70,000 shares and
75,000 shares of CTI common stock at $3.35 per share under the
CTI 1994 Equity Incentive Plan Incentive Stock Option Agreements
entered into as of December 5, 1995, and November 7, 1996,
respectively. The agreement pertaining to the grant of the
option to purchase the 70,000 shares contained the following
recital:
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Termination of Option.
A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:
(i) ten (10) years from the date of grant; or
12/05/05;
(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment or service
with the Company for any reason other than death or
because Optionee becomes disabled (within the meaning
of Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *
The agreement pertaining to the grant of the option to purchase
the 75,000 shares contained the following recital:
Termination of Option.
A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:
(i) ten (10) years from the date of grant; or
11/07/06;
(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment or service
with the Company for any reason other than death or
because Optionee becomes disabled (within the meaning
of Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *
c. Third Option
Petitioner was granted an option to purchase 27,500 shares
of CTI common stock at $16.0625 per share under the CTI 1994
Equity Incentive Plan Incentive Stock Option Agreement entered
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into as of December 9, 1997. The agreement pertaining to this
option contained the following recital:
Termination of Option.
A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:
(i) ten (10) years from the date of grant; or
12/09/07;
(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment with the
Company for any reason other than death or because
Optionee becomes disabled (within the meaning of
Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *
d. Fourth Option
Petitioner was granted an option to purchase 35,000 shares
of CTI common stock at $2.969 per share under the CTI 1994 Equity
Incentive Plan Incentive Stock Option Agreement entered into as
of December 10, 1998. The agreement pertaining to this option
contained the following recital:
Termination of Option.
A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:
(i) ten (10) years from the date of grant; or
December 10, 2008;
(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment with the
Company for any reason other than death or because
Optionee becomes disabled (within the meaning of
Section 22(e)(3) of the Code) (unless the exercise
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period is extended by the Committee until a date not
later than the expiration date of the Option) * * *
B. Petitioner’s Relationship With CTI After January 12, 2001
1. Board of Directors’ Resolution
In or about the end of 2000, petitioner advised Dr. Bianco
that she was going to terminate her employment with CTI because
she was having a personality conflict with a key member of the
staff. Dr. Bianco asked petitioner to remain affiliated with CTI
for approximately 1 year longer to establish a transition plan
for CTI. Petitioner agreed to do so, agreeing with CTI to enter
into a consulting agreement under which she would work for CTI in
a nonemployee capacity.
In connection therewith, CTI’s Board of Directors’
Compensation Committee adopted a resolution that stated that
petitioner ceased to be employed by CTI as of January 12, 2001,
that CTI continued to need petitioner’s services, and that
petitioner and CTI would enter into a consulting agreement to
obtain petitioner’s services.2 The resolution resolved:
cti shall enter into a consulting agreement with Ms.
Moore which incorporates at a minimum the following
terms and conditions:
For a period of one-year Ms. Moore may be
called upon to perform Corporate
Communications and Human Resource Development
duties and responsibilities as determined by
the CEO. It is expected Ms. Moore will
2
The resolution does not state the date of its making.
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devote approximately one-half the number of
hours of a full-time equivalent.
As compensation for this agreement, Ms. Moore
will receive:
a salary of $175,000
company-paid health and welfare benefits
As of January 12, 2001, the date of
termination, Ms. Moore held 112,788 vested
options and 35,000 unvested options to
purchase cti Common Stock granted in
accordance with the Corporation’s 1994
Employee Stock Option Plan (the “1994 Plan”),
which vested options would have been
exercisable for a period of up to three
months after the date of her termination with
the Corporation, as provided in the 1994
Plan.
The Compensation Committee deems it
appropriate and in the best interests of the
Corporation to continue vesting of the
unvested options according to the current
vesting schedule and whereas the remaining
unvested options would vest on December 10,
2000 and December 22, 2000, and extend the
exercise period for vested and unvested
options to 90 days after Ms. Moore completes
this consulting arrangement.
2. Consulting Agreement
Petitioner and CTI entered into the referenced consulting
agreement with an effective date of January 13, 2001, and a
termination date of January 12, 2002 (unless terminated earlier
or extended longer by agreement of the parties thereto). The
agreement stated that petitioner would report to Dr. Bianco and
would oversee and manage the corporate communications and human
resource development departments; attend senior management team
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meetings as mutually agreed upon by petitioner and Dr. Bianco;
conduct staff meetings as needed for corporate communications and
human resource development personnel; prepare the annual report
for CTI, including coordinating the annual shareholder meeting
and activities related thereto; manage and oversee CTI’s Internet
and Intranet websites; provide weekly contact with public
relations groups in the industry; interview and hire additional
staff for the corporate communications department; and perform
additional services as agreed upon by petitioner and CTI. The
agreement specified that “The parties hereto are acting as
independent contractors. Consultant will be responsible for and
will pay all taxes related to the receipt of payments hereunder
and shall give reasonable proof and supporting documents, if
reasonably requested, to verify the payment of such taxes.”
The agreement stated that petitioner would be paid for her
services at the rate of $175 per hour and that she would work no
more than 1,000 hours during the 1-year term of the agreement
unless she and CTI agreed otherwise. The agreement also stated
that CTI would pay for petitioner’s participation in health and
dental plans for the term of the agreement; CTI paid for that
participation under a plan that covered former employees. The
agreement also stated that petitioner was entitled to receive
reimbursement of her preapproved reasonable out-of-pocket
business expenses (e.g., food, lodging, air and ground travel)
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incurred in providing services to CTI. Petitioner was required
to submit to CTI invoices for her hourly pay, and she was
required to submit with those invoices documentation supporting
her claim to reimbursement for out-of-pocket expenses.
The consulting agreement shortened the vesting period of
petitioner’s stock options. It stated:
Options. Consultant and CTI are parties to the
1997 Option Agreement (“Option Agreement”) and the 1994
CTI Equity Incentive Option Plan (“Option Plan”) in
which Consultant vests in CTI incentive stock options.
In lieu of Consultant vesting in CTI incentive options
according to the Option Agreement, the parties agree
that Consultant shall vest in CTI incentive options for
the term of this Agreement as provided hereunder and in
the Option Plan.
Type
Option Option of Old Vest New Vest
No. Date Option Shares Price Date Date
P000698 12/10/98 ISO 8,750 2.969 12/10/01 4/12/01
P000698 12/10/98 ISO 2,916 2.969 12/10/01 7/12/01
C000892 12/22/99 ISO 5,834 3.063 12/22/01 7/12/01
C000892 12/22/99 ISO 5,833 3.063 12/22/01 10/12/01
C000892 12/22/99 ISO 2,917 3.063 12/22/02 10/12/01
C000892 12/22/99 ISO 8,749 3.063 12/22/02 1/12/02
For avoidance of any doubt whatsoever, Consultant shall
vest in each set of options provided this Agreement is
in effect as of the vesting date for that respective
set of options as described above (i.e. if Consultant
terminates this Agreement on 8/12/01 she would be
entitled to 17,500 vested options; she would not be
entitled to the remaining 17,499 unvested options).
Consultant would then have ninety (90) days from the
date of termination of this Agreement to exercise the
vested options.
Petitioner read the consulting agreement, thought she
understood it, signed it, and did not ask any questions regarding
it. She believed that by entering into the agreement she would
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work less. She understood that she would be responsible for
filing her own tax returns and paying her related taxes and that
CTI would not pay or withhold any taxes for her benefit. She
knew her employment status with CTI was changing. On or about
May 24, 2001, petitioner informed CTI’s section 401(k) plan that
she had terminated her employment with CTI on January 12, 2001,
and was electing to roll over her balance in that plan to her
individual retirement account at CIBC Oppenheimer.
After January 12, 2001, petitioner was neither an officer,
director, or 10-percent stockholder of CTI. She continued to
provide CTI with essentially the same types of services that she
had provided to CTI before January 13, 2001, but she worked fewer
hours after January 12, 2001, than she did before, and she was
not paid a salary but was paid in accordance with the hours that
she claimed on the invoices she submitted to CTI. After January
12, 2001, petitioner continued to report to Dr. Bianco, but she
was evaluated through verbal feedback and not as formally as
before. After January 12, 2001, she also could hire or
subcontract third parties to perform most of the services listed
in the consultation agreement, and she could have worked for
companies other than CTI. After August 2001, petitioner no
longer headed or was responsible for CTI’s human resource
department.
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CTI paid petitioner a bonus in 2001 for the work she had
performed for CTI while employed by it in 2000. Petitioner did
not receive a bonus in 2002 for the work she performed for CTI in
2001.
At or about the beginning of 2002, the parties to the
consulting agreement agreed that the term of the agreement should
be extended through March 3, 2002, so that petitioner could
review the performance of CTI’s employees. The consulting
agreement was so extended, and it terminated on March 3, 2002.
C. Exercise of Stock Options
On March 5, 2002, petitioner exercised some of her options
to buy CTI common stock. On that date, each of her purchased
shares had a fair market value of $23.19. As to one option,
petitioner paid an exercise price of $46,496 to purchase (at
$2.906 per share) 16,000 shares of CTI common stock with a total
fair market value of $371,040. Upon exercise of that option, she
also paid $97,596.57 to CTI so CTI could withhold and pay Federal
income, Social Security, and Medicare taxes associated with the
exercise. As to another option, petitioner paid an exercise
price of $58,120 to purchase (at $2.906 per share) 20,000 shares
of CTI common stock with a total fair market value of $463,800.
Upon exercise of that option, she also paid $115,415.96 to CTI so
CTI could withhold and pay Federal income, Social Security, and
Medicare taxes associated with the exercise. As to another
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option, petitioner paid an exercise price of $9,467.75 to
purchase (at $2.906 per share) 3,258 shares of CTI common stock
with a total fair market value of $75,553.02. Upon exercise of
that option, she also paid $18,801.26 to CTI so CTI could
withhold and pay Federal income, Social Security, and Medicare
taxes associated with the exercise. As to another option,
petitioner paid an exercise price of $95,094.10 to purchase (at
$2.969 per share) 32,029 shares of CTI common stock with a total
fair market value of $742,752.51. Upon exercise of that option,
she also paid $184,258.82 to CTI so CTI could withhold and pay
Federal income, Social Security, and Medicare taxes associated
with the exercise. As to another option, petitioner paid an
exercise price of $107,205 to purchase (at $3.063 per share)
35,000 shares of CTI common stock with a total fair market value
of $811,650. Upon exercise of that option, she also paid
$200,414.60 to CTI so CTI could withhold and pay Federal income,
Social Security, and Medicare taxes associated with the
exercise.3
After exercising her options, petitioner had legal title to,
was the beneficial owner of, had the right to receive dividends
on, and had the right to vote her purchased stock. At no time
3
In full, petitioner paid $316,382.85 to purchase 106,287
shares with a total fair market value of $2,464,795.53.
Petitioner also paid CTI $616,487.21 with respect to the
withholding taxes.
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after exercising the options was she obligated to return any of
that stock to CTI. During 2002 and thereafter, petitioner did
not sell any of the purchased shares. Those shares were in
electronic form.
D. Petitioners’ Agreement With CIBC Oppenheimer
Petitioners entered into a “Client Agreement” and an
“Investment Management Agreement” with their stockbroker, CIBC
Oppenheimer. The client agreement stated:
I agree to pay on demand any balance owing with
respect to any of my accounts, including interest and
commissions and any costs of collection (including
attorneys fees, if incurred by you). I understand that
you may demand full payment of the balance due in my
accounts plus any interest charges accrued thereon, at
your sole option, at any time without cause and whether
or not such demand is made for your protection. In
addition, Margin Loans are not made for any specific
term or duration but rather are due and payable at your
discretion upon demand * * *
The investment management agreement stated that “Client
represents that Client is the beneficial owner of any securities
Client may deliver to the Custodian and that there are no
restrictions on the transfer, sale and/or public distribution
thereof.” The investment management agreement also stated that
“Client understands and agrees that all transactions shall be for
Client’s account and risk and that neither CIBC WM [CIBC World
Markets Corp., the program manager of the assets of petitioners’
account at CIBC Oppenheimer] nor any Portfolio Manager is
guaranteeing, or otherwise making representations with respect
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to, the performance of the Account and that CIBC WM shall not be
liable for any losses in the Account”.
E. Payment of the Exercise Price and Withholding Taxes
CTI received payment in full for the exercise price and
withholding taxes due upon petitioner’s exercise of her options.
Petitioner borrowed $932,870.06 from CIBC Oppenheimer to pay the
total of the options’ exercise price ($316,382.85) and CTI’s
withholding obligation ($616,487.21). CIBC Oppenheimer wired the
$932,870.06 ($316,382.85 + $616,487.21) to CTI, and CIBC
Oppenheimer treated the wired funds as a borrowing that
petitioner had made on her margin account at CIBC Oppenheimer.
Petitioners were personally liable for the repayment of that
borrowing and any interest that accrued with respect thereto.
On July 29, 2002, petitioner repaid the principal of the
borrowing after she received margin calls from CIBC Oppenheimer.
She obtained the funds for repayment by selling stocks and bonds,
using available cash, borrowing money, and selling her house. On
July 29, 2002, the fair market value of petitioner’s CTI stock
(106,287 shares) was $3.175 per share or $337,461.23 in total.
F. CTI’s Insider Trading Policy and Trading Windows
According to CTI’s Insider Trading Policy Statement:
An Insider or Temporary Insider is permitted to
trade CTI stock only during certain specified periods
(the “Trading Window”) and only if the Insider or
Temporary Insider is not at the time in possession of
material, non-public information. CTI’s Trading Window
will be opened only upon written notification from
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CTI’s Chief Financial Officer (“CFO”). In general, the
Trading Window opens (i.e., trading is permissible) on
the third business day after CTI releases information
to the financial community about the prior quarter
results, and closes (i.e., trading is prohibited) at
the close of business on the fifteenth (15th) day of
the last month of a fiscal quarter. If the fifteenth
day of the month falls in a weekend, the window shall
close on the last business day preceding the fifteenth
day of the month.
The trading window was closed when petitioner exercised her
options on March 5, 2002. The trading window remained closed
until the third business day after May 13, 2002.
G. Petitioners’ 2002 Federal Income Tax Return
Petitioner received from CTI a 2002 Form 1099 in the amount
of $21,787.50. Petitioner also received from CTI a 2002 Form
W-2, Wage and Tax Statement, that reported that petitioner had
received $2,156,436.35 as wages, tips, or other compensation.
The Form W-2 listed $582,066.18 as the amount of Federal income
tax withheld. The wages reported by CTI on the Form W-2 included
the spread between the strike prices and the fair market value of
the stock received when petitioner exercised her stock options on
March 5, 2002.
On or about April 15, 2003, petitioners filed their 2002
Federal income tax return. They reported the following relevant
information on that return: $29,404 in wages, salaries, tips
etc.; business income of $19,324 ($21,788 in gross receipts less
$2,464 in expenses consisting of travel ($2,335) and meals and
entertainment ($129)); total adjusted gross income of $80,730;
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taxable income of $54,073; tax of $7,889; and Federal income tax
withheld of $582,148. They claimed on that return that they were
entitled to a refund of overpaid Federal income tax in the amount
of $574,259 ($582,148 - $7,889).
Attached to the return was a Form 4852, Substitute for Form
W-2, Wage and Tax Statement, or Form 1099-R, Distributions From
Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,
Insurance Contracts, Etc., on which petitioners reported that CTI
had paid petitioner $29,102.05 in wages or compensation. Also
attached to petitioners’ 2002 return were a “Form 4852
Calculation” prepared by The Issacson Law Firm and a “(Form 8275
Disclosure Statement) Memorandum of Law” prepared by petitioners’
tax return preparer and counsel herein Brian Isaacson (Isaacson).
The “Form 4852 Calculation” reported that petitioners had made a
$2,127,334.31 negative adjustment to petitioner’s wages as
reported on the 2002 Form W-2 to calculate petitioner’s wages as
$29,102.05 ($2,156,436.35 - $2,127,334.31 = $29,102.04). The
memorandum of law (memorandum of law) stated as facts that
petitioner “was granted stock options as part of taxpayer’s
employment contract”, that “taxpayer exercised employee stock
options using margin debt secured by the stock exercised”, and
that “taxpayer has not risked taxpayer’s own capital in the
transaction”. The memorandum of law concluded that “Under the
facts and circumstances test in Section 1.83(a)(2) [sic], it
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appears that the transfer to the taxpayer may be treated as
similar to the grant of an option”. This is so, the memorandum
of law rationalizes (without any coherent explanation), because
petitioner would not have to use her personal assets to pay the
margin debt were her CTI stock to be insufficient to satisfy the
debt in full. The memorandum of law stated that Isaacson was
trying to get CTI to change the referenced 2002 Form W-2 to
report the lower amount of wages but that “It is anticipated that
Cell Therapeutics, Inc. will not correct the taxpayer’s Form W-2
absent a ruling from the Internal Revenue Service”.
OPINION
A. Statutory Framework for Stock Options
Section 83(a) generally provides that when property is
transferred to a person in connection with the performance of
services, the fair market value of the property at the first time
the rights of the person having the beneficial interest in the
property are transferable or not subject to a substantial risk of
forfeiture, less the amount paid for the property, is includable
in the gross income of the person who performed the services.
See Tanner v. Commissioner, 117 T.C. 237, 241 (2001), affd.
65 Fed. Appx. 508 (5th Cir. 2003); see also United States v.
Tuff, 469 F.3d 1249, 1251-1252 (9th Cir. 2006). In general, an
employee who receives a nonstatutory stock option without a
readily ascertainable fair market value is taxed not on receipt
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of the option but at the time, pursuant to the employee’s
exercise of the option, the shares have been transferred to, and
become substantially vested in, the employee. See sec. 83(a),
(e)(3); Tanner v. Commissioner, supra at 242; sec. 1.83-1(a)(1),
Income Tax Regs. Shares become substantially vested in the
employee when the shares are either transferable or not subject
to a substantial risk of forfeiture. See United States v. Tuff,
supra at 1252; Racine v. Commissioner, T.C. Memo. 2006-162;
Facq v. Commissioner, T.C. Memo. 2006-111; sec. 1.83-3(b), Income
Tax Regs.
Section 83 does not apply to a “statutory” stock option;
i.e., an “incentive stock option” (ISO) within the meaning of
section 422(b), that meets the requirements of sections 421
through 424. As relevant herein, section 421(a) provides that if
the requirements of section 422(a) are met,4 a taxpayer does not
recognize income either upon the granting to the taxpayer of an
ISO or when the taxpayer receives stock upon the ISO’s exercise.
Recognition of income is deferred until disposition of the stock.
Sec. 421(a). Section 422(b) defines an ISO as a stock option
granted to an individual for any reason connected to his or her
employment, if granted by a corporate employer (or its parent or
4
Sec. 422(a) requires in relevant part that the option
holder be an employee of the company granting the option at all
times from the granting of the option until 3 months before the
date of exercise.
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subsidiary) to purchase the stock of the employer (or parent or
subsidiary), but only if the requirements of section 422(b)(1)
through (6) are met.
B. Whether Petitioner’s Stock Options Were ISOs
Petitioners argue that petitioner’s stock options were ISOs.
Respondent argues that petitioner’s options were not ISOs in that
they failed the requirements of section 422(b)(1) through (6).5
Respondent argues alternatively that the options do not qualify
for ISO treatment because petitioner was not an employee of CTI
during the 3 months before their exercise, as required by section
422(a)(2). We agree with respondent in both regards.
1. Requirements of Section 422(b)
Section 422(b) generally sets forth six requirements that
must be met for a stock option to qualify as an ISO. First, the
option must be granted pursuant to a plan. Sec. 422(b)(1).
Second, the option must be granted within 10 years from the date
of the plan’s adoption. Sec. 422(b)(2). Third, the option by
5
Respondent argues primarily that the options failed the
sec. 422(b) requirements upon their issuance. Respondent also
argues that petitioner’s consulting agreement with CTI caused the
options to be modified, see sec. 424(h)(1), and that the options
as modified failed those requirements as well. While petitioners
assert in their reply brief that the issue of whether the options
as originally granted were ISOs is a new issue improperly raised
on brief, we disagree. Among other things, we note that
petitioners’ petition (before amendment at trial) alleged that
“The Commissioner erred by failing to determine that the stock
options were classified as incentive stock options by Cell
Therapeutics, Inc.”
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its terms may not be exercisable more than 10 years after the
date the option is granted. Sec. 422(b)(3). Fourth, the option
price must not be less than the fair market value of the stock at
the time the option is granted. Sec. 422(b)(4). Fifth, the
option by its terms may not be transferable except by will or
laws of descent and distribution and must be exercisable during
the optionee’s lifetime only by the optionee. Sec. 422(b)(5).
Sixth, when the option is granted, the optionee cannot own stock
possessing more than 10 percent of the total combined voting
power of all classes of stock of the employer (or its parent or
subsidiary).
We agree with respondent that all of the section 422(b)
requirements were not met as to the options as originally issued.
To this end, we are unable to conclude that the options met the
requirements of section 422(b)(1) through (4). We are unable to
find on the basis of the credible evidence in the record that the
options were issued pursuant to a specific plan, that CTI’s
shareholders approved such a plan, or the date on which a plan
was adopted or approved. Nor are we able to find that the option
price was at or above the fair market value of the related stock
at the time of the options’ issuance. We also note that the
consulting agreement allowed petitioner to exercise her options
within 90 days after the consulting agreement expired, a date
that could have been more than 10 years after the grant date.
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We also agree with respondent that the options as originally
issued were later modified and that the options as modified also
failed the requirements of section 422(b). Section 424(h)(1)
provides that “if the terms of any option to purchase stock are
modified, extended, or renewed, such modification, extension or
renewal shall be considered as the granting of a new option.” In
this context, a “modification” denotes “any change in the terms
of the option which gives the employee additional benefits under
the option,” except that the term does not include a change in
the terms of an option “in the case of an option not immediately
exercisable in full, to accelerate the time at which the option
may be exercised.” Sec. 424(h)(3).
The consulting agreement modified the original options and
caused petitioner to receive a grant of new options pursuant to
section 424(h). In this regard, the consulting agreement set new
vesting dates for petitioner’s options and gave her 90 days from
the date of termination of the agreement to exercise the vested
options. Petitioner benefited from this change in that she was
given the right to exercise her options even if she ceased to be
an employee of CTI for more than 90 days; under the original
option agreements, the options would have expired 3 months or 90
days (depending upon the particular agreement) from the date of
her termination of employment with CTI for any reason other than
death or disability. Stated differently, as a result of the
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modification, petitioner could still exercise her options if she
ceased to be an employee of CTI for more than 90 days, as long as
the consulting agreement had not been terminated for more than 90
days.
The options as modified failed the requirements of section
422(b). There is no plan in the record, and the option prices on
the dates of grant were not shown to be equal to or greater than
the fair market value of the CTI stock on those dates. The
options also failed the requirement of section 422(b)(3) in that
the options could be exercised up to 90 days after the
termination of the consulting agreement, the term of which could
have been extended by agreement of the parties. The effect of
the modification was to give the options an indefinite term, so
that each option was not limited “by its terms” as required by
section 422(b)(3).
2. Requirement of Section 422(a)(2)
Respondent also argues that the options are not entitled to
ISO treatment because petitioner was not an employee of CTI “at
all times during the period beginning on the date of the granting
of the option and ending on the day 3 months before the date” she
exercised her options as required by section 422(a)(2). We
agree. We apply the common law rules of employment to decide
whether petitioner ceased to be an employee of CTI on December 5,
2001; i.e., 3 months before the exercise date of March 5, 2002.
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See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323-325
(1992); Weber v. Commissioner, 103 T.C. 378, 386 (1994), affd.
60 F.3d 1104 (4th Cir. 1995); sec. 1.421-1(h), Income Tax Regs.;
see also sec. 3401(c). Our decision is a question of fact, see
Profl. & Executive Leasing, Inc. v. Commissioner, 862 F.2d 751,
753 (9th Cir. 1988), affg. 89 T.C. 225 (1987); Ellison v.
Commissioner, 55 T.C. 142 (1970), and we are guided by certain
factors, none of which is dispositive in and of itself. These
factors are: (1) The degree of control exercised by the
principal over the details of the work, (2) the taxpayer’s
investment in the facilities used in the work, (3) the taxpayer’s
opportunity for profit or loss, (4) the permanency of the
relationship between the parties to a working relationship,
(5) the principal’s right of discharge, (6) whether the work
performed is an integral part of the principal’s business,
(7) what relationship the parties to a working relationship
believe they are creating, and (8) the provision of employee
benefits. See Nationwide Mut. Ins. Co. v. Darden, supra; NLRB v.
United Ins. Co., 390 U.S. 254, 258 (1968); Profl. & Executive
Leasing, Inc. v. Commissioner, supra; Ewens & Miller, Inc. v.
Commissioner, 117 T.C. 263, 270 (2001); Weber v. Commissioner,
supra. We analyze these factors seriatim.
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a. Degree of Control
The “degree of control” or “right to control” test is the
most important factor to consider in deciding the nature of a
working relationship. Matthews v. Commissioner, 92 T.C. 351, 361
(1989), affd. 907 F.2d 1173 (D.C. Cir. 1990). Consideration is
given not only to the control exercised by an alleged employer,
but also to the degree to which the alleged employer may
intervene to impose control. Radio City Music Hall Corp. v.
Commissioner, 135 F.2d 715, 717 (2d Cir. 1943); Weber v.
Commissioner, 103 T.C. 387.
Before January 13, 2001, petitioner was a member of CTI’s
strategic management team, she was expected to work at the office
full time, and she was required to be readily available to work
for CTI. Beginning on January 13, 2001, as a result of the
consulting agreement, petitioner was no longer required to work
(nor did she work) as many hours as she did beforehand, she no
longer had to be available to CTI at all times, and she was
allowed to conduct her work for CTI at any location she pleased.
In addition, in contrast with her work for CTI before January 13,
2001, petitioner afterwards did not receive written evaluations,
she had the right to work for other companies, and she had the
right to subcontract CTI business to third parties. Although
petitioner’s job was substantially similar to the one she did
before she began working for CTI pursuant to the consulting
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agreement, there were significant changes after the agreement
that call into question the level of CTI’s control over
petitioner. This factor favors a nonemployee relationship.
b. Investment in Facilities
After petitioner entered into the consulting agreement with
CTI, she continued to use her CTI office. She was able, had she
wanted, to work anywhere she pleased after entering into the
agreement. This factor is neutral.
c. Opportunity for Profit or Loss
Beginning on January 13, 2001, petitioner had more
flexibility and time to seek other employment. She also was able
to subcontract the consulting work she did for CTI; this provided
her more time to seek other opportunities. This factor favors a
nonemployment relationship.
d. Permanency of the Relationship
The consulting agreement contemplated that petitioner would
provide services to CTI for only one year, and it permitted the
parties to the agreement to terminate it with 30 days’ written
notice. After entering into the agreement, petitioner worked
fewer hours than she had before and by August 2001 no longer had
responsibility over CTI’s human resource department. This factor
favors a nonemployee relationship.
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e. Principal’s Right of Discharge
Petitioner’s consulting agreement was nonexclusive, and
either party could terminate the agreement with 30 days’ written
notice. This factor favors a nonemployee relationship.
f. Work as an Integral Part of Principal’s Business
After petitioner entered into the consulting agreement, she
was no longer as integral to CTI’s business as she was
beforehand. She worked fewer hours for CTI, the agreement lasted
only one year, she could pursue other consulting opportunities,
and she gave up all responsibility for CTI’s human resource
department. This factor favors a nonemployee relationship.
g. Relationship of the Parties
Petitioner and CTI entered into a nonexclusive
consulting agreement that stated specifically that petitioner was
an independent contractor. In addition, CTI calculated
petitioner’s income from her exercise of the stock options
pursuant to section 83, as if she was not a CTI employee for the
3 months before the date of that exercise. Further, petitioner
notified CTI’s section 401(k) plan that she had ceased working
for CTI as an employee on January 12, 2001. This factor favors a
nonemployee relationship.
h. Employee Benefits
During the period covered by the consulting agreement, CTI
paid petitioner’s health benefits pursuant to a plan for its
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former employees. Petitioner did not receive a bonus in 2002 for
the work she performed in 2001. Petitioner caused CTI’s section
401(k) plan to distribute her account balance to her broker as a
direct rollover into her individual retirement account. This
factor favors a nonemployee relationship.
i. Conclusion
The factors listed above support a finding that petitioner
worked for CTI on and after December 5, 2001, as an independent
contractor, and we make such a finding on the basis of the record
at hand. Accord Humphrey v. Commissioner, T.C. Memo. 2006-242.
We conclude that petitioner’s stock options, even if they were
otherwise ISOs within the meaning of section 422(b), did not
qualify under section 422(a)(2) for ISO treatment.
C. Whether Petitioner Received Income on Exercise of Options
We decide whether petitioner received income when she
exercised her options in 2002. Petitioners rely upon section
1.83-3(a)(2), Income Tax Regs., and argue that no transfer
occurred upon petitioner’s exercise of her options because, they
state, she paid for the exercise using nonrecourse debt.
According to petitioners, petitioner did not place any of her own
capital at risk until July 29, 2002, when she used petitioners’
resources to pay her borrowing from CIBC. We disagree with this
argument, which is the same argument that the Court of Appeals
for the Ninth Circuit recently considered and labeled
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“nonsense”.6 United States v. Tuff, 469 F.3d at 1253. As was
true in the case of the taxpayer there, petitioner exercised her
options and purchased her CTI stock with cash. While the cash
may not have come directly from her assets, but was borrowed from
CIBC Oppenheimer, she was personally liable to CIBC for repayment
of that borrowing. We also note that she owned her CTI stock
after the exercise and had all of the rights of ownership related
thereto.
Apparently seeing the illogic of their just-rejected
argument, petitioners in their petition and in their briefs
expand their position as set forth in the memorandum of law by
arguing that the shares obtained through the exercise of the
stock options were subject to a substantial risk of forfeiture or
were nontransferable due to CTI’s insider trading policy. Most
specifically, petitioners argue, petitioner exercised her options
during the corporate blackout period; thus, they conclude, the
shares were subject to a substantial risk of forfeiture and were
nontransferable until May 17, 2002, the day the restricted
windows under the corporate insider trading policy ended. We
disagree with this argument.
6
This argument has been previously considered and rejected
by this Court and others. See Facq v. Commissioner, T.C. Memo.
2006-111; Hilen v. Commissioner, T.C. Memo. 2005-226; see also
Palahnuk v. United States, 70 Fed. Cl. 87 (2006), affd. 475 F.3d
1380 (Fed. Cir. 2007); Facq v. United States, 363 F. Supp. 2d
1288 (W.D. Wash. 2005); Miller v. United States, 345 F. Supp. 2d
1046 (N.D. Cal. 2004), affd. 209 Fed. Appx. 690 (9th Cir. 2006).
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As was true in the case of petitioners’ previous argument,
this argument was considered and rejected by the Court of Appeals
for the Ninth Circuit in United States v. Tuff, supra at 1255-
1257. We do likewise here. A taxpayer’s rights in property
generally are subject to a substantial risk of forfeiture if the
taxpayer’s rights to full enjoyment of the property are
conditioned upon the future performance (or refraining from
performance) of substantial services, sec. 1.83-3(c)(1), Income
Tax Regs.; a taxpayer’s rights in property are transferable only
if the rights in such property of any transferee are not subject
to a substantial risk of forfeiture, sec. 83(c)(2). Petitioners
make no claim that petitioner’s rights to retain her CTI stock
were conditioned upon the future performance (or nonperformance)
of any services or the occurrence of any condition related to a
purpose of the transfer. In fact, petitioner’s consulting
agreement had terminated when she exercised the options, so her
rights to retain the shares were not conditioned on the future
performance or nonperformance of services. Nor do petitioners
argue that petitioner was subject to any risk, substantial or
otherwise, that she would have to return the stock to CTI at any
time after she exercised her options on March 5, 2002. To the
contrary, petitioners stipulated that at no time after exercising
her CTI stock options was petitioner under any obligation to
return the stock to CTI and that during 2002 and thereafter,
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petitioner did not sell any shares of CTI she obtained through
the March 5, 2002, exercise of stock options. See Merlo v.
Commissioner, T.C. Memo. 2005-178. While petitioner might have
violated CTI’s insider trading policy had she sold her CTI stock
to a third party upon receiving it, the possibility of such a
violation does not create a substantial risk of forfeiture within
the meaning of section 83. See United States v. Tuff, supra at
1255-1256.
D. Accuracy-Related Penalty
Respondent determined that petitioners are liable for an
accuracy-related penalty under section 6662(a) and (b)(2) for a
substantial understatement of income tax. In part, section
6662(a) and (b)(2) imposes a 20-percent accuracy-related penalty
for any portion of an underpayment that is attributable to a
substantial understatement of income tax. An “understatement” is
the excess of the amount of tax required to be shown on the
return for the taxable year over the amount of tax imposed that
is shown on the return, reduced by any rebate. Sec. 6662(d)(2).
A substantial understatement of income tax exists for any taxable
year for purposes of section 6662 if the amount of the
understatement for the taxable year exceeds the greater of 10
percent of the tax required to be shown on the return for the
taxable year or, in the case of an individual, $5,000. Sec.
6662(d)(1)(A).
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Respondent concedes that he bears the burden of production
under section 7491(c) and must come forward with sufficient
evidence indicating that it is appropriate to impose an
accuracy-related penalty on account of a substantial
understatement of income tax. See Higbee v. Commissioner,
116 T.C. 438, 446-447 (2001). In that we discern from the record
that petitioners’ understatement is in excess of $5,000, and of
10 percent of the amount required to be shown on the return, we
conclude that respondent has met this burden of production.
Petitioners bear the burden of proving that the accuracy-related
penalty does not apply because of reasonable cause, substantial
authority, or the like. Id.
In an attempt to meet their burden of proof, petitioners
argue in brief that they are not liable for the accuracy-related
penalty because they acted reasonably and in good faith by
relying on their tax adviser to prepare their 2002 Federal income
tax return correctly. Petitioners also try to prove that they
acted reasonably and in good faith by noting that the taxpayer in
Facq v. Commissioner, T.C. Memo. 2006-111, was in a similar
setting. There, the Court declined to sustain respondent’s
determination of an accuracy-related penalty for (among other
reasons) substantial understatement of income tax, stating that
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the issue was novel as of the time that the taxpayers filed their
tax return for the year at issue there.7
We agree with petitioners that they are not liable for the
accuracy-related penalty at issue. Such an accuracy-related
penalty is not imposed upon any portion of an underpayment as to
which a taxpayer acted with reasonable cause and in good faith.
Sec. 6664(c)(1). Whether the taxpayer satisfies those tests is a
factual determination, where the taxpayer’s effort to assess the
taxpayer’s proper tax liability is a very important
consideration. Sec. 1.6664-4(b)(1), Income Tax Regs. Reliance
on the advice of a tax professional may constitute reasonable
cause and good faith if, under all facts and circumstances, the
reliance is reasonable and the taxpayer acted in good faith. See
Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98
7
Petitioners also argue at length that respondent’s
determination of the accuracy-related penalty is “null and void”.
This is so, petitioners assert, because the notice of deficiency
neither shows specifically that respondent considered the
reasonable cause exception of sec. 6664, nor explains why that
exception was determined not to be applicable to this case. As
petitioners see it, such a showing and explanation in the notice
of deficiency is required by the Omnibus Budget Reconciliation
Act of 1989 (OBRA), Pub. L. 101-239, 103 Stat. 2106, as discerned
from the legislative history thereunder (specifically, H. Rept.
101-247, at 1393 (1989)). We disagree with this argument. We
read nothing in OBRA that requires that the inclusion of an
accuracy-related penalty in a notice of deficiency, to be valid,
must be accompanied by a specific showing that respondent
considered the reasonable cause exception of sec. 6664 and an
explanation as to why that exception was determined to be
inapplicable. See also Facq v. Commissioner, T.C. Memo.
2006-111.
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(2000), affd. 299 F.3d 221 (3d Cir. 2002); sec. 1.6664-4(c)(1),
Income Tax Regs.; see also Catalano v. Commissioner, 240 F.3d
842, 845 (9th Cir. 2001), affg. T.C. Memo. 1998-447. Reasonable
cause and good faith also may be found where a position taken on
a return involves an issue that is novel as of the time that the
return was filed. See Williams v. Commissioner, 123 T.C. 144,
153-154 (2004); Mitchell v. Commissioner, T.C. Memo. 2000-145;
cf. Van Camp & Bennion v. United States, 251 F.3d 862, 868 (9th
Cir. 2001) (“Where a case is one ‘of first impression with no
clear authority to guide the decision makers as to the major and
complex issues,’ a negligence penalty is inappropriate” (quoting
Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985),
affg. in part and vacating as to an addition to tax for
negligence 80 T.C. 34 (1983))).
We find reasonable cause on the basis of the fact that the
issue at hand was novel at the time petitioners filed their tax
return. To be sure, while the Court of Appeals for the Ninth
Circuit in United States v. Tuff, 469 F.3d at 1253, rejected the
taxpayer’s margin debt argument as “nonsense”, the court stated
that the issue was “A question of first impression in this
circuit”, id. at 1251. Given this statement, and the absence
when petitioners filed their 2002 Federal income tax return of
any “clear authority to guide the decision makers as to the major
and complex issues”, Foster v. Commissioner, supra at 1439, we
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decline to sustain respondent’s determination that petitioners
are liable for an accuracy-related penalty for substantial
understatement of income tax. Accord Montgomery v. Commissioner,
127 T.C. 43, 67 (2002); Racine v. Commissioner, T.C. Memo. 2006-
162; Facq v. Commissioner, T.C. Memo. 2006-111.
E. Holdings
We hold that petitioner realized income in 2002 when she
exercised her stock options received from CTI. We also hold that
petitioners are not liable for the accuracy-related penalty
determined by respondent under section 6662(a) and (b)(2). We
have considered all arguments made by petitioners for a contrary
holding as to the deficiency, and we have considered all
arguments made by respondent for a contrary holding as to the
accuracy-related penalty. As to the arguments that we have
considered but not discussed herein, we have rejected those
arguments as without merit.
Decision will be entered
for respondent as to the
deficiency; decision will be
entered for petitioners as to
the accuracy-related penalty.