Kadillak v. Cir

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
ANTHONY J. KADILLAK, 
Petitioner-Appellant, No. 07-70600
v.
 Tax Ct. No.
2860-04L
COMMISSIONER OF INTERNAL
REVENUE, OPINION
Respondent-Appellee.

Appeal from a Decision of the
United States Tax Court
Argued and Submitted
June 3, 2008—Seattle, Washington
Filed July 29, 2008
Before: Melvin Brunetti, Ronald M. Gould, and
Consuelo M. Callahan, Circuit Judges.
Opinion by Judge Brunetti
9603
9606 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
COUNSEL
Don Paul Badgley, Badgley-Mullins Law Group, Seattle,
Washington; and Brian G. Isaacson, Merriam & Isaacson,
Seattle, Washington, for the petitioner-appellant.
Francesca U. Tamami and Richard Farber, Tax Division, U.S.
Department of Justice, Washington, D.C., for the respondent-
appellee.
OPINION
BRUNETTI, Circuit Judge:
Taxpayer Anthony Kadillak appeals a tax court decision
upholding the Commissioner of Internal Revenue’s determi-
nations of his income tax liabilities for tax years 2000 and
2001. The case concerns Kadillak’s acquisition, and later for-
feiture and sale, of vested and nonvested shares of stock
through the exercise of incentive stock options (“ISOs”), and
the tax consequences of those transactions, especially for pur-
poses of the Alternative Minimum Tax (“AMT”). In denying
Kadillak’s petition for review, the tax court determined that
Kadillak’s election under I.R.C. § 83(b) to recognize AMT
income on his nonvested shares in 2000 was valid; Kadillak
was therefore not entitled to a claim of right deduction under
I.R.C. § 1341 when his nonvested shares were later forfeited
to his employer upon his termination; and because the sale of
his remaining shares in 2002 did not result in any alternative
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9607
tax net operating loss (“ATNOL”) under I.R.C.
§ 56(d)(2)(A)(i), Kadillak could not claim an ATNOL carry-
back deduction to reduce his AMT income for 2000. We have
jurisdiction under I.R.C. § 7482(a)(1) and affirm.
I. FACTS & PROCEEDINGS BELOW
In April 2000, Kadillak purchased 32,000 shares of stock
by exercising an ISO that had been granted to him by his
employer, Ariba Technologies, Inc. Of those 32,000 shares,
17,333 were vested, and 14,667 were nonvested. The non-
vested shares were subject to a vesting schedule based on
length of employment. While nonvested, the shares were clas-
sified as “Restricted,” held in an escrow account, and subject
to Ariba’s right of repurchase at the option price upon the ter-
mination of Kadillak’s employment, which was “at will” and
could be terminated by either party, at any time, and for any
reason, with or without cause.
Although the fair market value exceeded Kadillak’s option
price by well over $3 million, by holding the shares rather
than cashing in he avoided realizing any regular income on
the transaction in 2000 because the spread on the exercise of
an ISO is tax deferred under I.R.C. § 421(a)(1). Nonetheless,
the transaction was not entirely non-taxable. It was subject to
the Alternative Minimum Tax (“AMT”), which is imposed
“separate from and in addition to the regular income tax” with
the purpose of ensuring “that high-income taxpayers cannot
avoid significant tax liability through the use of exclusions,
deductions, and credits.” Merlo v. Comm’r, 492 F.3d 618, 620
(5th Cir. 2007). For AMT purposes, I.R.C. § 56(b)(3) exempts
ISOs from the tax deferral provision of § 421 and therefore
subjects them to I.R.C. § 83, which imposes a tax on dis-
counted property transfers in connection with the performance
of services. See Montgomery v. Comm’r, 127 T.C. 43, 53
(2006). Thus, in 2000, Kadillak was required to report AMT
income (but not regular income) on all shares that had vested
by year end. See I.R.C. § 83(a).
9608 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
In addition, Kadillak filed a voluntary election under I.R.C.
§ 83(b) to report AMT income in 2000 on the acquisition of
his nonvested shares. Under § 83(a), the receipt of property is
not yet taxable if it is “subject to a substantial risk of forfei-
ture.” As it is undisputed that Kadillak’s nonvested shares fit
that definition due to his at will employment and his employ-
er’s right of repurchase upon termination, he could have
waited until the shares vested to include them in AMT
income. Section 83(b), however, allows a taxpayer to elect to
report gross income in the year of receipt, notwithstanding the
risk of forfeiture. Such an election can be advantageous if
nonvested shares are expected to further appreciate before
they vest, because it allows the recipient to claim taxable
income while the fair market value is still relatively low and
defer taxes on any appreciation until the shares are resold. But
there is also a potential downside. If the risk of forfeiture later
materializes, “no deduction shall be allowed in respect of such
forfeiture.” I.R.C. § 83(b)(1); see Theophilos v. Comm’r, 85
F.3d 440, 448 n.24 (9th Cir. 1996).
In this case, the strategy backfired. In 2001, Ariba termi-
nated Kadillak’s employment and exercised its right to repur-
chase at Kadillak’s cost his remaining nonvested shares,
which by that time had been reduced to 6,667 shares pursuant
to the vesting schedule. Although in 2000 Kadillak had
elected to realize AMT income of nearly $680,000 on those
shares, by forfeiting them at his own cost in 2001 he realized
no regular capital gain or loss but an AMT capital loss of the
same $680,000.
In 2002, Kadillak sold his remaining 25,333 vested shares
to a third party. For regular tax purposes, the sale caused him
to realize a capital gain of over $60,000. For AMT purposes,
however, his basis had been adjusted upward by the realiza-
tion of AMT income in 2000, causing him to realize an AMT
capital loss on the sale of over $2.5 million.
Kadillak originally filed his 2000 and 2001 tax returns
under the assumption that his § 83(b) election was valid. For
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9609
tax year 2000, in which he exercised the ISO, he reported no
regular taxable income on the transaction but an AMT capital
gain of $3,262,998 on all 32,000 vested and nonvested shares.
He accordingly reported AMT of $932,309, a total tax liabil-
ity of $1,099,388, and a balance owing of $963,597, of which
he paid only $25,000 with his return. For tax year 2001, in
which he was forced to forfeit his nonvested shares, he
reported no gain or loss on the forfeiture for either regular tax
or AMT purposes. Kadillak’s cost basis and the repurchase
price were identical; and although he realized an AMT capital
loss from the forfeiture, he claimed no deduction because the
loss was attributable in part to his § 83(b) election. Kadillak
reported zero tax liability for 2001 and, despite his outstand-
ing liability from 2000, requested a refund of $12,720.
Rather than pay his 2000 tax liability, Kadillak pursued a
different solution. He hired a tax attorney and, in 2003, filed
amended returns for both tax years 2000 and 2001. The 2000
return was amended in two respects. First, he asserted that his
§ 83(b) election was invalid and reduced his reported AMT
income accordingly by excluding any shares that were still
nonvested at year end. Second, he claimed ATNOL carryback
deductions based on the AMT capital losses he realized in
2001 from the forfeiture of his nonvested shares and in 2002
from the third-party sale of his vested shares. These amend-
ments collectively nullified any AMT income in 2000 from
the exercise of Kadillak’s ISO, reduced his AMT liability
from $932,309 to $16,712, and reduced his total tax liability
from $1,099,388 to $183,524, leaving an outstanding liability
of $22,733.
Kadillak further amended his 2001 return to conform to his
newly amended 2000 return and his claim that he realized no
AMT income on his nonvested shares in 2000 because his
§ 83(b) election was invalid. Whereas Kadillak’s original
2001 return reported no AMT income from the exercise of his
ISO, no AMT liability, and no total tax liability, his amended
return reported $340,213 in AMT income for the nonvested
9610 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
shares that vested in 2001, $100,845 in AMT liability, and
total tax liability in the same amount, which he did not pay.
The IRS did not accept Kadillak’s 2000 amended return,
which would have substantially reduced his outstanding lia-
bility. It did accept his 2001 amended return, however, which
substantially increased his reported liability for that year. The
IRS then issued a notice of federal tax lien for 2000 and a
notice of intent to levy for 2001.
After exhausting his administrative remedies, Kadillak filed
the underlying tax court petition challenging the lien and levy.
Rather than defending both, the Commissioner immediately
conceded that the tax assessments for 2000 and 2001 were
inconsistent and took the position that Kadillak’s original
returns had both correctly reported his respective tax liabili-
ties. If the court agreed, the Commissioner would abate the
$100,845 tax assessment for 2001, which Kadillak had
reported on his amended return only on the assumption that
the § 83(b) election in 2000 was invalid and the 2000 amend-
ments were correct.
Although he accepted the Commissioner’s concession,
Kadillak defended his amended returns. In two motions for
partial summary judgment, he contended, among other things,
that (1) the § 83(b) election was invalid; (2) even if the elec-
tion were valid, he was entitled to a “claim of right” deduction
under I.R.C. § 1341 from the 2001 forfeiture of his nonvested
shares; and (3) he was entitled to an ATNOL carryback
deduction in 2000 based on the AMT capital losses he sus-
tained on the forfeiture of his nonvested shares in 2001 and
on the third-party sale of his vested shares in 2002.
Rejecting each of those arguments, the tax court denied
Kadillak’s motions and granted summary judgment for the
Commissioner. We review de novo the tax court’s decisions
on summary judgment, including its interpretations of the tax
code and accompanying regulations. Gladden v. Comm’r, 262
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9611
F.3d 851, 853 (9th Cir. 2001); UnionBanCal Corp. v.
Comm’r, 305 F.3d 976, 981 (9th Cir. 2002).
II. SECTION 83(b) ELECTION
In the tax court, Kadillak advanced multiple theories in
support of his contention that his § 83(b) election in 2000 was
invalid, such that he was not required to immediately recog-
nize AMT income on his nonvested shares. He now relies on
just one: He was unable to make a valid election under § 83
because his acquisition of the nonvested shares through the
exercise of his ISO was not a transfer of “property” within the
meaning of I.R.C. § 83 and Treasury Regulation § 1.83-3(e).
Kadillak does not take issue with the tax court’s reasoning
that the benefits he received upon acquiring the nonvested
shares, including his acquisition of all stockholder rights and
his entitlement to receive all regular dividends, constituted a
“beneficial interest” under I.R.C. § 83. Instead, he points out
that a beneficial interest in assets is not alone sufficient; for
such a beneficial interest to be “property,” the assets also
must have been “transferred or set aside from the claims of
creditors of the transferor.” Treas. Reg. § 1.83-3(e).1
In that regard, Kadillak argues that merely depositing his
nonvested shares into an escrow account did not adequately
protect them from the claims of his employer’s creditors. He
speculates that if Ariba had filed for bankruptcy, its creditors
could have forced it to terminate Kadillak’s at-will employ-
ment and exercise its right to repurchase his nonvested shares
at cost. He further likens an escrow account to a “rabbi trust”2
1
The regulation states, in pertinent part: “For purposes of section 83 and
the regulations thereunder, the term ‘property’ includes real and personal
property other than either money or an unfunded and unsecured promise
to pay money or property in the future. The term also includes a beneficial
interest in assets (including money) which are transferred or set aside from
the claims of creditors of the transferor, for example, in a trust or escrow
account.” Treas. Reg. § 1.83-3(e).
2
A rabbi trust is a commonly-used mechanism for deferred compensa-
tion and deferred taxation, in which “[f]unds held by the trust are out of
9612 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
and argues that the doctrine of constructive receipt does not
require the recognition of income under § 83 where deferred
compensation is subject to substantial limitations or restric-
tions, including the claims of the creditors of the corporation.
[1] We have no quarrel with Kadillak’s hypothesis. Given
the terms of Kadillak’s employment contract and the Ariba
stock plan, it is conceivable that the creditors of a bankrupt
Ariba could force it to terminate Kadillak and then repurchase
his nonvested shares at cost. But Kadillak misses the point, as
the scenario he envisions only incidentally involves the claims
of Ariba’s creditors. The real culprits are Ariba’s rights of ter-
mination and repurchase, which Ariba could exercise of its
own accord, at any time and for any reason, regardless of any
financial difficulty or pressure from creditors. Viewed in that
light, Kadillak’s hypothesis demonstrates nothing more than
that his nonvested shares were “subject to a substantial risk of
forfeiture” and therefore would be ordinarily excluded from
income under I.R.C. § 83(a), not that they were outside the
scope of § 83 altogether. As the very purpose of a taxpayer’s
§ 83(b) election is to realize income on assets that otherwise
would not be included in income under § 83(a) due to a sub-
stantial risk of forfeiture, the mere fact that an asset is subject
to a substantial risk of forfeiture is no justification either for
excluding it from the definition of “property” and the cover-
age of § 83, or for invalidating an otherwise valid § 83(b)
election.
[2] Also without merit is Kadillak’s suggestion that, even
aside from Ariba’s right of repurchase, depositing the non-
vested shares into an escrow account was insufficient to sat-
isfy Treasury Regulation § 1.83-3(e). Despite Kadillak’s
manifest and repeated misquotations of the regulation in his
reach of the employer, but are subject to the claims of the employer’s
creditors in the event of bankruptcy or insolvency.” In re IT Group, Inc.,
448 F.3d 661, 665 (3d Cir. 2006).
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9613
briefs, the regulation quite plainly enumerates “a trust or
escrow account” as the prototypical vehicles for “transferr-
[ing] or set[ting] aside [assets] from the claims of creditors.”
Id. Moreover, even if Kadillak might be correct that certain
types of trusts or escrow accounts could fail to satisfy the reg-
ulatory requirements, because he has provided no evidence
that the escrow account used by Ariba was, in fact, inadequate
to protect his shares from Ariba’s creditors, we have no rea-
son to depart from the general rule in this case.
[3] Because Kadillak’s nonvested shares were “property”
within the coverage of I.R.C. § 83 and Treasury Regulation
§ 1.83-3(e), he was fully capable of making a § 83(b) election
to recognize income on the shares in the year of receipt, not-
withstanding the substantial risk of forfeiture. As we are pre-
sented with no other reason for invalidating the election, we
conclude that it was valid and that Kadillak was accordingly
required to report AMT income on his nonvested shares, as he
did on his original 2000 tax return.
III. CLAIM OF RIGHT DEDUCTION
Kadillak next contends that, even if the § 83(b) election is
valid, he was entitled to a “claim of right” deduction under
I.R.C. § 1341 because the nonvested shares that were includ-
able in AMT income in 2000 were forfeited in 2001 at an
AMT capital loss.
He again misapplies the tax code. Section 1341(a) indeed
permits taxpayers to compute their tax differently where they
reported income on the receipt of property in one tax year and
then forfeited that property in a later tax year. But the statute
applies only if “a deduction is allowable for the taxable year
because it was established after the close of such prior taxable
year (or years) that the taxpayer did not have an unrestricted
right to such item or to a portion of such item,” among other
requirements. I.R.C. § 1341(a)(2) (emphasis added). As clari-
fied in the accompanying regulation, the deduction must be
9614 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
allowable “under other provisions” of the tax code. Treas.
Reg. § 1.1341(a)(1).
[4] In this case, Kadillak fails to satisfy § 1341(a)(2)
because the flush language of § 83(b)(1) expressly disallows
any deduction respecting the forfeiture of his nonvested
shares that were subject to his valid § 83(b) election. The stat-
ute plainly states: “If such election is made, . . . and if such
property is subsequently forfeited, no deduction shall be
allowed in respect of such forfeiture.” I.R.C. § 83(b)(1).
[5] Kadillak therefore could not claim any deduction from
the forfeiture of his nonvested shares in 2001. Besides being
ineligible for a “claim of right” deduction under I.R.C § 1341,
his deduction was also limited under Treasury Regulation
§ 1.83 2(a) to the excess, if any, of the amount paid for the
shares over the amount realized upon the forfeiture. Of
course, as Ariba repurchased the shares at cost, there was no
excess and therefore no deduction.
IV. ATNOL CARRYBACK DEDUCTION
Kadillak finally attempts to reduce his 2000 tax liability by
claiming the AMT capital losses he sustained in 2001 and
2002 as ATNOL deductions and then carrying back those
deductions to 2000. Because the § 83(b) election was valid,
Kadillak realized an AMT capital loss of nearly $680,000 on
the forfeiture of his nonvested shares in 2001, and he realized
an AMT capital loss of over $2.5 million on the resale of his
vested shares in 2002. In order to claim those losses as
ATNOLs, he reads I.R.C. § 56 as establishing a “sequential
formula” that allows him to fully deduct his AMT capital loss
as an ATNOL under I.R.C. § 56(d)(2)(A)(i), notwithstanding
the limitations on capital loss deductions in I.R.C. §§ 172(d)
and 1211(b).
[6] Once again, Kadillak misapplies the tax code. Section
56 indeed provides that the ATNOL deduction “shall be
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9615
allowed in lieu of the net operating loss deduction allowed
[for regular tax purposes] under section 172.” I.R.C.
§ 56(a)(4). But the statute hardly exempts ATNOL from the
limitations of § 172. Quite the contrary, § 56 goes on to define
ATNOL by expressly incorporating the definition of regular
NOL in § 172 and then enumerating specific exceptions, none
of which allow a taxpayer to avoid the capital loss limitations
in § 172(d) or § 1211(b). See I.R.C. § 56(d)(1) (“For purposes
of subsection (a)(4), the term “alternative tax net operating
loss deduction” means the net operating loss deduction allow-
able for the taxable year under section 172, except that . . .”);
Merlo, 492 F.3d at 623-24.
At issue here is the exception in § 56(d)(1)(B)(i), which
provides that in computing the ATNOL deduction, the NOL
under § 172(c) “shall be adjusted as provided in paragraph
(2).” In turn, § 56(d)(2) provides:
(2) Adjustments to net operating loss computation.
(A) Post-1986 loss years. In the case of a
loss year beginning after December 31,
1986, the net operating loss for such year
under section 172(c) shall
(i) be determined with the adjustments
provided in this section [56] and section 58,
and
(ii) be reduced by the items of tax pref-
erence determined under section 57 for
such year.
An item of tax preference shall be taken
into account under clause (ii) only to the
extent such item increased the amount of
the net operating loss for the taxable year
under section 172(c).
9616 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
I.R.C. § 56(d)(2)(A). In other words, the ATNOL deduction
under § 56(d) is determined by first computing NOL under
§ 172(c) “with the adjustments” provided in §§ 56 and 58, and
then subtracting tax preference items determined under § 57.
[7] In this case, Kadillak seeks to take advantage of the
incentive stock option adjustment in § 56(b)(3), which, along
with the § 83(b) election, was responsible for his realization
of AMT income on the acquisition of his vested and non-
vested shares in 2000 and, correspondingly, his realization of
AMT capital losses from the dispositions in 2001 and 2002.
The problem, however, is that § 172(c) does not allow him to
deduct his net capital losses as an NOL. Section 172(c) directs
that NOL “shall be computed with the modifications specified
in subsection (d).” And subsection (d) in turn provides that
“the amount deductible on account of losses from sales or
exchanges of capital assets shall not exceed the amount
includable on account of gains from sales or exchanges of
capital assets.” I.R.C. § 172(d)(2)(A). “Accordingly,
§ 172(d)(2)(A) works so that net capital losses are effectively
excluded from the computation of NOL.” Merlo, 492 F.3d at
623.
Kadillak may still be able to use his AMT capital losses to
adjust his AMT income; however, because he cannot claim
such losses as ATNOLs under § 56(a)(4) and (d)(2), his only
option is to claim them under § 56(b)(3) as direct adjustments
to AMT income. Moreover, even when claimed in that man-
ner, his AMT capital loss deductions are limited by other pro-
visions. For tax year 2001, Kadillak is prohibited under
§ 83(b)(1) from taking any deduction in respect of the forfei-
ture of his nonvested shares that were subject to his valid
§ 83(b) election. And for 2002, Kadillak’s AMT capital loss
deduction in respect of the sale of his vested shares is subject
to the $3,000 excess capital loss limitation in § 1211(b). See
Merlo, 492 F.3d at 623.
[8] Kadillak attempts to avoid the restrictions of § 172(d)
and § 1211(b) by reading § 56(d) as establishing a different
KADILLAK v. COMMISSIONER OF INTERNAL REVENUE 9617
“sequential formula” for computing ATNOL than the formula
provided in § 172(c) for computing regular NOL. Specifi-
cally, he reads § 56(d)(1)(B)(i) as requiring that a taxpayer
compute ATNOL by first calculating NOL under § 172(c)
while fully taking into account the limitations of § 172(d) and
§ 1211(b), and then making the adjustments “provided in
paragraph (2)” of § 56(d). I.R.C. § 56(d)(1)(B)(i). However,
the statutory text belies that reading. First, rather than altering
the § 172 formula, § 56(d)(1) expressly defines the ATNOL
deduction as “the net operating loss deduction allowable . . .
under section 172,” subject to only certain exceptions. Thus,
§ 56(d)(1) generally incorporates the § 172 formula, including
any limitations on allowance of deductions; and the statute
thereby disallows any deduction that is disallowed by
§ 172(c) and not specifically allowed by an exception in
§ 56(d). Second, paragraph (2) of § 56(d) contradicts Kadil-
lak’s contention that paragraph (1)’s reference to paragraph
(2) establishes a sequence distinct from the § 172 formula.
Paragraph (2) actually provides that, for purposes of comput-
ing ATNOL, the NOL “under section 172(c) shall . . . be
determined with the adjustments provided in this section [56]
and section 58.” I.R.C. § 56(d)(2)(A)(i) (emphasis added). In
other words, rather than directing taxpayers to determine
ATNOL by calculating NOL under § 172(c) before making
the AMT adjustments in §§ 56 and 58, § 56(d) actually directs
taxpayers to calculate NOL under § 172(c) with AMT-
adjusted figures.
We also reject Kadillak’s contention that the flush language
of § 56(d)(2)(A) supports his interpretation. It states: “An
item of tax preference shall be taken into account under clause
(ii) [of § 56(d)(2)(A)] only to the extent such item increased
the amount of the net operating loss for the taxable year under
section 172(c).” I.R.C. § 56(d)(2)(A). Because the flush lan-
guage expressly applies only to the § 57 adjustments in clause
(ii), and not the § 56 adjustments in clause (i), it has no bear-
ing on Kadillak’s ability (or inability) to claim his AMT capi-
tal losses as an ATNOL under clause (i).
9618 KADILLAK v. COMMISSIONER OF INTERNAL REVENUE
[9] We therefore join with the Fifth Circuit in holding that
an individual taxpayer’s AMT capital losses are subject to the
limitations in I.R.C. §§ 172(d) and 1211(b) and therefore are
not deductible as an ATNOL under I.R.C. § 56(d)(2)(A)(i).
Merlo, 492 F.3d at 623-24. Accordingly, the tax court did not
err when it determined that no ATNOLs existed in 2001 and
2002 that could be carried back. See id. at 624.
V. CONCLUSION
The tax court’s decision denying Kadillak’s motions for
summary judgment and granting summary judgment in favor
of the Commissioner is
AFFIRMED.