United States Court of Appeals for the Federal Circuit
2006-5069
JONATHAN PALAHNUK,
and KIMBERLY PALAHNUK,
Plaintiffs-Appellants,
v.
UNITED STATES,
Defendant-Appellee.
Don Paul Badgley, Badgley-Mullins Law Group, of Seattle, Washington, argued for
plaintiffs-appellants.
Joan I. Oppenheimer, Attorney, Tax Division, United States Department of Justice,
of Washington, DC, argued for defendant-appellee. With her on the brief were Eileen J.
O’Connor, Assistant Attorney General, and Richard Farber, Attorney.
Appealed from: United States Court of Federal Claims
Judge Nancy B. Firestone
UNITED STATES COURT OF APPEALS FOR THE FEDERAL CIRCUIT
2006-5069
JONATHAN PALAHNUK,
and KIMBERLY PALAHNUK,
Plaintiffs-Appellants,
v.
UNITED STATES,
Defendant-Appellee.
_______________________
DECIDED: February 12, 2007
________________________
Before MAYER, BRYSON and DYK, Circuit Judges.
MAYER, Circuit Judge.
Jonathan and Kimberly Palahnuk (“Appellants”) appeal from the judgment of the
United States Court of Federal Claims that income from stock options was taxable in the
year they exercised their options rather than when they paid off the margin loan used to
purchase the stock. Palahnuk v. United States, 70 Fed. Cl. 87 (2006). We affirm.
Background
Jonathan Palahnuk (“Palahnuk”) entered into two agreements with his employer,
Metromedia Fiber Network, Inc. (“Metromedia”), to purchase shares of Metromedia
Class A common stock. The first agreement gave him the option to purchase 8,160
shares and the second gave him the option to purchase an additional 53,520 shares.
On March 15, 2000, Palahnuk exercised some of these options to purchase 26,760
shares1 of Metromedia stock. He paid for these shares using a margin loan from CIBC
Oppenheimer (“Oppenheimer”) in the amount of $99,948.60. At the time of purchase,
the shares were worth $2,185,957.50. On October 27, 2000, Palahnuk exercised
options to purchase an additional 8,160 shares of Metromedia stock. This purchase
was also financed with a margin loan from Oppenheimer, this one for $58,851.44.2 At
the time of purchase, these shares were worth $134,640.00.
Palahnuk used the Oppenheimer loans to pay Metromedia in full when these
stock transactions occurred. The shares were then deposited in an account in
Palahnuk’s name that was maintained by Oppenheimer. Upon exercising his options,
Palahnuk became the registered owner of the stock, and acquired the right to vote the
shares, receive dividends, and pledge the stock as collateral for a loan; Oppenheimer
obtained a security interest in the shares; and Metromedia was completely divested of
any interest in the shares because it had been paid in full with the funds from the margin
loan.
Per his agreement with Oppenheimer, Palahnuk was not required to make any
periodic principal or interest payments on the margin loan. Rather, he merely was
required to maintain a predetermined minimum balance of cash and/or collateral in his
Oppenheimer account. The loan agreement included deficiency clauses whereby
1
As the result of a 2:1 split, these 26,760 shares were the equivalent of
53,520 shares when the second option was granted.
2
This represented the exercise price of $15,238.80, plus withholding taxes
of $43,342.64.
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Oppenheimer was authorized to liquidate the stock if the account balance fell below this
minimum threshold, and Palahnuk agreed to be liable for any deficiency in his accounts.
On March 16, 2001, Palahnuk sold other stock and used the proceeds to pay off
the Oppenheimer margin loans at issue here. Later in 2001, he sold all of the
Metromedia stock at issue for a total of $286,760.77. While this amount was greater
than the exercise price of $115,187.40, it was significantly less than the value of the
stock when the options were exercised in 2000, i.e., $2,320,597.50.
Appellants initially reported their profit from these transactions as gross income
on their tax return for tax year 2000. They showed gross income from this transaction
of $2,205,413.20, which was the difference between the market value of the stock at the
time of purchase and the price they paid to exercise their options.
On April 10, 2003, however, the appellants filed an amended return for tax year
2000, seeking a refund of $627,019 plus interest. They asserted that the stock
transactions were taxable events when they paid off the margin loan in 2001, rather
than when they obtained ownership of the stock from Metromedia in 2000. The IRS
took no action on their amended return, leading them to file this case. The Court of
Federal Claims ruled in favor of the government on cross motions for summary
judgment and dismissed the case. Appellants appeal, and we have jurisdiction under
28 U.S.C. § 1295(a)(3).
Discussion
We review the trial court’s grant of summary judgment de novo, reapplying the
same standard used by the trial court. Lacavera v. Dudas, 441 F.3d 1380, 1382 (Fed.
Cir. 2006). Summary judgment is appropriate when “the pleadings, depositions,
2006-5069 3
answers to interrogatories, and admissions on file, together with the affidavits, if any,
show that there is no genuine issue as to any material fact and that the moving party is
entitled to a judgment as a matter of law.” Rule 56(c) of the Rules of the United States
Court of Federal Claims; see also Dana Corp. v. United States, 174 F.3d 1344, 1347
(Fed. Cir. 1999).
Pursuant to I.R.C. § 83(a), the financial gain realized by an employee upon
exercising stock options is taxable as gross income in the year that the options were
exercised if two prerequisites are satisfied. First, the shares must be “transferred” to the
employee, which occurs when the employee acquires “a beneficial ownership interest”
in the stock. Treas. Reg. §§ 1.83-1(a)(1), -3(a)(1). Second, the shares must become
“substantially vested” in the employee, which happens when the stock becomes “either
transferable or not subject to a substantial risk of forfeiture.” Id. §§ 1.83-1(a)(1), -3(b).
If both conditions are satisfied, the employee realizes gross income equal to the
difference between the fair market value of the stock at the moment it became
substantially vested, and the amount paid to exercise the stock options. Id. § 1.83-
1(a)(1).
1. Whether a transaction is a stock transfer or the grant of an option to purchase
the stock in the future is a question of fact. Id. § 1.83-3(a)(2). This determination is
made by analyzing “the type of property involved, the extent to which the risk that the
property will decline in value has been transferred, and the likelihood that the purchase
price will, in fact, be paid.” Id.
Upon exercising his stock options, the purchase price of the stock was, in fact,
paid to Metromedia, and Palahnuk became the beneficial (and actual) owner of the
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stock. Any risk of decline in the value of the shares was transferred from Metromedia to
Palahnuk; whether Palahnuk ultimately transferred that risk to Oppenheimer has no
bearing on our analysis. A transfer from Metromedia to Palahnuk indisputably occurred
in 2000.
Palahnuk incorrectly cites Example (2) of Treas. Reg. § 1.83-3(a)(7)3 as support
for his position that a transfer did not occur until he repaid the margin loan. The
corporation in that example was never paid for the stock, and since the employee did
not have any personal liability on the note used to pay for the stock, there is a very real
possibility that the corporation would never be paid. That is significantly different from
our scenario because Metromedia was paid in full and transferred all of its rights in that
stock to Palahnuk.
A better analogy can be drawn from common real estate transfers. The buyer
obtains a mortgage loan from a bank to pay the seller for the property. At closing, the
seller is paid in full with the funds from the mortgage loan, and is completely divested of
3
Example (2) of Treas. Reg. § 1.83-3(a)(7) provides as follows:
On November 17, 1972, W sells to E 100 shares of
stock in W corporation with a fair market value of $ 10,000 in
exchange for a $10,000 note without personal liability. The
note requires E to make yearly payments of $2,000
commencing in 1973. E collects the dividends, votes the
stock and pays the interest on the note. However, he makes
no payments toward the face amount of the note. Because E
has no personal liability on the note, and since E is making
no payments towards the face amount of the note, the
likelihood of E paying the full purchase price is in substantial
doubt. As a result E has not incurred the risks of a beneficial
owner that the value of the stock will decline. Therefore, no
transfer of the stock has occurred on November 17, 1972,
but an option to purchase the stock has been granted to E.
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his interest in the property; the buyer becomes the beneficial owner of the property,
obtaining all the rights and privileges associated with owning the property, but also
incurring the risk of loss should the property be damaged or destroyed; and the bank
obtains a security interest on the property in the form of a mortgage. No one would
dispute that a transfer has occurred in this situation, and it is equally certain that a
transfer occurred when the stock options were executed, regardless of whether the
transaction was funded with the buyer’s own cash or a margin loan from a broker.
2. Whether the stock was substantially vested is also a question of fact. Treas.
Reg. § 1.83-3(b), (c). Stock becomes substantially vested “when it is either transferable
or not subject to a substantial risk of forfeiture.” Id. § 1.83-3(b). “A substantial risk of
forfeiture exists where” the property rights that were transferred are conditioned “upon
the future performance (or refraining from performance) of substantial services by any
person, or the occurrence of a condition related to a purpose of the transfer [wherein]
the possibility of forfeiture is substantial if such condition is not satisfied.” Id. § 1.83-
3(c)(1).
There is no evidence on the record suggesting any possibility that Palahnuk’s
rights in the stock could have been revoked by Metromedia. That Oppenheimer could
have sold Palahnuk’s stock in certain situations is of no moment. The transfer from
Metromedia to Palahnuk had already occurred, and what Palahnuk chose to do with his
stock thereafter is irrelevant. The stock became substantially vested in Palahnuk at the
moment he executed his options in 2000.
Therefore, the transaction was a taxable event in 2000, the tax year during which
the stock options were exercised by Palahnuk, rather than when he fully repaid the
2006-5069 6
Oppenheimer margin loan in 2001. Accord Cidale v. United States, No. 05-51372, 2007
WL 49636 (5th Cir. Jan. 9, 2007); United States v. Tuff, 469 F.3d 1249 (9th Cir. 2006);
Miller v. United States, No. 04-17470, 2006 WL 3487016 (9th Cir. Dec. 4, 2006); see
also Facq v. United States, 363 F. Supp. 2d 1288 (W.D. Wash. 2005); Racine v.
Comm’r, 92 T.C.M. (CCH) 100, 2006 WL 2346444 (2006).
Conclusion
Accordingly, the judgment of the United States Court of Federal Claims is
affirmed.
AFFIRMED
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