United States v. Tuff

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT

UNITED STATES OF AMERICA,  No. 05-35195
Plaintiff-Appellee,
v.  D.C. No.
CV-04-00570-TSZ
JAMES H. TUFF,
OPINION
Defendant-Appellant.

Appeal from the United States District Court
for the Western District of Washington
Thomas S. Zilly, District Judge, Presiding

Argued and Submitted
October 26, 2006—Seattle, Washington

Filed December 4, 2006

Before: Alfred T. Goodwin and Alex Kozinski,
Circuit Judges, and Milton I. Shadur,* Senior District Judge.

Opinion by Judge Goodwin

*The Honorable Milton I. Shadur, Senior United States District Judge
for the Northern District of Illinois, sitting by designation.

19019
 UNITED STATES v. TUFF 19023
COUNSEL

Don Paul Badgley, Badgley-Mullins Law Group, Seattle,
Washington, for the defendant-appellant.

Michael J. Haungs, Tax Division, Department of Justice,
Washington, D.C., for the plaintiff-appellee.

OPINION

GOODWIN, Circuit Judge:

James H. Tuff (“Tuff”) appeals the summary judgment
granted the United States in its action to recover $208,513.20
refunded to Tuff by the Internal Revenue Service (“IRS”) in
connection with stock options Tuff exercised in 1999 through
a margin loan from Morgan Stanley. We affirm the judgment.

I. BACKGROUND

The appeal turns on whether Tuff received income in the
form of shares of stock when he exercised his options, or
when Morgan Stanley liquidated the shares after their value
had declined.

The material facts are not in dispute. Tuff was employed by
RealNetworks, Inc., at a management level, and was classified
as a corporate insider who could sell RealNetworks shares
only during open trading windows approved by the company.
As part of his compensation package Tuff received stock
options, which he exercised twice in 1999 to purchase Real-
Networks shares that had a total market value at the time of
purchase of $460,093.75. The exercise, or “strike,” price of
these shares was $6,137.00, making the difference, or spread,
between their market value and exercise price $453,956.75.
19024 UNITED STATES v. TUFF
Tuff financed these purchases by borrowing from Morgan
Stanley, writing checks to RealNetworks from his Morgan
Stanley account to cover both the strike price and federal
withholding taxes each time he exercised an option. The
shares were deposited in an account in Tuff’s name, and Tuff
became the registered owner of the stock. He had the right to
vote the stock, receive dividends, and pledge the stock as col-
lateral for a loan. Taking advantage of these rights, Tuff
pledged the stock as collateral pursuant to a client account
agreement with Morgan Stanley. The Agreement provided:

You agree at all times to maintain such margins for
your account with Dean Witter Reynolds as required
by law or custom, or as we may deem necessary or
advisable. You also promise to discharge your obli-
gations to Dean Witter Reynolds upon demand; this
obligation survives termination of your account with
Dean Witter Reynolds.1

Under the Agreement, Morgan Stanley had the right to liq-
uidate Tuff’s RealNetworks shares, through margin calls,
when necessary to maintain collateral in Tuff’s account equal
to the outstanding debt multiplied by 1.33. Prior to the sale of
any of his RealNetworks shares in a margin call, however,
Tuff had the option to deposit cash or other securities to main-
tain his account margin and still retain all his RealNetworks
shares. After Tuff received margin calls in 1999 and did not
deposit additional equity in his account, Morgan Stanley sold
2,200 of his RealNetworks shares; 1,200 during blackout peri-
ods when Tuff was precluded from trading RealNetworks
shares.

Tuff and his wife filed a Form 1040 joint income tax return
for tax year 1999, reporting $540,543.00 of Form W-2 income
1
Although the agreement refers to Dean Witter Reynolds, Tuff’s
account was with Morgan Stanley Dean Witter & Co. and certain services
were offered through Dean Witter Reynolds, Inc.
 UNITED STATES v. TUFF 19025
from RealNetworks, which represented Tuff’s salary plus the
aggregate spread from the exercise of stock options described
above. In January, 2002, the Tuffs filed a Form 1040X
amended return/claim for refund, asserting that no income
arose when Tuff exercised the options in 1999, and listing his
W-2 income as $86,586.00, a difference of $453,957.00 from
the original return. The Form 1040X also claimed a refund of
the withholding tax Tuff paid RealNetworks upon exercising
the options. After issuing the Tuffs a check for $208,513.20
in March 2002, the IRS reconsidered its position and sought
to recover the refund. This action followed.

On the parties’ cross-motions for summary judgment, the
district court rejected Tuff’s primary argument: that his
receipt of RealNetworks shares was not taxable in 1999 when
he exercised his options, but only later when Morgan Stanley
sold them to restore the margin. The district court also
rejected Tuff’s alternative argument that he should recognize
ordinary, rather than capital, loss for the decline in the fair
market value of his RealNetworks shares at the end of each
blackout period, as well as each time Morgan Stanley sold the
shares during blackout periods. The district court, as noted,
granted summary judgment in favor of the United States and
against Tuff in the amount of $208,513.20, plus interest.

II. THE TAXABLE EVENT

[1] A question of first impression in this circuit: When an
employee exercises a non-qualified stock option2 granted by
the employer to purchase shares with money borrowed from
a third party, pledging the shares as collateral for the loan, is
the property “transferred” and “substantially vested” for tax
2
Statutory stock options are compensatory options that meet certain
criteria and are treated differently under the Internal Revenue Code. See
I.R.C. § 422. Options that do not meet these requirements, such as the
RealNetworks options in this case, are nonstatutory, or nonqualified, stock
options. Cramer v. Comm’r, 64 F.3d 1406, 1408-09 (9th Cir. 1995).
19026 UNITED STATES v. TUFF
purposes at the time the option is exercised, or at the time the
shares are later liquidated? Citing no relevant authority, Tuff
contends that in these circumstances no taxable transfer
occurs when the option is exercised. An overview of the statu-
tory and regulatory provisions governing the taxation of stock
options is useful to understand Tuff’s arguments.

A. Statutory and Regulatory Framework for Taxation
of Stock Options

[2] When an employee receives a non-qualified stock
option that does not have a readily ascertainable fair market
value, as was the case with the options at issue, the receipt of
the option generally is not taxable. I.R.C. § 83(e)(3). Rather,
the employee is taxed upon exercising the option and receiv-
ing shares if two conditions are met. First, the shares must be
transferred to the employee. Under the applicable regulations,
a transfer occurs when the employee acquires a beneficial
ownership interest in the shares. 26 C.F.R. § 1.83-3(a)(1).
Second, they must be substantially vested in the employee.
I.R.C. § 83(a); 26 C.F.R. § 1.83-1(a). Shares are substantially
vested in the employee when they are either transferable or
not subject to a substantial risk of forfeiture. 26 C.F.R. § 1.83-
3(b). If both conditions are met, the employee must recognize
income in the amount by which the shares’ fair market value
exceeds the exercise price paid. I.R.C. § 83(a).

Whether a risk of forfeiture is substantial depends on the
facts and circumstances. 26 C.F.R. § 1.83-3(c)(1). Shares (or
any other property transferred in connection with the perfor-
mance of services) are subject to a substantial risk of forfei-
ture when the owner’s rights to their full enjoyment are
conditioned upon any person’s future performance of substan-
tial services. I.R.C. § 83(c)(1). Property is transferable if the
employee can sell, assign, or pledge his or her interest in the
property to a person other than the transferor, and this third-
party transferee is not required to give up the property or its
 UNITED STATES v. TUFF 19027
value if a substantial risk of forfeiture later materializes. 26
C.F.R. § 1.83-3(d).

[3] In this case the RealNetworks shares were transferred
to and substantially vested in Tuff when he exercised his
stock options. RealNetworks issued the shares to Tuff, who
then held legal title to the shares and was entitled to receive
dividends. After Tuff exercised his options, RealNetworks
imposed no further conditions upon his ownership interest. He
had the right to vote the shares. He had the right immediately
to sell the shares, because he exercised his options during
open trading windows. Tuff had the right to pledge the shares
as collateral, and indeed did so to secure his loan from Mor-
gan Stanley.

[4] Under the general rules described above, the transfer of
the stock to Tuff in 1999 was a taxable event. Seeking to
avoid this result, Tuff argues that under the Morgan Stanley
agreement, he received only another option rather than the
shares themselves.

B. Exception for Certain Transfers Treated as the
Grant of an Option

[5] Treasury Regulation § 1.83-3(a)(2) (“section 1.83-
3(a)(2)”) provides that income is not recognized when a
“transfer” of property occurs by treating the exercise of some
stock options as the grant of another option, rather than a
transfer of shares. Section 1.83-3(a)(2) states:

[I]f the amount paid for the transfer of property is an
indebtedness secured by the transferred property, on
which there is no personal liability to pay all or a
substantial part of such indebtedness, such transac-
tion may be in substance the same as the grant of an
option. The determination of the substance of the
transaction shall be based upon all the facts and cir-
cumstances. The factors to be taken into account
19028 UNITED STATES v. TUFF
include 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 pur-
chase price will, in fact, be paid.

26 C.F.R. § 1.83-3(a)(2).

The regulations illustrate how section 1.83-3(a)(2) operates
in this example:

Example (2). On November 17, 1972, W sells to E
100 shares of stock in W corporation with a fair mar-
ket 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.

26 C.F.R. § 1.83-3(a)(7) Example (2) (“Example (2)”).

Attempting to fit this example, Tuff argues that a transfer
occurs within the meaning of I.R.C. § 83 only when an
employee places his own capital “at risk.” Because he paid for
his options with borrowed money, using debt secured by the
stock, Tuff argues he had no capital at risk, and therefore no
 UNITED STATES v. TUFF 19029
transfer occurred until the RealNetworks stock was later sold
to satisfy Morgan Stanley margin calls. We disagree.3

C. Tuff’s Stock Purchases Financed by Third Party
Margin Debt Do Not Qualify for the Treasury
Regulation § 1.83(a)(2) Exception

[6] Section 1.83-3(a)(2) states that a transfer of property
may be the same in substance as the grant of option when the
amount paid in exchange for property “is an indebtedness.” In
this case, RealNetworks transferred stock to Tuff and was
paid in full. RealNetworks never held a note, or any other
form of indebtedness, in exchange for the stock. Nonetheless,
Tuff contends that section 1.83-3(a)(2) and Example (2) turn
on what an employee pays for property, rather than on what
the employer receives. Therefore, Tuff argues, if an employee
borrows money to purchase stock, without placing his own
capital, other than the stock, at risk, no transfer has occurred
within the meaning of I.R.C. § 83. This is nonsense.

Example (2) does not address the source the employee
chooses to fund the payment or what an employee places at
risk. Instead, Example (2) illustrates how a transaction styled
as a sale operates, in substance, to grant an option to purchase
property. Rather than giving the employee an option to pur-
chase stock at a set price for a set time, the employer in
Example (2) actually transfers stock to the employee in
exchange for a note. However, the structure of the transaction
allows the employee to choose whether to finalize the
exchange by paying on the debt. In substance, the employer
3
Although we appear to be the first court of appeals to address these
arguments, we note that both the United States Court of Federal Claims
and the United States Tax Court have recently considered, and rejected,
many of the same arguments Tuff urges here. See Palahnuk v. United
States, 70 Fed. Cl. 87 (2006); Racine v. Comm’r, T.C.M. 2006-162, 2006
WL 2346444 (2006); Hilen v. Comm’r, T.C.M. 2005-226, 2005 WL
2387488 (2005). We largely agree with the analysis undertaken by these
courts.
19030 UNITED STATES v. TUFF
has created, and the employee holds, an option to purchase the
stock at a later time. Contrary to Tuff’s arguments, whether
an employee has capital at risk is entirely irrelevant to the
transaction in Example (2). Instead, Example (2) is concerned
with whether an employer has in substance created an option
to purchase property.

[7] Therefore, when examining the similarity of Example
(2) to Tuff’s purchases, the critical inquiry is what RealNet-
works transferred and when it received payment, not how
Tuff financed his purchases. See Palahnuk v. United States,
70 Fed. Cl. 87, 91-92 (2006).

[8] In Example (2), it is uncertain whether the employer
will receive the full purchase price, and equally uncertain
whether the employer will transfer unconditional ownership
of the stock. In Tuff’s case, unlike Example (2), RealNet-
works received the full purchase price of the stock in
exchange for transferring unconditional ownership to Tuff.
Although Tuff used debt to exercise his options, he borrowed
the money from Morgan Stanley, rather than paying by incur-
ring debt to RealNetworks. If he failed to pay the loan, his
shares were subject to forfeiture to Morgan Stanley, not to
RealNetworks. In light of these fundamental differences
between the instant case and the hypothetical posed in Exam-
ple (2), we reject Tuff’s argument that financing the exercise
of stock options with third party margin debt is in any way
similar to the alternative method of granting employee stock
options described in Example (2).

Not only do Tuff’s purchases fall outside the ambit of
Example (2), but consideration of all the facts and circum-
stances confirms they are not in substance the same as the
grant of an option under 26 C.F.R. § 1.83-3(a)(2). As to the
first factor, Tuff held title to the publicly-trades shares, had
the right to receive dividends, and could vote, sell, and pledge
the shares. Tuff in fact did pledge the shares as collateral for
the margin loan from Morgan Stanley. In these circumstances,
 UNITED STATES v. TUFF 19031
this factor weighs against a claim that Tuff’s purchases were
in any real way similar to the grant of an option.

The second factor in section 1.83-3(a)(2) considers the
extent to which the risk of decline in the value of the property
has been transferred. Tuff argues that he had no capital at risk
because under the Agreement with Morgan Stanley, if the col-
lateral in his account fell below the debt balance multiplied by
1.33, Morgan Stanley would sell the shares to satisfy Tuff’s
debt and thus Tuff would avoid the possibility of a deficiency
ever arising. Thus, Tuff contends, he did not assume the risk
that the value of his stock would decline, and therefore that
risk was never transferred. He is wrong.

[9] Tuff’s “capital at risk” arguments, and the structure of
his Agreement with Morgan Stanley, are entirely beside the
point. The regulation does not require that the risk of decline
in value be transferred to and permanently vested in the
employee, but rather considers only whether it has been trans-
ferred from the employer. 26 C.F.R. § 1.83-3(a)(2). That Tuff
may have later shifted this risk to Morgan Stanley has no
bearing on our inquiry, and we need not entertain Tuff’s argu-
ments under I.R.C. § 465 that his debt to Morgan Stanley was
in the nature of non-recourse debt for which he had no per-
sonal responsibility.4 In this case RealNetworks transferred
the shares to Tuff unconditionally, and with them, all risk that
they might decline in value. The second factor thus also
weighs against concluding that Tuff’s purchases were in sub-
stance the same as the grant of an option.
4
Moreover, Tuff did bear some risk that the RealNetworks shares would
decline in value. The Agreement provided that if the value of the collateral
in Tuff’s account fell below a certain level, he would be required to
deposit additional assets or Morgan Stanley would sell RealNetworks
shares to satisfy the debt. Because this could occur only if the stock
declined in value, Tuff did bear some risk that the stock value would
decline. Furthermore, language in the Agreement made Tuff “personally
liable for any deficiency remaining” after Morgan Stanley sold the Real-
Networks shares.
19032 UNITED STATES v. TUFF
[10] The final factor concerns the likelihood that the pur-
chase price will be paid. In this case Tuff paid the purchase
price in full to RealNetworks upon exercising his options,
thereby extinguishing any possibility that his purchases could
be treated as the grant of an option.

[11] In light of these facts and circumstances, Tuff’s exer-
cise of RealNetworks stock options in 1999 were not similar
in substance to the grant of a stock option, and therefore 26
C.F.R. § 1.83-3(a)(2) does not control this issue. Accordingly,
we hold that a taxable transfer of property within the meaning
of I.R.C. § 83 occurred each time Tuff exercised his RealNet-
works options.

III. BLACKOUT PERIOD AND RECALCULATION

Tuff urges alternatively that he is entitled to have his case
remanded in order for the district court to recalculate his tax
liability incrementally as of the date each blackout period
lapsed. Tuff believes that a unique set of factors allows him
to take advantage of 26 C.F.R. § 1.83-1(e), which states that:

If a person is taxable under section 83(a) when the
property transferred becomes substantially vested
and thereafter the person’s beneficial interest in such
property is nevertheless forfeited pursuant to a lapse
restriction, any loss incurred by such person (but not
by a beneficiary of such person) upon such forfeiture
shall be an ordinary loss to the extent the basis in
such property has been increased as a result of the
recognition of income by such person under section
83(a) with respect to such property.

26 C.F.R. § 1.83-1(e) (emphasis added).

Tuff argues that two different types of events occurred
while he owned the RealNetworks stock at issue which allow
him to utilize the benefit of 26 C.F.R. § 1.83-1(e). First, he
 UNITED STATES v. TUFF 19033
argues that the mere lapse of a blackout period is a taxable
event that “require[s]” him to recognize ordinary, as opposed
to capital, loss because the risk of loss in the market value of
his RealNetworks stock during blackout periods, coupled with
the prohibition on sale during such periods, creates a substan-
tial risk of forfeiture. Second, Tuff argues that sales of his
RealNetworks stock by Morgan Stanley during blackout peri-
ods also “require[s]” him to recognize ordinary loss, because
his property was forfeited pursuant to a lapse restriction. He
cites no relevant authority for this proposition, and we have
found none.

[12] Defining a few key terms is necessary. First, 26 C.F.R.
§ 1.83-3(i) defines a lapse restriction as “a restriction other
than a nonlapse restriction as defined in paragraph (h) of this
section, and includes (but is not limited to) a restriction that
carries a substantial risk of forfeiture.” In other words, it is a
temporary restriction that carries a substantial risk of forfei-
ture. Second, “[a] substantial risk of forfeiture exists where
rights in property that are transferred are conditioned, directly
or indirectly, upon the future performance (or refraining from
performance) of substantial services by any person, or occur-
rence of a condition related to a purpose of the transfer, and
the possibility of forfeiture is substantial if such condition is
not satisfied.” 26 C.F.R. § 1.83-3(c)(1) (emphasis added).
Importantly, however, “[t]he risk that the value of the prop-
erty will decline during a certain period of time does not con-
stitute a substantial risk of forfeiture.” Id.

A. The Mere Lapse of a Blackout Period is not a
Taxable Event Because a Blackout Period is not a Lapse
Restriction

[13] Tuff’s first argument can be disposed of quickly. Tuff
alleges that the blackout periods are a lapse restriction
because, if he were to violate the restriction and sell his stock
during a blackout period, the possibility that his stock would
be forfeited is substantial. In virtually every example provided
19034 UNITED STATES v. TUFF
in the regulations, however, the occurrence of the condition
creating a substantial risk of forfeiture is related, as the regu-
lation requires, to the initial transfer of the property. Section
1.83-3(c)(2) clearly illustrates this important distinction which
Tuff ignores:

Where an employee receives property from an
employer subject to a requirement that it be returned
if the total earnings of the employer do not increase,
such property is subject to a substantial risk of for-
feiture. On the other hand, requirements that the
property be returned to the employer if the employee
is discharged for cause or for committing a crime
will not be considered to result in a substantial risk
of forfeiture.

The first example is a lapse restriction because the condi-
tion, increased earnings, is related to the likely purpose of the
transfer, to motivate the employee to work hard. The second
example is not a lapse restriction because it is difficult to con-
ceive of a way in which the condition, termination for cause
or commission of a crime, could be related to the purpose of
any transfer.

[14] The facts of this case are far more similar to the sec-
ond example than the first. Here, the occurrence of the condi-
tion allegedly creating a substantial risk of forfeiture, the
selling of stock during a blackout period, is not at all related
to the purpose of the transfer. A blackout period is used to
avoid the appearance of impropriety with respect to insider
trading, and Tuff makes no effort to show how this condition
could be related to the purpose of any stock transfer. A major
portion of Tuff’s argument that the blackout periods create a
substantial risk of forfeiture is that they caused him to suffer
a loss in the market value of his RealNetworks stock while he
was prohibited from selling them. As noted, however, the def-
inition of substantial risk of forfeiture expressly excludes the
 UNITED STATES v. TUFF 19035
risk that the property will decline in value. See 26 C.F.R.
§ 1.83-3(c)(1).

Tuff also attempts to demonstrate that the blackout periods
create a substantial risk of forfeiture by way of a comparative
analogy to I.R.C. § 83(c)(3).5 According to Tuff, because
Congress has determined that a civil suit pursuant to § 16(b)
of the Securities Exchange Act of 1934 amounts to a substan-
tial risk of forfeiture, so too should civil suits resulting from
sales of stock during blackout periods. This argument misses
the point entirely.

By enacting I.R.C. § 83(c)(3), Congress demonstrated that
civil suits are not generically covered by I.R.C. § 83. Contrary
to Tuff’s argument, this indicates that for a civil violation to
be considered a substantial risk of forfeiture, Congress must
act specifically to include it within the scope of I.R.C. § 83.
See, e.g., United States v. Lopez-Perera, 438 F.3d 932, 936
(9th Cir. 2006) (explaining that when Congress demonstrates
its understanding of the meaning of a statute through the
enactment of new provisions, that congressionally-ratified
meaning should be applied by the courts). Congress has not
amended I.R.C. § 83 to include civil suits for blackout period
violations in the definition of substantial risk of forfeiture, and
we will not speculate on a hypothetical application.

B. Morgan Stanley’s Sale of Tuff’s Shares Does Not
Satisfy the Requirements of 26 C.F.R. § 1.83-1(e)

[15] The second of Tuff’s arguments is disposed of even
more quickly. According to Tuff, because Morgan Stanley
sold his RealNetworks shares in a margin call during a black-
out period, his RealNetworks shares were forfeited pursuant
5
I.R.C. § 83(c)(3) provides that where the sale of property at a profit
could subject a person to suit under section 16(b) of the Securities
Exchange Act of 1934, the person’s rights in the property are both “sub-
ject to a substantial risk of forfeiture,” and “not transferable.”
19036 UNITED STATES v. TUFF
to a lapse restriction. This argument rests on Tuff’s concep-
tion of the blackout period as a “lapse restriction.” If we were
to assume arguendo that a blackout period could be consid-
ered a lapse restriction, Tuff’s argument fails because he did
not forfeit his RealNetworks stock pursuant to a lapse restric-
tion, but pursuant to the Agreement he freely entered into
with Morgan Stanley. Tuff could have paid down the debt he
owed Morgan Stanley in order to satisfy the margin require-
ments. Had he done so, Tuff would have been able to keep all
his RealNetworks shares, the blackout period notwithstand-
ing. In fact, the purpose of the blackout periods was to ensure
that Tuff retained his RealNetworks stock for the duration of
the blackout period, not to serve as a means to forfeit the
shares. Tuff in effect asks this court to hold that a blackout
period has the exact opposite effect of its intended purpose.
We decline to do so.

IV. CONCLUSION

We affirm the district court’s judgment with respect to both
of Tuff’s grounds of appeal. The taxable transfers occurred
when Tuff exercised his options, and 26 C.F.R. § 1.83-1(e)
does not allow recognition of ordinary losses merely because
the taxpayer’s employer imposes blackout periods to guard
against insider trading.

AFFIRMED