T.C. Memo. 2005-178
UNITED STATES TAX COURT
ROBERT J. MERLO, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21538-03. Filed July 20, 2005.
Brian G. Isaacson and Don Paul Badgley, for petitioner.
Sandra Veliz, for respondent.
MEMORANDUM OPINION
HAINES, Judge: This case is before the Court on the
parties’ cross-motions for partial summary judgment pursuant to
Rule 121.1 The issues for decision are: (1) Whether
petitioner’s rights to shares of stock of Exodus Communications,
1
Unless otherwise indicated, Rule references are to the Tax
Court Rules of Practice and Procedure, and section references are
to the Internal Revenue Code, as amended.
- 2 -
Inc. (Exodus) he acquired during 2000 as a result of exercising
an incentive stock option (ISO) were subject to a substantial
risk of forfeiture; and (2) whether petitioner is entitled to an
alternative tax net operating loss (ATNOL) deduction under
section 56(d).
Background
At the time he filed his petition, petitioner resided in
Dallas, Texas.
On July 2, 1999, petitioner commenced work for Service
Metrics, Inc. (SMI), as Vice President of Marketing. On July 14,
1999, SMI granted petitioner a stock option to purchase 275,000
shares of SMI common stock.
On November 19, 1999, petitioner entered into an employment
agreement with Exodus. On November 23, 1999, Exodus acquired
SMI. Pursuant to the reorganization agreement, petitioner’s SMI
stock option was assumed by Exodus and was converted into an
option to purchase shares of Exodus common stock.
According to the Exodus prospectus entitled “Stock Options
Granted Under the Service Metrics, Inc. 1998 Stock Option Plan
Assumed by Exodus Communications, Inc.”:
The Service Metrics Plan generally does not impose
any restrictions on the resale of shares of Common
Stock purchased under the Service Metrics Plan. * * *
In accordance with federal law and Exodus’ policy
prohibiting insider trading, you [petitioner] are
always prohibited from trading in Exodus securities
when you [petitioner] have inside information.
- 3 -
The Exodus Procedures and Guidelines Governing Securities
Trades by Company Personnel (Exodus Procedures) states in
pertinent part:
It is illegal for any Director, officer or employee of
Exodus communications, Inc. (the “Company”), to trade
in the securities of the Company while in the
possession of material nonpublic information about the
Company. * * *
* * * * * * *
Violation of this policy or federal or state insider
trading or tipping laws by any Director, officer or
employee may subject a Director to dismissal
proceedings and an officer or employee to disciplinary
action by [Exodus] up to and including termination for
cause.
The Exodus Procedures contain no requirement that petitioner
return the stock to Exodus if he attempted to sell his stock in
violation of its insider trading policy.
On August 28, 2000, petitioner and Exodus entered into a
Settlement Agreement and General Release, effective as of August
4, 2000, under which petitioner ceased to hold the position of
Vice President, Marketing of Exodus. On December 21, 2000,
petitioner exercised his ISO to purchase 46,125 shares of Exodus
common stock. Petitioner’s employment with Exodus terminated on
December 31, 2000.
- 4 -
Exodus filed bankruptcy on September 26, 2001. In a press
release dated November 12, 2001, Exodus announced that the
company’s common stock had no value.
On his 2000 Form, 1040, U.S. Individual Income Tax Return,
petitioner included in his alternative taxable income for
alternative minimum tax (AMT) purposes $452,025, the excess of
the price for Exodus common stock reported on NASDAQ on April 15,
2001, over the price he paid for the stock. Petitioner did not
use the stock’s fair market value on the December 21, 2000, ISO
exercise date. Instead, petitioner filed Form 8275-R, Regulation
Disclosure Statement, disclosing that he relied on proposed
legislation H.R. 2794, 107th Cong., 1st Sess. (2001), then
pending in Congress, to use the stock’s fair market value on
April 15, 2001. The proposed legislation would have allowed
taxpayers to use the difference between the amount paid for
shares purchased pursuant to the exercise of an ISO during 2000
and the fair market value of such shares on April 15, 2001, for
purposes of computing their AMT. H.R. 2794, 107th Cong., 1st
Sess. (2001), was never enacted.
On November 13, 2003, respondent mailed petitioner a notice
of deficiency, in which respondent determined a deficiency of
$4,833 in petitioner’s 1999 Federal income tax and a deficiency
of $169,510 in petitioner’s 2000 Federal income tax. In the
notice of deficiency respondent stated:
- 5 -
The fair market value of Exodus Communications, Inc.
common stock, at the date that certain stock options
were exercised (December 21, 2000) was $23.25 per share
instead of the amount used to compute the
adjustments/preferences on [F]orm 6251 of the income
tax return. Therefore, the amount of the
adjustment/preference is $1,057,415.00 instead of the
$452,025.00 reported on the return. * * *
On December 4, 2003, prior to filing a petition for
redetermination of the notice of deficiency, petitioner filed a
Form 1040X, Amended U.S. Individual Income Tax Return for 2000,
reducing his alternative taxable income for AMT purposes by
$452,025, the excess of the price for Exodus common stock
reported on NASDAQ on April 15, 2001, over the price he paid for
the stock, thereby eliminating the $116,973 of AMT reported on
his 2000 Federal income tax return and claiming a tax refund of
$149,757. Under Part II, Explanation of Changes to Income,
Deductions, and Credits, of the 2000 amended Federal income tax
return, petitioner stated: “Return adjusted to reflect shares
subject to substantial risk of forfeiture and non-transferable.”
Petitioner filed a petition for redetermination of the
notice of deficiency for the year 2000 with the Court on December
18, 2003.
On December 27, 2004, respondent filed a motion for partial
summary judgment on the issue of whether petitioner’s rights to
shares of stock of Exodus he acquired during 2000 as a result of
exercising an ISO were subject to a substantial risk of
forfeiture.
- 6 -
On December 28, 2004, petitioner filed with the Court a
cross-motion for partial summary judgment in petitioner’s favor
that: (1) Petitioner’s rights to shares of stock acquired during
2000 as a result of exercising an ISO were subject to a
substantial risk of forfeiture; and (2) petitioner is entitled to
an ATNOL deduction under section 56(d).
Discussion
Summary judgment is intended to expedite litigation and
avoid unnecessary and expensive trials. Fla. Peach Corp. v.
Commissioner, 90 T.C. 678, 681 (1988). The Court may grant
partial summary judgment when there are no genuine issues of
material fact and a decision may be rendered as a matter of law.
Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520
(1992), affd. 17 F.3d 965 (7th Cir. 1994); Zaentz v.
Commissioner, 90 T.C. 753, 754 (1988). We conclude that there is
no genuine issue of material fact as to whether petitioner’s
right to shares of Exodus stock was subject to a substantial risk
of forfeiture and that a decision may be rendered as a matter of
law. We also conclude there is a material issue of fact as to
whether petitioner is entitled to an ATNOL deduction under
section 56(d).
Petitioner admits that petitioner’s stock option meets the
requirements of section 422 and qualifies as an ISO. Under
section 421(a), a taxpayer is allowed to defer regular tax on
- 7 -
income resulting from a stock option meeting the requirements of
section 422 or 423 until the taxpayer sells the shares of stock.
Were our inquiry to end here petitioner would not have been
required to recognize any gain until he disposed of the shares of
stock he acquired by exercising his ISO. Our inquiry cannot end
here because of the application of the AMT.
Under section 56(b)(3), “Section 421 shall not apply to the
transfer of stock acquired pursuant to the exercise of an
incentive stock option (as defined in section 422).” Therefore,
for AMT purposes, shares of stock acquired by exercising a stock
option that qualifies as an ISO under section 422 are treated as
shares of stock acquired by means of exercising a nonqualified
stock option under section 83. See sec. 56(b)(3); sec. 1.83-
7(a), Income Tax Regs.; see also Speltz v. Commissioner, 124 T.C.
(2005) (slip op. at 22-23).
Under section 83, a taxpayer generally must recognize income
when he exercises a compensatory stock option to the extent that
the fair market value of the shares of stock transferred to him
exceeds the price he pays at the time he exercises the option if
the taxpayer’s rights in the shares are transferable or not
subject to a substantial risk of forfeiture.2 Sec. 83(a); Tanner
2
Section 83(a) provides:
SEC. 83(a) General Rule.–-If, in connection with
the performance of services, property is transferred to
(continued...)
- 8 -
v. Commissioner, 117 T.C. 237, 242 (2001), affd. 65 Fed. Appx.
508 (5th Cir. 2003); sec. 1.83-7(a), Income Tax Regs.
Caselaw establishes that a restriction on the
transferability of property does not affect the timing of income
inclusion or the amount of income required to be included under
section 83 if the property is not subject to a substantial risk
of forfeiture. See Pledger v. Commissioner, 71 T.C. 618 (1979),
affd. 641 F.2d 287 (5th Cir. 1981); Sakol v. Commissioner, 67
T.C. 986 (1977), affd. 574 F.2d 694 (2d Cir. 1978); Koss v.
Commissioner, T.C. Memo. 1989-330, affd. 908 F.2d 962 (3d Cir.
1990).
Under section 83(c)(3), if a taxpayer selling his shares of
stock could be subject to a suit under section 16(b) of the
2
(...continued)
any person other than the person for whom such services
are performed, the excess of--
(1) the fair market value of such property
(determined without regard to any restriction other
than a restriction which by its terms will never lapse)
at the first time the rights of the person having the
beneficial interest in such property are transferable
or are not subject to a substantial risk of forfeiture,
whichever occurs earlier, over
(2) the amount (if any) paid for such property,
shall be included in the gross income of the person who
performed such services in the first taxable year in
which the rights of the person having the beneficial
interest in such property are transferable or are not
subject to a substantial risk of forfeiture, whichever
is applicable. * * *
- 9 -
Securities Exchange Act of 1934, ch. 404, 48 Stat. 896, “such
person’s rights in such property are (A) subject to a substantial
risk of forfeiture”. Section 83(c)(3) does not apply beyond the
initial 6-month period provided in section 16(b) of the
Securities Exchange Act of 1934. Tanner v. Commissioner, supra
at 245-256.
Petitioner does not claim that he would have been subject to
liability under section 16(b) of the Securities Exchange Act of
1934.
A taxpayer’s right to his shares of stock may be subject to
a substantial risk of forfeiture if his rights to full enjoyment
of the shares of stock is conditioned upon the future performance
of substantial services. Sec. 83(c)(1). The record is devoid of
any facts that show petitioner’s right to full enjoyment of his
shares of Exodus stock was conditioned upon the future
performance of substantial services.
Petitioner alleges his shares of Exodus stock were subject
to a substantial risk of forfeiture and not freely transferable
because they were blacked out from trading by reason of Exodus’s
insider trading policy. In his brief, petitioner relies on
Robinson v. Commissioner, 805 F.2d 38 (1st Cir. 1986), revg. 82
T.C. 444 (1984).
The Court of Appeals for the First Circuit in Robinson v.
Commissioner, supra at 40-41, held that a taxpayer’s shares of
- 10 -
stock were subject to a substantial risk of forfeiture until a
1-year sellback provision lapsed. The employer in Robinson could
have compelled its employee to sell the shares of stock back to
it at the price the employee paid at the time he exercised his
stock option if the employee attempted to sell the shares of
stock within a year of exercising his stock option.
Robinson is distinguishable from the instant case on its
facts. Petitioner has not shown that Exodus could have ever
compelled him to return his shares of stock. The remedy chosen
expressly by Exodus to enforce its insider trading policy was not
a forfeiture of the shares, but disciplinary proceedings against
the offending employee, up to and including involuntary
termination of employment.
The Court of Appeals for the Ninth Circuit, citing section
1.83-3(c)(1), Income Tax Regs., has noted that “The risk of
forfeiture analysis requires a court to determine the chances the
employee will lose his rights in property transferred by his
employer.” Theophilos v. Commissioner, 85 F.3d 440, 447 n.18
(9th Cir. 1996), revg. on another issue T.C. Memo. 1994-45.
The evidence in the instant case shows that petitioner had
no substantial risk of losing the rights to his shares of Exodus
stock. There is no evidence that Exodus could have ever
compelled petitioner to return his shares after he exercised his
ISO; no sellback provision is present; nor is there any evidence
- 11 -
that Exodus could have compelled petitioner to forfeit his shares
of stock.
In consequence of the foregoing, we hold that petitioner’s
rights to his shares of Exodus stock were not subject to a
substantial risk of forfeiture. We therefore shall grant
respondent’s motion for partial summary judgment.
Petitioner also alleges that he is entitled to an ATNOL
deduction under section 56(d). An ATNOL deduction is the net
operating loss deduction allowable for the taxable year under
section 172 and is computed by taking into consideration all the
adjustments to taxable income under sections 56 and 58 and all
the preference items under section 57 (but only to the extent
that the items increased the net operating loss for the year for
regular tax purposes). Sec. 56(d)(1). Section 172 defines the
net operating loss as “the excess of the deductions allowed by
this chapter over the gross income.” Sec. 172(c). In the case
of a noncorporate taxpayer, 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. Sec. 172(d)(2)(A). In addition, where
deductions are not attributable to the taxpayer’s trade or
business, the deductions generally will be allowed only to the
extent of the amount of the gross income not derived from the
taxpayer’s trade or business. Sec. 172(d)(4).
- 12 -
Determination of whether petitioner is entitled to such
deduction is based upon facts and circumstances which are not
before the Court. Granting of the motion for summary judgment
with respect to this issue would be premature, because material
issues of fact exist, not the least of which is whether
petitioner was engaged in his activity as an investor or trader.
We therefore shall deny petitioner’s motion for summary judgment
as to whether he is entitled to an ATNOL deduction under section
56(d).
In reaching our holdings herein, we have considered all
arguments made, and to the extent not mentioned above, we
conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing,
An appropriate order
will be issued.