T.C. Memo. 2005-226
UNITED STATES TAX COURT
KEITH D. HILEN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21768-03. Filed September 29, 2005.
Brian G. Isaacson and Duncan C. Turner, for petitioner.
Sandra Veliz, for respondent.
MEMORANDUM OPINION
HAINES, Judge: This case is before the Court on the
parties’ cross-motions for summary judgment pursuant to Rule
121.1 The issue for decision is whether petitioner received
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. Amounts are
rounded to the nearest dollar.
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gross income from the exercise of nonstatutory stock options in
1999.
Background
At the time of the filing of the petition in this case,
petitioner resided in Santa Rosa, California.
In May 1995, petitioner commenced work for Strategic
Concepts Corp. Strategic Concepts Corp. later changed its name
to InsWeb Corp. (InsWeb).
As part of his compensation package, petitioner received
grants of options to purchase InsWeb common stock. Each grant
gave petitioner the right to purchase a specified number of
InsWeb shares for a specified price per share at a future date.
To exercise his stock options, petitioner was required to notify
InsWeb in writing and make arrangements to pay InsWeb an amount
sufficient to cover the exercise price and any Federal, State,
and local taxes InsWeb was required to withhold from wages.
On November 15, 1998, petitioner’s employment with InsWeb
was terminated. However, petitioner entered into a consulting
relationship with InsWeb and was employed as a consultant under
his separation agreement from November 15, 1998, to September 30,
1999. Because petitioner’s employment was terminated, under the
terms of his option agreements the last day that he was able to
exercise his stock options was December 31, 1999.
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On July 23, 1999, InsWeb had an initial public offering of
its stock.
On August 26, 1999, petitioner signed a promissory note and
a security agreement for a $250,000 loan from Comerica Bank-
California (Comerica) to exercise his stock options, pledging the
shares of InsWeb common stock he would receive as collateral.
The security agreement provided that, if petitioner was found to
be in default, Comerica could sell the collateral and apply the
proceeds to the outstanding balance on the indebtedness. The
security agreement also stated that after such sale the “Debtor
shall remain liable for any deficiency, which it shall pay to
Bank immediately upon demand”. During 1999 and 2000, petitioner
had a checking account with Comerica. At all times relevant to
this case, Comerica and InsWeb were separate corporate entities.
On September 7, 1999, petitioner partially exercised one of
his nonstatutory stock options, option No. 106, to purchase
20,000 shares of InsWeb common stock. The fair market value of
the stock petitioner received was $572,500. Petitioner paid an
exercise price to InsWeb of $26,000.
Petitioner exercised option No. 106 again on December 30,
1999, to purchase 11,250 shares of InsWeb common stock. The fair
market value of the stock petitioner received was $285,469. The
exercise price petitioner paid to InsWeb was $14,625.
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On December 30, 1999, petitioner also exercised another of
his nonstatutory stock options, option No. 17, to purchase 23,625
shares of InsWeb common stock. The fair market value of the
stock petitioner received was $599,484. The exercise price
petitioner paid to InsWeb was $11,813.
Petitioner paid InsWeb for the shares of common stock with
checks from his Comerica checking account.
The stock certificates petitioner received included a
restrictive legend that stated the shares could not be
transferred, sold, or otherwise disposed of before January 18,
2000. Despite this, petitioner had the right to receive
dividends and exercise his voting rights with respect to the
shares.
On October 21, 2000, petitioner filed a Form 1040, U.S.
Individual Income Tax Return, for 1999. Petitioner reported
wages of $1,448,531. Attached to petitioner’s income tax return
was a Form W-2, Wage and Tax Statement, from InsWeb reporting
wages of $1,435,031, which included the spread between the
exercise prices and the fair market values of the stock he
received when he exercised his nonstatutory stock options on
September 7, 1999, and December 30, 1999.
Petitioner defaulted on his Comerica loan, and Comerica
issued a notice of private sale of collateral dated December 21,
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2000, to sell the shares of InsWeb common stock petitioner had
pledged as collateral.
On February 7, 2001, petitioner filed a Form 1040X, Amended
U.S. Individual Income Tax Return, for 1999 claiming a refund of
$108,488. In the amended return petitioner reduced the amount of
wage income from InsWeb by the spread between the fair market
value and the exercise price he paid for shares of stock he
received when he exercised his nonstatutory stock options on
December 30, 1999.
On September 19, 2001, petitioner filed for chapter 7
bankruptcy in the Bankruptcy Court for the Northern District of
California. In his bankruptcy schedules, petitioner listed
Comerica as a creditor. Petitioner also stated in his schedules
that Comerica had filed suit against him to collect on the
promissory note.
Petitioner filed a second Form 1040X for 1999 on August 4,
2003, claiming a refund of $404,537. In the second amended
return petitioner reduced the amount of wage income from InsWeb
by the spread between the fair market value and the exercise
price he paid for shares of stock he received when he exercised
his nonstatutory stock options on September 7 and December 30,
1999.
On October 1, 2003, respondent sent petitioner a notice of
deficiency in which respondent denied petitioner’s claim for
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refund and determined petitioner had received additional capital
gains of $6,941 and had a tax deficiency of $1,470 for 1999.
On December 27, 2004, respondent filed a motion for partial
summary judgment in respondent’s favor upon the issue of whether
petitioner received gross income from the exercise of his
nonstatutory stock options in 1999.2
On December 30, 2004, petitioner filed a cross-motion for
summary judgment.
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
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 are no genuine
issues of material fact as to whether petitioner received gross
income from the exercise of nonstatutory stock options in 1999
and that a decision may be rendered as a matter of law.
2
Petitioner has since conceded that he received $6,941 of
capital gains in addition to the amount he had reported on his
Federal tax return for 1999, which was the remaining issue not
covered by respondent’s motion for partial summary judgment.
Therefore, respondent’s motion shall be treated as a motion for
summary judgment.
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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 exercise price he pays if the taxpayer’s rights in
the shares are transferable or not subject to a substantial risk
of forfeiture. Sec. 83(a); Tanner v. Commissioner, 117 T.C. 237,
242 (2001), affd. 65 Fed. Appx. 508 (5th Cir. 2003); sec. 1.83-
7(a), Income Tax Regs.
Section 83(a) provides:
SEC. 83(a). General Rule.–-If, in connection with
the performance of services, property is transferred to
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. * * *
Petitioner alleges that, because he exercised his
nonstatutory stock options with “essentially nonrecourse
financing”, the recognition of his gain would be delayed until he
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made a substantial payment on the debt. Petitioner argues that
the exercise of his nonstatutory stock options falls under
section 1.83-3(a)(2), Income Tax Regs., which provides: “The
grant of an option to purchase certain property does not
constitute a transfer of such property.” While the instant case
concerns whether petitioner recognized income upon exercise of
his nonstatutory stock options, not upon the grant of those
options to him, petitioner’s argument is that because he used a
loan from Comerica to exercise his nonstatutory stock options,
he, in effect, received options to buy the shares of stock.
Petitioner relies on the further clarification provided by
the regulation:
if 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
transaction may be in substance the same as the grant
of an option. * * * [Sec. 1.83-3(a)(2), Income Tax
Regs.]
The regulation also suggests that “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”
should be taken into consideration in determining whether a
transfer has occurred. Id.
In addition, petitioner cites section 1.83-3(a)(7), Example
(2), Income Tax Regs., and argues that when an employee exercises
stock options using nonrecourse debt, he does not bear the risk
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of decline in value except to the extent he or she makes payments
toward the principal of the debt.
Section 1.83-3(a)(7), Example (2), Income Tax Regs., is
distinguishable from the present case. In the example, the
employee received shares of stock from his employer in exchange
for a nonrecourse note. In this case, the indebtedness was not
owed to the employer, InsWeb, but to an unrelated third party.
Also contrary to the example, petitioner was personally liable to
Comerica.
The facts do not support petitioner’s assertion that when he
received his shares of InsWeb common stock, he in effect received
only options to purchase InsWeb common stock at a future date.
The amount petitioner paid InsWeb was not indebtedness of any
nature. Rather, petitioner paid InsWeb in full by checks for the
exercise prices as well as the required withholding amounts for
taxes. In addition, the type of property transferred was shares
of stock which he actually received. After exercising his
nonstatutory stock options, petitioner had the right to receive
dividends and the right to vote with respect to the shares of
stock he purchased. Thus, petitioner did not receive another
option but instead received shares of stock.
Furthermore, petitioner incurred personal liability to pay
all of the debt secured by the shares. There was no provision in
the promissory note or security agreement which limited
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petitioner’s liability to repay Comerica. In fact, Comerica
filed suit to collect on its note, forcing petitioner into
chapter 7 bankruptcy.
Therefore, the shares of InsWeb common stock were
“transferred” to petitioner, within the meaning of section 1.83-
3(a), Income Tax Regs., when petitioner exercised his
nonstatutory stock options.
Petitioner next alleges the proper date of transfer for
determination of tax is January 18, 2000, instead of September 7
and December 30, 1999. Petitioner argues his rights to the
shares of InsWeb common stock he acquired through exercising his
nonstatutory stock options were nontransferable and subject to a
substantial risk of forfeiture under section 1.83-3(c), Income
Tax Regs., because of the restrictive legend on the stock
certificates. In his brief, petitioner relies on Robinson v.
Commissioner, 805 F.2d 38 (1st Cir. 1986), revg. 82 T.C. 444
(1984).
In Robinson v. Commissioner, supra at 40-41, the Court of
Appeals for the First Circuit held that a taxpayer’s shares of
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
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stock option if the employee had 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 was not subject to a sellback provision that
required him to return the shares of stock to InsWeb in the event
he attempted to sell the stock before January 18, 2000.
For a taxpayer to be allowed to defer recognition of income,
section 83(a) requires that shares of stock be both
nontransferable and subject to a substantial risk of forfeiture.
Petitioner was not prohibited from pledging his shares of InsWeb
common stock as collateral. This may be taken as an indicium
that petitioner’s shares of InsWeb common stock, upon receipt,
were transferable within the meaning of section 1.83-3(d), Income
Tax Regs. See Tanner v. Commissioner, 117 T.C. 237, 242 (2001),
affd. 65 Fed. Appx. 508 (5th Cir. 2003).
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. without published
opinion 908 F.2d 962 (3d Cir. 1990).
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A taxpayer’s right to his shares of stock may be subject to
a substantial risk of forfeiture if his right 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 showing that petitioner’s right to full enjoyment of
his shares of InsWeb common stock was conditioned upon the future
performance of substantial services.
Petitioner also alleges a substantial risk of forfeiture
existed because he was prohibited from transferring his shares as
their fair market value declined. Section 1.83-3(c)(1), Income
Tax Regs., however, specifically provides that the risk that the
value of property will decline during a certain period does not
constitute a substantial risk of forfeiture.
The Court of Appeals for the Ninth Circuit, citing section
1.83-3(c)(1), Income Tax Regs., has noted: “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.
Although petitioner was restricted from transferring his
shares of stock until after January 18, 2000, the evidence shows
that petitioner had no substantial risk of losing the rights to
his shares of InsWeb common stock. There is no evidence that
InsWeb could have compelled him to return his shares of stock; no
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sellback provision is present; nor is there any evidence that
InsWeb could have compelled petitioner to forfeit his shares of
stock.3
Finally, petitioner alleges that his inability to sell his
shares of InsWeb common stock as their fair market value declined
resulted in his beneficial interests in the shares having been
“constructively forfeited” under section 1.83-1(e), Income Tax
Regs.
Section 1.83-1(e), Income Tax Regs., provides:
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 * * *
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.
Section 1.83-1(e), Income Tax Regs., is not applicable to
petitioner’s case. There is no evidence of forfeiture pursuant
to a lapse restriction, nor was petitioner’s right to the shares
3
Under sec. 83(c)(3), if a taxpayer selling his shares of
stock at a profit could be subject to a suit under the Securities
Exchange Act of 1934, ch. 404, sec. 16(b), 48 Stat. 896 (current
version at 15 U.S.C. sec. 78p(b)(2000)), “such person’s rights in
such property are (A) subject to a substantial risk of
forfeiture, and (B) not transferable.” Sec. 83(c)(3) does not
apply beyond the initial 6-month period provided in sec. 16(b) of
the Securities Exchange Act of 1934. Tanner v. Commissioner, 117
T.C. 237, 245-256 (2001), affd. 65 Fed. Appx. 508 (5th Cir.
2003).
Petitioner does not claim that he would have been subject to
liability under sec. 16(b) of the Securities Exchange Act of 1934
upon sale of his shares of InsWeb common stock at a profit.
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of InsWeb common stock subject to a substantial risk of
forfeiture. Petitioner’s shares of stock were not forfeited but
were sold to pay Comerica when he filed for bankruptcy.
In consequence of the foregoing, we hold petitioner received
gross income from the exercise of his nonstatutory stock options
in 1999.
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
and decision will be entered.