Facq v. Comm'r

T.C. Memo. 2006-111

UNITED STATES TAX COURT

JEAN-REMY FACQ AND JENNIFER HUFF-FACQ, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2757-05. Filed May 23, 2006.

Don Paul Badgley and Brian Gary Isaacson, for petitioners.

Kirk M. Paxson and William C. Schmidt, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KROUPA, Judge: Respondent determined a $6,706,234

deficiency in petitioners’ Federal income taxes and determined

that petitioners were liable for a $1,341,246.80 accuracy-related

penalty under section 6662(a)1 for 2000.2 We are asked to

1
All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
2
Respondent also determined a $73,512 deficiency and
(continued...)
 -2-

decide, after concessions,3 whether petitioners received income

in 2000 when petitioner Jean-Remy Facq4 (Mr. Facq) exercised his

stock options through a margin account and whether petitioners

are liable for the accuracy-related penalty under section 6662(a)

for 2000. We hold that petitioners received income in 2000 when

Mr. Facq exercised his stock options, but petitioners are not

liable for the accuracy-related penalty for 2000.

FINDINGS OF FACT

The parties agree that there is no genuine issue of material

fact regarding the stock option income issue and that decision

may be made as a matter of law. The facts regarding the

accuracy-related penalty have been fully stipulated pursuant to

Rule 122.5 The stipulation of facts and the accompanying

exhibits are incorporated by this reference. Petitioners resided

in Kirkland, Washington, at the time they filed the petition.

2
(...continued)
determined that petitioners were liable for a $14,702.40
accuracy-related penalty for 2001. The parties have resolved all
issues relating to 2001 in a stipulation of settled issues, and
we shall not consider this year further.
3
Petitioners have conceded certain arguments petitioners
made in their petition with respect to the taxability of the
transaction at issue in this case.
4
Petitioner Jennifer Huff-Facq (Mrs. Facq) is a petitioner
in this case because she filed a joint income tax return with her
husband, Jean-Remy Facq, for 2000.
5
This case was originally before the Court on the parties’
motions for partial summary judgment as to the stock option
income issue. At the hearing on the parties’ motions, the
parties informed the Court that the accuracy-related penalty
portion of this case could be fully stipulated for decision.
 -3-

Mr. Facq’s Employment

Mr. Facq is a skilled software designer. After working at

Microsoft in the MSN department for about 5 years, he decided to

leave when Microsoft canceled a project in which he had devoted

significant time during the mid-1990s. He began to talk to other

employees at Microsoft to see whether other opportunities were

available. A friend introduced him to Naveen Jain (Mr. Jain),

another Microsoft employee, who was planning to leave Microsoft

to start a new Internet business with an idea he had. Mr. Facq

was interested in the idea and decided to depart Microsoft and

join Mr. Jain’s new Internet and mobile technologies venture,

InfoSpace, in February 1996.

Mr. Facq and Mr. Jain were the two initial founding

employees of InfoSpace. Mr. Facq was responsible for the

technical aspects of InfoSpace. Mr. Facq created, developed,

maintained, and modified the software and technology InfoSpace

used to generate revenues. For example, Mr. Facq developed and

wrote the Web server, ad server, and user manager service

programs. Mr. Jain, on the other hand, handled the

administrative side of the business. Mr. Jain served as

President and administrative head of InfoSpace, allowing Mr. Facq

to focus on the technical aspects required to make InfoSpace

successful. Mr. Facq’s roles included Chief Technical Officer,

Senior Software Design Engineer, and Chief Systems Architect.
 -4-

The Options

Mr. Facq initially accepted a salary of $45,000 per year

from InfoSpace. In exchange for Mr. Facq’s agreement to work for

a relatively modest base salary, InfoSpace also granted Mr. Facq

options to purchase stock in InfoSpace. InfoSpace first gave Mr.

Facq options to purchase 100,000 shares of InfoSpace stock for

$0.01 per share. InfoSpace increased this offer in April 1996

and granted Mr. Facq options to purchase 300,000 shares of stock

for $0.01 per share. These options vested over a 4-year period

and were exercisable in full after April 10, 2000, if Mr. Facq

continued to work at InfoSpace. These options were granted

pursuant to a nonqualified stock option agreement, which Mr. Facq

signed in 1998. Mrs. Facq also signed a consent of spouse in

1998.

InfoSpace debuted its stock to the public in an initial

public offering (IPO) on December 15, 1998. InfoSpace employees,

including Mr. Facq, could not exercise their options for the

first 6 months after the IPO. Mr. Facq and the other option

holder employees watched the value of the stock climb slowly,

counter to their expectations that the stock would rapidly rise.

In anticipation of the stock’s value increasing, Mr. Facq

prepared to exercise his options. He signed a margin account

agreement with Hambrecht and Quist in February 1999. This

agreement enabled Mr. Facq to borrow money to exercise his

InfoSpace options. He could use the loan proceeds to pay the

exercise price and the amount required to be withheld in taxes.
 -5-

Mr. Facq’s margin account was secured by the shares he would

receive, to be held in the margin account. If the value of the

shares in the margin account decreased below a certain level,

Hambrecht and Quist was authorized (pursuant to the Margin Loan

Agreement, and NASD and SEC rules) to sell the shares to repay

the amount Mr. Facq owed. Mr. Facq was personally liable for

repayment of any shortfall.

In 2000, Mr. Facq used his Hambrecht and Quist account on

several occasions to borrow money to exercise the options.6 Mr.

Facq’s purchases in 2000 are shown in the table below, which also

indicates the exercise prices and the amount of withholding taxes

for each purchase funded through the margin account.

Purchase Shares Exercise Tax Market Value
Date Purchased Price Withholding of Shares
Feb. 7, 2000 56,000 $140 $1,289,589.25 $4,364,500.00
Feb. 15, 2000 144,000 360 4,252,621.23 14,440,500.00
Mar. 7, 2000 100,000 500 7,718,382.64 18,870,429.60
Apr. 17, 2000 200,000 500 2,650,352.75 9,000,000.00
May 24, 2000 200,000 500 2,723,977.75 9,250,000.00
July 28, 2000 50,000 93,750 -- 1,593,750.00

6
The number of shares Mr. Facq purchased is not consistent
with the initial number of shares InfoSpace granted Mr. Facq
because stock splits occurred between the grant of the options
and when Mr. Facq exercised them.
 -6-

Mr. Facq used his margin account not only to borrow the

funds necessary to exercise his options but also to fund the

payments of withholding taxes. He also used the margin account

to borrow money to purchase other items in 1999 and 2000. For

example, he purchased a Dodge Viper, a 53-foot boat, a Ferrari

F50, a Lamborghini Diablo, a condominium in Whistler, British

Columbia, Canada, a house in France for his parents, and a house

in Woodinville, Washington.

Mr. Facq had title to his InfoSpace shares subject to the

interest of Hambrecht and Quist securing the repayment of his

loans. Mr. Facq had the right to vote the shares, to receive

dividends with respect to the shares, and to pledge the shares as

collateral. Mr. Facq generally kept the shares in his margin

account and did not sell them immediately to pay the amount he

owed to Hambrecht and Quist. He was confident in the success of

the business he helped create and anticipated that the stock

would continue to appreciate like many other Internet stocks of

the time.

Unfortunately, the value of the stock declined significantly

in mid-2000. As the value of the stock declined, Hambrecht and

Quist issued Mr. Facq numerous margin calls on his account in

July and August 2000. Mr. Facq had to either deposit funds in

the account or Hambrecht and Quist would sell some of the

InfoSpace stock to cover the outstanding debts. Mr. Facq

accepted a $3 million loan from Mr. Jain and a $3 million loan

from InfoSpace to pay down the margin debt he owed to Hambrecht
 -7-

and Quist and help resolve his precarious financial situation.

The loans from Mr. Jain and InfoSpace were secured by Mr. Facq’s

options and, in the case of the loan from Mr. Jain, Mr. Facq’s

InfoSpace shares.

Despite all the margin calls, Mr. Facq continued to purchase

items using the account. Because the margin account lacked

sufficient assets, Mr. Facq had to accept a $5 million loan from

Mr. Jain to satisfy a contract he made to purchase a home on

Mercer Island, Washington.

Mr. Facq also wanted to keep his shares in InfoSpace in case

the stock rebounded. He tried to borrow from InfoSpace to pay

down the margin loans so that the shares in his margin account

would not be sold to satisfy his debt. This was to no avail,

however. Mr. Facq transferred his account to Salomon Smith

Barney in September 2000. In 2001, Salomon Smith Barney was

forced to sell all the shares of InfoSpace that Mr. Facq owned to

meet the margin requirements.

Petitioners’ Return

Petitioners timely filed their Federal income tax return for

2000. Petitioners reported $46,414,655 of income for the year

and tax due of $18,341,070, while the W-2, Wage and Tax

Statement, from InfoSpace reported that Mr. Facq received

$63,327,671.77 of income in 2000. Petitioners attached a Form

8275, Disclosure Statement, to their return that cited section

1.83-3(k), Income Tax Regs., to explain the approximate $16.9

million difference between the amount of gross income shown on
 -8-

the W-2 versus the amount petitioners reported on their return.

The disclosure statement stated that Mr. Facq’s exercise of his

options was not taxable because the shares he received were

subject to a substantial risk of forfeiture and nontransferable.

Petitioners cited section 1.83-3(k), Income Tax Regs., and

argued that the shares were subject to restrictions on transfer

due to pooling of interest accounting rules. Petitioners have

since conceded that no pooling restrictions applied that made Mr.

Facq’s shares subject to a substantial risk of forfeiture and

nontransferable when he received them in 2000.

Mr. Facq is not educated in the tax laws of the United

States and is not a lawyer or an accountant. He relied on his

accountants, Sweeny Conrad, and his tax attorneys, Chicoine &

Hallett, to prepare the return for 2000 and the accompanying

disclosure statement.

Respondent examined petitioners’ return for 2000 and issued

petitioner a notice of deficiency (deficiency notice) dated

December 22, 2004. Respondent determined in the deficiency

notice that petitioners should have included in income the spread

between the fair market value of the shares and the exercise

price for the shares pursuant to section 83. Respondent

accordingly determined that $25,047,304 was the correct tax

liability, giving rise to a $6.7 million deficiency. Respondent

also determined that petitioners were liable for the accuracy-

related penalty. Petitioners timely filed a petition for review

with this Court.
 -9-

OPINION

I. Receipt of Income on Exercise of Option

We are asked to decide whether petitioners received income

when Mr. Facq exercised his options through a margin account in

2000. Petitioners argue that exercising an option through a

margin account is properly treated as the grant of another option

to buy the shares and that petitioners were thus not taxable when

Mr. Facq exercised his options. Instead, petitioners were

subject to tax when the shares were sold to pay the margin debt.

Petitioners’ arguments are virtually identical to those

decided in this Court, three District Courts, and the Court of

Federal Claims. See Hilen v. Commissioner, T.C. Memo. 2005-226,

appeal docketed, No. 06-70290 (9th Cir., Jan. 19, 2006); Palahnuk

v. United States, 70 Fed. Cl. 87 (2006); United States v. Tuff,

359 F. Supp. 2d 1129 (W.D. Wash. 2005), appeal docketed, No.

05-35195 (9th Cir., Mar. 7, 2005); Facq v. United States, 363 F.

Supp. 2d 1288 (W.D. Wash. 2005), appeal docketed, No. 05-35124

(9th Cir., Feb. 8, 2005); Miller v. United States, 345 F. Supp.

2d 1046 (N.D. Cal. 2004), appeal docketed, No. 04-17470 (9th

Cir., Feb. 7, 2005). Respondent argues that the exception

treating the exercise of an option as the grant of another option

does not apply and that the income was properly reported when Mr.

Facq exercised his options rather than when the shares were sold

to pay off the margin debt. We agree with respondent and with

the holdings in the other cases.
 -10-

We begin with the general rule of taxability of options to

best understand petitioners’ arguments.

A. General Framework

When an employee receives a nonstatutory stock option7 that

does not have a readily ascertainable fair market value, the

employee is not taxed on the receipt of the option at that time,

although it is part of his or her compensation. Sec. 83(e)(3).

Instead, the employee is generally taxed when he or she exercises

the option and receives shares, if the shares have been

transferred to, and are substantially vested in, the employee.

Sec. 83(a); Tanner v. Commissioner, 117 T.C. 237, 242 (2001),

affd. 65 Fed. Appx. 508 (5th Cir. 2003); Hilen v. Commissioner,

supra; sec. 1.83-3(a), Income Tax Regs. The taxpayer must

recognize income in the amount that the fair market value of the

shares he or she receives exceeds the exercise price that he or

she pays. Sec. 83(a).

For the taxpayer to be taxed at the time he or she exercises

the option and receives the shares, the shares must be

transferred to and substantially vested in the employee. Sec.

1.83-3(a), Income Tax Regs. A transfer to the employee occurs

when the employee acquires a beneficial ownership interest in the

property. Miller v. United States, supra at 1049; sec. 1.83-
3(a), Income Tax Regs. The shares are substantially vested in

7
Statutory stock options are compensatory options that meet
certain criteria and are treated differently under the Code. See
sec. 422. Stock options that do not meet the requirements of
statutory stock options are nonstatutory stock options.
 -11-

the employee when the shares are either transferable or not

subject to a substantial risk of forfeiture. Miller v. United

States, supra; sec. 1.83-3(b), Income Tax Regs.

The shares are subject to a substantial risk of forfeiture

when the owner’s rights to their full enjoyment are conditioned

upon the future performance of substantial services by any

individual. Sec. 83(c)(1); Miller v. United States, supra; sec.

1.83-3(c)(1), Income Tax Regs. Whether a risk of forfeiture is

substantial depends on the facts and circumstances. Sec. 1.83-

3(c)(1), Income Tax Regs. The shares are transferable only if a

transferee’s rights in the property are not subject to a

substantial risk of forfeiture. Sec. 83(c)(2); sec. 1.83-3(d),

Income Tax Regs. Property is transferable if the person

receiving the property can sell, assign, and pledge his or her

interest in the property to any person other than the transferor

and if the transferee is not required to give up the property in

the event a substantial risk of forfeiture materializes. Sec.

1.83-3(d), Income Tax Regs.

B. Application of Framework to Mr. Facq’s Options

Mr. Facq received nonstatutory stock options in 1996 and was

not taxed then. We must consider whether, instead, petitioners

are taxed when Mr. Facq exercised his options and received

InfoSpace shares in 2000.8

8
There is no longer a dispute whether the InfoSpace shares
were substantially vested in Mr. Facq when he exercised them in
2000. Petitioners alleged in their petition that the shares were
subject to a substantial risk of forfeiture and nontransferable
(continued...)
 -12-

The parties dispute whether there was a transfer of the

shares to Mr. Facq when Mr. Facq exercised his options. Mr. Facq

acquired beneficial ownership of the shares when he exercised his

options in 2000. He obtained legal title to the shares. He was

entitled to receive dividends, vote the shares, and pledge the

shares as collateral. Mr. Facq’s rights were subject only to

Hambrecht and Quist’s interest as the margin account provider.

See sec. 1.83-3(a), Income Tax Regs.

Without considering any exceptions, the shares would be

treated as transferred and thus taxable to Mr. Facq under the

general rule when he exercised his options because he acquired

beneficial ownership of the InfoSpace shares. See Miller v.
United States, supra at 1050. Accordingly, the shares would be

taxable when Mr. Facq exercised his options in 2000. Petitioners

argue, however, that we should not treat the shares as

transferred to Mr. Facq, because an exception to this general

rule applies. If petitioners are correct that the exception

applies, there would be no transfer and Mr. Facq would not be

subject to tax in 2000. See sec. 83(a).

8
(...continued)
because the shares were subject to transfer restrictions under
the pooling of interest accounting rules, but have since conceded
this issue. Petitioners also alleged in their petition that the
shares were subject to a substantial risk of forfeiture and
nontransferable because Mr. Facq was subject to liability under
sec. 16(b) of the Securities Exchange Act of 1934, but they have
conceded this as well. See sec. 83(c). Petitioners raise no
other arguments that the shares were not substantially vested in
Mr. Facq in 2000.
 -13-

C. Exception Treating Certain Transfers as the Grant of an
Option

An exception to the general rule treats certain exercises of

options and receipts of shares as the grant of another option

instead of a transfer of shares. Sec. 1.83-3(a)(2), Income Tax

Regs. The exception treats the transaction as another option

where the amount paid for the exercise is a debt secured by the

shares on which there is no personal liability. Id. Whether a

transaction is viewed in substance as the grant of an option

rather than a transfer depends on the facts and circumstances.

Id. This analysis includes factors such as the type of property

involved, the extent to which the risk the property will decline

in value has been transferred, and the likelihood that the

purchase price will be paid. Id.

Petitioners argue that their situation is the same as that

described in section 1.83-3(a)(7), Example (2), Income Tax Regs.

(Example 2), where an employee pays his or her employer for

shares by giving the employer a note for the purchase price on

which the employee has no personal liability. See sec. 1.83-

3(a)(7), Example (2), Income Tax Regs. Petitioners contend that

because the employee in Example 2 is treated as having received

an option, petitioners should also be treated as having received

an option.

Petitioners argue the key factor to be considered is whether

an employee has capital at risk. If the employee has no capital

at risk, they argue, the transaction is in substance the grant of

an option regardless of whether the debt is to the employer or to
 -14-

a margin account provider. According to petitioners, Congress

intended to deny capital gains treatment to those who do not make

any capital investment in their options. See Palahnuk v. United

States, 70 Fed. Cl. at 92. In keeping with their argument,

petitioners note that Mr. Facq exercised his options using a loan

from Hambrecht and Quist and therefore Mr. Facq had no capital at

risk. Accordingly, petitioners argue, no transfer occurred until

Hambrecht and Quist sold the stock to satisfy the margin calls on

Mr. Facq’s account.

We disagree with petitioners’ position. Example 2's focus

is on what the employer transferred or received in exchange, not

on what the employee has at risk.9 Palahnuk v. United States,

supra. Example 2 describes an alternative method of providing an

employee an option to purchase property. Palahnuk v. United

States, supra; sec. 1.83-3(a)(7), Example (2), Income Tax Regs.

Rather than grant the employee an option, the employer makes

stock available to the employee in exchange for a note. Sec.

1.83-3(a)(7), Example (2), Income Tax Regs. Although the

transaction is referred to as a sale, in reality the employee has

received an option. Id. The employee may acquire the stock

later if the employee chooses by paying the note. Palahnuk v.

Commissioner, supra; sec. 1.83-3(a)(7), Example (2), Income Tax

Regs.

9
In fact, options with a readily ascertainable fair market
value are taxed at the time of grant, when the employee has no
capital at risk. Sec. 83(e)(3), (4); Palahnuk v. United States,
70 Fed. Cl. 87, 93 (2006).
 -15-

Petitioners ignore a key feature of Example 2: there, it is

not certain whether the employee will pay the debt to the

employer (i.e., exercise the employee’s option to purchase the

stock). Palahnuk v. United States, supra. Unlike Example 2, it

was certain when Mr. Facq exercised his options that InfoSpace

would receive the cash in full satisfaction of the exercise

price. Mr. Facq borrowed money from Hambrecht and Quist, not

InfoSpace, to exercise his options. If he failed to pay the

loan, the shares would be (and eventually were) forfeited to the

margin account provider, who would sell the shares. Mr. Facq’s

shares in InfoSpace would not go back to InfoSpace regardless of

what Mr. Facq did. See Palahnuk v. United States, supra. The

transaction at issue in this case is therefore not similar to the

transaction described in Example 2. See Hilen v. Commissioner,

T.C. Memo. 2005-226; Palahnuk v. United States, supra; sec. 1.83-

3(a)(7), Example (2), Income Tax Regs.

Moreover, the transaction at issue here is not in substance

the same as a grant of an option. See Hilen v. Commissioner,

supra; sec. 1.83-3(a)(2), Income Tax Regs. As noted previously,

we, as well as three District Courts and the Court of Federal

Claims, have since found that the purchase of stock with third-

party margin debt under similar circumstances is not in substance

the same as the grant of an option. Hilen v. Commissioner,
supra; Palahnuk v. United States, supra; United States v. Tuff,

359 F. Supp. 2d 1129 (W.D. Wash. 2005); Facq v. United States,

363 F. Supp. 2d 1288 (W.D. Wash. 2005); Miller v. United States,
 -16-

345 F. Supp. 2d at 1046. In particular, the District Court for

the Western District of Washington decided this same issue with

respect to Mr. Facq’s refund action for 1999. Facq v. United

States, supra. We agree with the analyses of the three factors10

and the holdings in these opinions and find that Mr. Facq’s

transaction was not in substance the same as the grant of an

option.

We now analyze the three factors. First, the type of

property involved is publicly traded shares of stock. Mr. Facq

had title to the shares (subject to the interest of Hambrecht and

Quist because the shares were in the margin account), and had the

right to receive dividends, to vote the shares, and to pledge the

shares. In fact, Mr. Facq did pledge the shares to Hambrecht and

Quist as collateral for the margin loans. This factor weighs

against finding that the transaction is, in substance, similar to

the grant of an option. See Hilen v. Commissioner, supra;

Palahnuk v. United States, supra; Miller v. United States, supra

at 1050-1051.

We next consider whether the risk that the property will

decline in value has been transferred. Sec. 1.83-3(a)(2), Income

Tax Regs. Petitioners argue that we should concentrate on

whether Mr. Facq was personally liable for the margin loans.

They argue that he was not because Hambrecht and Quist required

10
The factors to be considered 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 the
purchase price will be paid. Sec. 1.83-3(a)(2), Income Tax Regs.
 -17-

Mr. Facq to keep a certain value in the margin account, and if

the value of the shares declined below that specified value, Mr.

Facq would have to deposit additional assets or the shares would

be sold.11 We disagree with petitioner’s interpretation of the

risk transfer factor. The proper inquiry is not whether the

taxpayer was personally liable, but whether the risk of a decline

in value of the shares was transferred from the employer.

Palahnuk v. United States, 70 Fed. Cl. at 93. When InfoSpace

transferred the shares, it no longer bore the risk of a decline

in value. Either Hambrecht and Quist or Mr. Facq bore that risk.

We need not determine whether it was Hambrecht and Quist or Mr.

Facq; either way, InfoSpace no longer had the risk.12 Palahnuk

v. United States, supra; Facq v. United States, supra.

Accordingly, this factor weighs against finding that the

substance of the transaction was the same as the grant of an

option. Palahnuk v. United States, supra.

11
Petitioners also encourage us to consider sec. 465 in
determining whether Mr. Facq was personally liable to Hambrecht
and Quist for the margin loan. We decline to consider sec. 465
in this context because that section pertains to deductions.
Facq v. United States, 363 F. Supp. 2d 1288, 1290-1291 (W.D. Wa.
2005); United States v. Tuff, 359 F. Supp. 2d 1129, 1135-1136
(W.D. Wa. 2005); Miller v. United States, 345 F. Supp. 2d 1046,
1051 (N.D. Cal. 2004).
12
We note that Mr. Facq did bear some risk that the value of
the InfoSpace shares would decline. If the balance in his margin
account declined, Mr. Facq would have to take steps to retain his
shares. He would have to deposit additional assets or the stock
would be sold. These facts indicate that Mr. Facq bore some risk
that the value of the stock would decline. See Hilen v.
Commissioner, T.C. Memo. 2005-226; Facq v. United States, supra;
Miller v. United States, supra.
 -18-

We finally consider the likelihood the purchase price will

be paid. Sec. 1.83-3(a)(2), Income Tax Regs. This factor

examines whether the purchase price for the property is paid, not

whether the indebtedness incurred to pay the purchase price will

be paid. Hilen v. Commissioner, supra; Facq v. United States,

supra; Miller v. United States, supra. InfoSpace received the

exercise price of the shares (plus amounts from Mr. Facq’s margin

account to fund the tax withholding payments) when Mr. Facq

exercised his options. Accordingly, this factor also weighs

against finding that the substance of the transaction was the

same as the grant of an option. Hilen v. Commissioner, supra.

In summary, the facts and circumstances, including the three

specified factors, indicate that in substance, Mr. Facq’s use of

his margin account to exercise his options to buy InfoSpace stock

was not the same as the grant of an option. See Hilen v.

Commissioner, supra; Palahnuk v. United States, supra; Facq v.

United States, supra; Miller v. United States, supra.

We therefore find that a transfer of stock occurred under

section 83 when Mr. Facq exercised his stock options in 2000 and

that the exception treating some transfers as grants of options

does not apply to this case. We accordingly sustain respondent’s

determination that Mr. Facq received income in 2000 when he

exercised his options.

We next consider whether petitioners are liable for the

accuracy-related penalty.
 -19-

II. Accuracy-Related Penalty

Respondent determined that petitioners are liable for the

accuracy-related penalty due to negligence or disregard of rules

and regulations.13 See sec. 6662(b)(1). Respondent

alternatively determined that petitioners were liable for the

accuracy-related penalty because they substantially understated

their tax.14 See sec. 6662(b)(2).

We note that this is the first time the Commissioner is

asserting the penalty in cases involving stock purchased through

a margin account. Hilen v. Commissioner, T.C. Memo. 2005-226;

Facq v. United States, 363 F. Supp. 2d 1288 (W.D. Wash. 2005);

Miller v. United States, 345 F. Supp. 2d 1046 (N.D. Cal. 2004);

Palahnuk v. United States, supra.

While respondent bears the initial burden of production as

to the accuracy-related penalty and must come forward with

sufficient evidence that it is appropriate to impose the penalty,

the taxpayer bears the burden of proof as to any exception to the

accuracy-related penalty. See sec. 7491(c); Rule 142(a); Higbee

v. Commissioner, 116 T.C. 438, 446-447 (2001). One such

13
Negligence is the lack of due care or failure to do what a
reasonable and ordinarily prudent person would do under the same
circumstances. Neely v. Commissioner, 85 T.C. 934 (1985).
Disregard is characterized as any careless, reckless, or
intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(1) and
(2), Income Tax Regs.
14
There is a substantial understatement of tax if the amount
of the understatement exceeds the greater of either 10 percent of
the tax required to be shown on the return, or $5,000. Sec.
6662(a), (b)(1) and (2), (d)(1)(A); sec. 1.6662-4(a) and (b)(1),
Income Tax Regs.
 -20-

exception to the accuracy-related penalty applies to any portion

of an underpayment if the taxpayer can prove that there was

reasonable cause for the taxpayer’s position and that the

taxpayer acted in good faith with respect to that portion. Sec.

6664(c)(1); sec. 1.6664-4(b), Income Tax Regs.

The determination of whether a taxpayer acted with

reasonable cause and in good faith depends on the pertinent facts

and circumstances, including the taxpayer’s efforts to assess his

or her proper tax liability, the knowledge and experience of the

taxpayer, and the reliance on the advice of a professional. Sec.

1.6664-4(b)(1), Income Tax Regs. When a taxpayer selects a

competent tax adviser and supplies him or her with all relevant

information, it is consistent with ordinary business care and

prudence to rely upon the adviser’s professional judgment as to

the taxpayer’s tax obligations. United States v. Boyle, 469 U.S.

241, 250-251 (1985). Moreover, a taxpayer who seeks the advice

of an adviser does not have to challenge the adviser’s

conclusions, seek a second opinion, or try to check the advice by

reviewing the tax code himself or herself. Id.

Mr. Facq knew he was not educated in United States tax law

and decided to seek professional assistance in preparing

petitioners’ returns. He retained tax attorneys, Chicoine &

Hallett, and accountants, Sweeny Conrad, and relied upon them to

accurately and properly prepare a return for 2000. We find

nothing in the record to indicate that it was unreasonable for

Mr. Facq to accept the advice of his advisers and not to seek a
 -21-

second opinion. See id. (such a requirement would nullify the

purpose of seeking the advice of an expert in the first place).

Furthermore, the cases on whether a taxpayer realized gain on the

stock purchased with third-party margin debt had yet to be

litigated at the time petitioners filed the return for 2000.

There was therefore no definitive authority to guide petitioners

on whether they could exclude approximately $16.9 million of gain

from stock acquired with third-party margin debt. Because the

issue, at the time they filed their return, was novel, we find

that petitioners had reasonable cause and acted in good faith in

excluding the gain when they filed their return. See Williams v.

Commissioner, 123 T.C. 144 (2004) (declining to impose a penalty

involving issue of first impression and the interrelationship

between complex tax and bankruptcy laws). We do not find

subsequent adverse caselaw to be relevant in considering whether

petitioners had reasonable cause and acted in good faith with

respect to the understatement when they filed their return.15

We find, therefore, that petitioners have carried their

burden that they had reasonable cause and acted in good faith to

15
The mere fact that we held against petitioners on the
substantive issue does not, in and of itself, require holding for
respondent on the penalty. See Hitchins v. Commissioner, 103
T.C. 711, 719-720 (1994) (“Indeed, we have specifically refused
to impose * * * [a penalty] where it appeared that the issue was
one not previously considered by the Court and the statutory
language was not entirely clear.”).
 -22-

exclude the gain of approximately $16.9 million at the time they

filed their return.16

Conclusion

After careful consideration of the facts and circumstances

of this case, we sustain respondent’s deficiency determination

but find that petitioners are not liable for the accuracy-related

penalty under section 6662(a).

To reflect the foregoing,

An order and decision

will be entered for respondent

as to the deficiency but for

petitioners as to the penalty.

16
Petitioners also urged us to conclude that the penalty
portion of the deficiency notice was null and void because
respondent “automatically” asserted the accuracy-related penalty
without first considering whether any exceptions applied.
Petitioners, therefore, are essentially asking us to peer behind
the deficiency notice, which we generally do not do and will not
do in this case. See Scar v. Commissioner, 814 F.2d 1363, 1368
(9th Cir. 1987), revg. 81 T.C. 855 (1983); Edwards v.
Commissioner, T.C. Memo. 2002-169, affd. on unrelated issue 119
Fed. Appx. 293 (D.C. Cir. 2005); Corcoran v. Commissioner, T.C.
Memo. 2002-18 (and cases cited therein), affd. 54 Fed. Appx. 254
(9th Cir., 2002). Specifically, petitioners’ reliance on Scar,
is misplaced. Scar explicitly states that the Commissioner need
not explain how the determinations were made. This Court and the
Court of Appeals, for the Ninth Circuit have limited the
invalidation of a deficiency notice under Scar to circumstances
where the deficiency notice reveals on its face that the
Commissioner failed to make a determination. See Clapp v.
Commissioner, 875 F.2d 1396, 1402 (9th Cir. 1989); Campbell v.
Commissioner, 90 T.C. 110 (1988); Edwards v. Commissioner, supra.