Svoboda v. Comm'r

T.C. Memo. 2006-235

UNITED STATES TAX COURT

JORGE O. AND CLELIA E. SVOBODA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13195-04. Filed November 2, 2006.

Jorge O. and Clelia E. Svoboda, pro sese.

Karen Nicholson Sommers, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined an income tax deficiency

and an accuracy-related penalty under section 6662(a)1 with

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986 as in effect for the taxable
year in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
 - 2 -

respect to petitioners' 2002 taxable year. After concessions,2

the issues for decision are: (1) Whether petitioner Jorge O.

Svoboda received compensation income of $73,374 from his employer

Fluor Corporation (Fluor) upon his exercise of stock options, and

sale of the acquired stock, during the taxable year; and (2)

whether petitioners are liable for an accuracy-related penalty

under section 6662(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. At the time they filed

the petition, petitioners Jorge O. Svoboda (petitioner) and

Clelia E. Svoboda (Mrs. Svoboda) resided in San Clemente,

California.

Petitioner was born in Chile in 1941 and emigrated to the

United States more than 40 years ago. After moving to the United

States, petitioner earned a master's degree in business

2
Petitioners have conceded that they are not entitled to
any deduction for contributions to an individual retirement
account and that they failed to report taxable dividends of
$6.00. Respondent has conceded that petitioners did not have
unreported income with respect to a State income tax refund.
Petitioners have also conceded that, in the event respondent's
determinations in the notice of deficiency are sustained (except
with respect to the State income tax refund), petitioners are
liable for an increased deficiency and increased addition to tax
when their liability for the alternative minimum tax is taken
into account.
 - 3 -

administration. Petitioner was employed by Fluor as an

electrical engineer and manager from September 1966 until

February 2002. He remained a consultant to Fluor after his

retirement until 2004.3 Petitioner has also taught applied

economics.

Fluor granted stock options to petitioner at various times

during 1994 through 1998 pursuant to its "Executive Incentive

Performance Plan". On two occasions in 2002, petitioner acted

through a brokerage firm to exercise certain of his stock options

and immediately sell the acquired shares at the market price.

Petitioner accomplished these transactions through a process

known as the Cashless Exercise Program (CEP) at the brokerage

firm Morgan Stanley Dean Witter & Co. (Morgan Stanley). The CEP

was designed to allow participants to obtain the value of their

stock options without having to advance the purchase price for

the stock upon exercise of the option. Under the CEP, petitioner

would direct Morgan Stanley to exercise specified stock options

of his and immediately sell the acquired stock at the prevailing

market price. Petitioner would then receive the proceeds of the

sale less the stock's acquisition cost (at the option price),

withholding taxes, and brokerage commissions.

3
The record does not disclose whether petitioner performed
these consulting services as an employee of Fluor or as an
independent contractor.
 - 4 -

The first stock option transaction took place on February

25, 2002. Petitioner directed Morgan Stanley to exercise options

and sell the acquired stock for options that had been granted to

him on December 6, 1994 (939 shares), December 9, 1997 (1,078

shares), and December 8, 1998 (2,346 shares). Fluor provided to

petitioner an accounting of the February 25, 2002, transaction

entitled "Computation Worksheet for Non-Qualified Stock Option

Exercise for Shares". The worksheet recorded that the option

exercise resulted in the acquisition of the aforementioned 4,363

shares at a cost of $102,968.11 and their sale at a $165,367.70

fair market value on the exercise date. The difference,

$62,399.59, was recorded by Fluor on the worksheet as the "wage

element" of the transaction. Fluor withheld amounts for Federal

and State income and employment taxes from petitioner's

$62,399.59 proceeds.

The second stock option transaction took place on July 10,

2002. Petitioner directed Morgan Stanley to exercise options and

sell the acquired stock for options that had been granted to him

on September 11, 1995 (1,078 shares) and December 8, 1998 (783

shares). Fluor provided to petitioner an accounting of the July

10, 2002, transaction also entitled "Computation Worksheet for

Non-Qualified Stock Option Exercise for Shares". The worksheet

recorded that the option exercise resulted in the acquisition of

the aforementioned 1,861 shares at a cost of $55,946.43 and their
 - 5 -

sale at a $66,921.56 fair market value on the exercise date. The

difference, $10,975.13, was recorded by Fluor on the worksheet as

"taxable compensation" from the transaction. Fluor withheld

amounts for Federal and State income and employment taxes from

petitioner's $10,975.13 proceeds.

Fluor issued petitioner a Form W-2, Wage and Tax Statement,

for 2002 that reported $102,226.81 under "Wages, tips, other

compensation". The parties have stipulated that this amount

represents the sum of $28,852.09 paid as salary to petitioner in

2002, the $62,399.59 in proceeds from the February 25, 2002,

stock option transaction, and the $10,975.13 in proceeds from the

July 10, 2002, stock option transaction. The Form W-2 reported

$73,374.72 (i.e., the sum of the foregoing proceeds from stock

option transactions) as an amount under "Nonqualified plans".

Following petitioner's receipt of the Form W-2, he contacted

the payroll department at Fluor. Petitioner indicated his belief

that the stock option transaction proceeds resulted in capital

gain rather than compensation income and inquired as to why those

amounts were included in the figure for "Wages, tips, other

compensation" on the Form W-2. Petitioner was advised by the
 - 6 -

Fluor payroll department that this was the manner in which the

company reported such transactions.

Petitioner prepared petitioners' Federal income tax return

for 2002. To reflect his belief that the Form W-2 issued to him

by Fluor had incorrectly listed the stock option transaction

proceeds as compensation income, petitioner placed a handwritten

notation on the copy of the Form W-2 attached to petitioners'

2002 return. That notation indicated that the $102,226.81 amount

listed under "Wages, tips, other compensation" consisted of

"WAGES $28,852 CAPITAL GAINS $73,645".4

Petitioners reported a total of $65,690 as wages on the 2002

return, including $28,852.09 in wages for petitioner and

$36,837.55 in wages for Mrs. Svoboda. Petitioner reported on

Schedule D, Capital Gains and Losses, of the 2002 return what he

calculated as the net result of the February and July 2002 stock

option transactions; namely $51,4695 of long-term capital gain,

4
Petitioner appears to have made a mathematical error in
calculating his "Capital Gains" figure, as $73,645 plus $28,852
does not equal the $102,226.81 amount listed on the Form W-2.
5
There are two errors underlying this figure. First, the
parties stipulated that the long-term capital gain that
petitioners reported on Schedule D of their 2002 return from the
2002 stock option transactions was $56,949. However, the
Schedule D is part of the record, and it demonstrates that the
reported gain from the stock options transactions was $51,469.
The figure to which the parties stipulated resulted from the
erroneous treatment of a $2,740 loss on one block of Fluor stock
as a gain, producing the $5,480 ($2,740 x 2) discrepancy between
(continued...)
 - 7 -

treating the date of the options' grant as the acquisition date

of the stock and the date of option exercise and sale as the sale

date.

Following notification by respondent that the 2002 return

was under examination, petitioner made several efforts to

investigate the proper tax treatment of the two stock option

transactions. In the course of his subsequent discussions with

Internal Revenue Service personnel, petitioner was referred to

IRS Publication 525, Taxable and Nontaxable Income.

5
(...continued)
$56,949 and $51,469. We are not bound by stipulations of fact
that appear contrary to the facts disclosed by the record, see
Rule 91(e); Blohm v. Commissioner, 994 F.2d 1542, 1553 (11th Cir.
1993), affg. T.C. Memo. 1991-636, and accordingly find that
petitioners reported $51,469 of long-term capital gain from the
Fluor stock option transactions in 2002.
Second, petitioner conceded at trial that the sales price
for the same block of Fluor stock was incorrectly reported on the
Schedule D as $19,025 when it should have been $40,859, which
results in a gain of $19,093 rather than the reported loss of
$2,740. (Respondent described the correct gain as $19,025, but
the documentary evidence suggests the gain is $19,093.) When a
gain of approximately $19,000 is substituted for the reported
loss of $2,740, the net long-term gain arising from petitioners'
reporting of the Fluor stock option transactions approximates the
$73,374.72 in proceeds from "Nonqualified plans" reported on the
Form W-2 issued by Fluor to petitioner. We expect the parties to
address any remaining discrepancies in their Rule 155
computations.
 - 8 -

OPINION

Income on Exercise of Stock Options

Respondent determined that petitioners' 2002 return

understated his compensation income by $73,374, an amount

representing the aggregate difference between the option prices

and sales prices of the Fluor stock petitioner acquired and sold

in 2002 pursuant to stock options. Petitioners contend that the

foregoing amount is capital gain because it was realized from the

sale of stock acquired pursuant to incentive stock options.

Generally, the income tax treatment of the grant of an

option to purchase stock in connection with the performance of

services, and the transfer of stock pursuant to the exercise of

such an option, is determined under section 83(a) and the

regulations thereunder. Such stock options are known as

"nonqualified stock options" or "nonstatutory stock options".

The receipt of a nonqualified stock option does not generate

income in the recipient unless the option has a readily

ascertainable fair market value.6 Instead, the recipient's

exercise of the nonqualified option to acquire stock gives rise

to gross income at the time of exercise, equal to the amount by

which the fair market value of the stock at the exercise date

6
Neither party contends that the stock options held by
petitioner had a "readily ascertainable fair market value" at the
time that Fluor granted the options to petitioner. See sec. 83;
sec. 1.83-1(a), Income Tax Regs.; sec. 1.83-7(a), Income Tax
Regs.
 - 9 -

exceeds the option price that he or she pays. Sec. 83(a); Racine

v. Commissioner, T.C. Memo. 2006-162; sec. 1.83-7(a), Income Tax

Regs. The recipient thereupon obtains a basis in the acquired

stock equal to the option price plus any amount includible in

gross income as a result of the option exercise. Any gain or

loss upon the subsequent sale of the stock will be capital in

character. Secs. 1001, 1221(a); sec. 1.83-4(b)(1), Income Tax

Regs.

Certain employee stock options qualify for alternative

treatment under the provisions of section 421. Specifically,

section 421 applies to options that qualify as incentive stock

options (ISOs) under section 422 (and to options that are issued

pursuant to an employee stock purchase plan as defined in section

423). When the applicable section 422 requirements for an ISO

are met, section 421 provides that no income shall result at the

time of the transfer of stock upon the exercise of the option.

Sec. 421(a)(1). The stock acquired through the ISO exercise will

generally qualify as a capital asset in the hands of the

employee, and the difference between the amount received on

disposition of the stock and the employee's basis will be capital

in character. Secs. 1001(a), 1221 and 1222; Spitz v.

Commissioner, T.C. Memo. 2006-168; sec. 14a.422A-1, Q&A-1,

Temporary Income Tax Regs., 46 Fed. Reg. 61840 (Dec. 21, 1981).

However, if the stock acquired pursuant to an ISO is disposed of
 - 10 -

by the option holder within 2 years of the granting of the option

or within 1 year after the stock's transfer to him, section 421

does not apply, and the stock's acquisition and sale are taxed

under the provisions of section 83. Sec. 422(a)(1); Spitz v.

Commissioner, supra; sec. 14a.422A-1, Q&A-2(a), Temporary Income

Tax Regs., 46 Fed. Reg. 61840 (Dec. 21, 1981).

Petitioners contend that petitioner acquired the Fluor stock

at issue pursuant to ISOs. Their only evidence for this claim is

petitioner's testimony to that effect. All other evidence in the

record points to the contrary conclusion that the options

petitioner held were nonqualified options. The computation

worksheets provided to petitioner by Fluor concerning the two

stock option transactions were each entitled "Computation

Worksheet for Non-Qualified Stock Option Exercise for Shares",

and each described the difference between the option price and

the fair market value of the stock at exercise as either the

"wage element" or "taxable compensation". The Form W-2 issued by

Fluor to petitioner reported the proceeds from the stock option

transactions under the "Nonqualified plans" category. Finally,

Fluor collected withholding taxes with respect to the proceeds,

which would not have been required with respect to the

disposition of stock acquired pursuant to an ISO.7 See Notice

7
Moreover, had petitioner been granted ISOs (as he claims)
which were exercised in 2002, he would have had alternative
minimum taxable income in 2002 measured by the excess of the
(continued...)
 - 11 -

2001-14, 2001-1 C.B. 516.

While on this record we are not persuaded that petitioner

held ISOs, the result in this case is the same whether the stock

was acquired pursuant to ISOs or nonqualified stock options.

That is because it is undisputed that in both transactions

petitioner exercised his option to acquire the stock, and sold

the stock, on the same day. Thus, if one assumes petitioner held

ISOs, he nonetheless would have forfeited the deferral and

capital gains treatment provided in section 421(a), by virtue of

his sale of the stock on the day it was transferred to him, in

violation of the 1-year holding period mandated in section

422(a)(1). As a consequence, he would have realized ordinary

income upon the disposition of the stock, under section 83(a),

equal to the difference between the option price and the fair

market value of the stock on the date of exercise. Sec. 421(b);

Spitz v. Commissioner, supra; sec. 14a.422A-1, Q&A-2(a),

Temporary Income Tax Regs., 46 Fed. Reg. 61840 (Dec. 21, 1981).

Alternatively, if one assumes petitioner held nonqualified

stock options, then petitioners were required to recognize

ordinary income, under section 83(a), upon the transfer of the

stock to petitioner in 2002 pursuant to the exercise of his

7
(...continued)
Flour stock's fair market value on the exercise date over the
exercise price. See Merlo v. Commissioner, 126 T.C. 205, 209
(2006).
 - 12 -

options, equal to the difference between the option price and the

fair market value of the stock on the date of transfer.

Petitioner's sale of the stock on the same day generates no gain,

as his basis in the stock (consisting of his option price and the

amount of ordinary income recognized under section 83(a)) equaled

his sales price.

Petitioner contends, however, that his Fluor stock options

were ISOs and that he satisfied the holding period of section

422(a)(1). That section provides as follows:

SEC. 422. INCENTIVE STOCK OPTIONS

(a) In General.--Section 421(a) shall apply with
respect to the transfer of a share of stock to an
individual pursuant to his exercise of an incentive
stock option if--

(1) no disposition of such share is made
by him within 2 years from the date of the
granting of the option nor within 1 year
after the transfer of such share to him * * *

IRS Publication 525 (as applicable for the preparation of 2002

Federal income tax returns) provides an explanation of the

section 422(a)(1) holding period requirement as follows:

If you receive a statutory stock option, do not
include any amount in your income either when the
option is granted or when you exercise it. You have
taxable income or deductible loss when you sell the
stock that you bought by exercising the option. Your
income or loss is the difference between the amount you
paid for the stock (the option price) and the amount
you receive when you sell it. You generally treat this
amount as capital gain or loss and report it on
Schedule D (Form 1040), Capital Gains and Losses, for
 - 13 -

the year of the sale.

However, you may have ordinary income for the year
that you sell the stock in either of the following
situations.
• You do not meet the holding period
requirement. This situation applies only if
you sell the stock within 1 year after its
transfer to you or within 2 years after the
option was granted.

Relying on Publication 525, petitioner interprets the section

422(a)(1) holding period provision as affording taxpayers a

"choice": a taxpayer may comply with the holding period either

by holding the option for 2 years after its grant, or by holding

the stock for 1 year after its acquisition pursuant to the

option.8 In other words, petitioner interprets the two

disjunctive holding periods as alternative qualifying conditions;

that is, if either period is satisfied, then the holding period

requirement is met. Therefore, in petitioner's view, he

qualifies by virtue of his disposal of the stock more than 2

years after the grant of the options.

Neither section 422(a)(1), nor its explication in

Publication 525, is susceptible to the interpretation advocated

by petitioner. The language of section 422(a) is plain and

clear:

Section 421(a) shall apply with respect to the transfer
of a share of stock to an individual pursuant to his

8
Petitioners' view of the language, as they argue on brief,
is that "The word OR means a choice".
 - 14 -

exercise of an incentive stock option if--

(1) no disposition of such share is made by
him within 2 years from the date of the
granting of the option nor within 1 year
after the transfer of such share to him * * *
[Emphasis added.]

The language of Publication 525 is no less plain and clear: "You

do not meet the holding period requirement * * * if you sell the

stock within 1 year after its transfer to you or within 2 years

after the option was granted." Thus, contrary to petitioner's

interpretation, the two disjunctive holding periods are alternate

disqualifying conditions; that is, if either obtains, section

421(a) does not apply. Since petitioner did not satisfy the one-

year-after-transfer holding period, section 421(a) does not apply

to the transfer of the Fluor stock to him.

We accordingly sustain respondent's determination that

petitioners failed to report $73,374 of compensation income in

2002.

Accuracy-Related Penalty

Respondent determined that petitioners were liable for a

section 6662(a) accuracy-related penalty based on a substantial

understatement of income tax. See sec. 6662(a) and (b)(2). A

"substantial understatement" exists for this purpose if the

amount of tax required to be shown on the return exceeds that
 - 15 -

shown by the greater of 10 percent of the tax required to be

shown or $5,000. Sec. 6662(d)(1)(A).

The Commissioner has the burden of production under section

7491(c) with respect to the liability of any individual for a

penalty imposed by the Internal Revenue Code and must come

forward with sufficient evidence indicating that it is

appropriate to impose the penalty. See Higbee v. Commissioner,

116 T.C. 438, 446-447 (2001). Once the Commissioner meets his

burden of production, the taxpayer must come forward with

persuasive evidence that the Commissioner's determination as to

the penalties is incorrect or that the taxpayer had reasonable

cause or substantial authority for his position. See id. at 447;

sec. 1.6664-4, Income Tax Regs.

We have sustained respondent's determination of a $73,374

increase in petitioner's taxable wages for tax year 2002.9 In

petitioners' circumstances, the omission10 would produce an

understatement exceeding the greater of $5,000 or 10 percent of

the tax required to be shown on their return. Accordingly,

9
Petitioners' reporting of the proceeds from the stock
option transactions as capital gains did not offset this
omission, as the capital gains claimed with respect to the stock
option transactions were absorbed by petitioners' reported
capital losses in excess of $300,000.
10
Petitioners have also conceded that they were not
entitled to a $7,000 deduction claimed with respect to an IRA
contribution. Petitioners have offered no argument to the effect
that the portion of the underpayment attributable to this item is
due to reasonable cause or any other mitigating factor.
 - 16 -

respondent has satisfied his burden of production, and

petitioners bear the burden of establishing the applicability of

the reasonable cause exception.

A penalty under section 6662(a) will not be imposed with

respect to any portion of the underpayment as to which the

taxpayer acted with reasonable cause and in good faith. Sec.

6664(c)(1). The decision as to whether a taxpayer acted with

reasonable cause and in good faith is made by taking into account

all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1),

Income Tax Regs.

The regulations interpreting section 6664(c)(1) provide:

The determination of whether a taxpayer acted with
reasonable cause and in good faith is made on a case-by-case
basis, taking into account all pertinent facts and
circumstances. * * * Generally, the most important factor is
the extent of the taxpayer's effort to assess the taxpayer's
proper tax liability. Circumstances that may indicate
reasonable cause and good faith include an honest
misunderstanding of fact or law that is reasonable in light
of all the facts and circumstances, including the
experience, knowledge and education of the taxpayer. * * *
[Sec. 1.6664-4(b)(1), Income Tax Regs.]

Petitioner emigrated to the United States more than 40 years

ago and earned a master's degree in business administration after

doing so. He was employed as an electrical engineer and manager

by Fluor Corporation for many years and has taught applied

economics.
 - 17 -

Petitioner argues, in defense of his reporting of the stock

option transactions as capital gain, that the income he received

on account of the stock options was at risk from the time the

options were granted until they were exercised. By contrast,

petitioner argues, wage income is not at comparable risk. Thus,

petitioner believes, stock options are more akin to a capital

asset giving rise to capital gain than an item of compensation

income. From an economic perspective, wherein petitioner's

experience lies, there is some foundation for his position.

Employee stock options are, however, given in exchange for

services, and compensation for services generates ordinary income

for Federal income tax purposes. Consequently, the Federal

income tax treatment of employee stock options is a thornier

issue than petitioner's observations would allow. Nonetheless,

we conclude, in light of all the facts and circumstances, that

petitioner's reporting of the income from the stock option

transactions constituted an honest misunderstanding of the law

that is reasonable in light of his experience, knowledge, and

education. Consequently, there was reasonable cause for the

understatement attributable to the failure to report the stock

option proceeds as compensation income.

To reflect the foregoing, and after concessions by both

parties,

Decision will be entered

under Rule 155.