Walter v. Comm'r

T.C. Memo. 2007-2

UNITED STATES TAX COURT

EDWARD L. WALTER AND JAMIE K. WALTER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8321-05. Filed January 3, 2007.

Deborah R. Jaffe and Robert M. McCallum, for petitioners.

Julie L. Payne, for respondent.

MEMORANDUM OPINION

LARO, Judge: This case is before the Court for decision

without trial. See Rule 122.1 Petitioners petitioned the Court

to redetermine respondent’s determination of a $167,401

1
Rule references are to the Tax Court Rules of Practice and
Procedure. Unless otherwise indicated, section references are to
the applicable versions of the Internal Revenue Code.
 -2-

deficiency in their 2000 Federal income tax and an addition to

tax of $5,197.70 under section 6651(a). After concessions by

respondent, we are left to decide the date on which to value

stock transferred to Edward Walter (petitioner) through his

exercise of stock options. Respondent argues that the

appropriate valuation date is July 14, 2000. Petitioners argue

that the appropriate valuation date is July 18, 2000. We agree

with respondent.

Background

All facts were stipulated or contained in the exhibits

submitted therewith. We find the facts accordingly. At the time

of the filing of the petition herein, petitioners resided on

Bainbridge Island, Washington.

Stock Option Grants

Petitioner was employed by Primus Knowledge Solutions Inc.

(Primus), until his employment terminated on May 5, 2000. As an

employee of Primus, petitioner was granted three separate options

to purchase its publicly traded common stock. More specifically,

respective stock option letter agreements dated February 4, 1999,

granted petitioner a nonqualified stock option (first option) to

purchase 78,182 shares of Primus stock, a nonqualified stock

option (second option) to purchase 16,666 shares of Primus stock,

and an incentive stock option (third option) to purchase 48,484

shares of Primus stock. The exercise price under each of these
 -3-

options was $8.25 per share. As of July 2000, petitioner was

sufficiently vested to purchase 27,676 of the shares mentioned in

the first option, 5,899 of the shares mentioned in the second

option, and 17,163 of the shares mentioned in the third option.

The stock option letter agreements pertaining to the first

and second options provided for payment of the exercise price of

the shares described therein as follows:

The option may be exercised by the delivery of: (a)
Cash, personal check (unless, at the time of exercise,
the Plan Administrator[2] determines otherwise), bank
certified or cashier’s check; or (b) Unless the Plan
Administrator in its sole discretion determines
otherwise, shares of the capital stock of the Company
held by you for a period of at least six months having
a fair market value at the time of exercise, as
determined in good faith by the Plan Administrator,
equal to the exercise price. * * * As a condition to
the exercise of a non-qualified stock option, you shall
make such arrangements as the Company may require for
the satisfaction of any federal, state or local
withholding tax obligations that may arise in
connection with such exercise.

The stock option letter agreement pertaining to the third option

provided for payment of the exercise price of the shares

described therein as follows:

Unless the Plan administrator at any time determines
otherwise, the option may be exercised by the delivery
of: (a) Cash, personal check, bank certified or
cashier’s check; or (b) Shares of the capital stock of
the Company held by you for a period of at least six
months having a fair market value at the time of

2
Primus’s 1995 Stock Incentive Compensation Plan (the
1995 Plan) defined the “Plan Administrator” as Primus’s board of
directors or any properly designated committee of the board.
 -4-

exercise, as determined in good faith by the Plan
Administrator, equal to the exercise price.

1995 Stock Incentive Compensation Plan

The stock options granted by the three stock option letter

agreements were granted pursuant to the 1995 Plan, and each of

those agreements incorporated the 1995 Plan by reference.

Section 7.4 of the 1995 Plan states that an optionee may exercise

his or her stock options “by written notice to the Company, in

accordance with procedures established by the Plan Administrator,

setting forth the number of shares with respect to which the

Option is being exercised and accompanied by payment in full as

described in Section 7.5 of the Plan.” Section 7.5 of the 1995

Plan states that payment in full may be made by the following

means:

The exercise price for shares purchased under an Option
shall be paid in full to the Company [Primus] by
delivery of consideration equal to the product of the
Option exercise price and the number of shares
purchased. Such consideration must be paid in cash,
except that the Plan Administrator may, either at the
time the Option is granted or at any time before it is
exercised and subject to such limitations as the Plan
Administrator may determine, authorize payment in cash
and/or one or more of the following alternative forms:
(i) Common Stock already owned by the Holder for at
least six months (or any shorter period necessary to
avoid a charge to the Company’s earnings for financial
reporting purposes) having a Fair Market Value on the
day prior to the exercise date equal to the aggregate
Option exercise price; (ii) a promissory note
authorized pursuant to Section 11 of the Plan; (iii) if
the Common Stock is publicly traded, delivery of a
properly executed exercise notice, together with
irrevocable instructions, to (a) a brokerage firm
designated by the Company to deliver promptly to the
 -5-

Company the aggregate amount of sale or loan proceeds
to pay the Option exercise price and any withholding
tax obligations that may arise in connection with the
exercise and (b) the Company to deliver the
certificates for such purchased shares directly to such
brokerage firm, all in accordance with the regulations
of the Federal Reserve Board; or (iv) such other
consideration as the Plan Administrator may permit.

Section 14 of the 1995 Plan states that Primus may require an

optionee to pay Primus the amount of any withholding tax that

Primus is required to withhold with respect to the grant,

exercise, payment, or settlement of the option. The 1995 Plan

does not provide for postponing the delivery of shares of stock

to an optionee who exercises a stock option.

Petitioner’s Piper Jaffray Account

During all periods relevant to this case, U.S. Bancorp Piper

Jaffray (Piper Jaffray) was a brokerage firm designated by Primus

as one authorized to pay the optionee’s exercise price and

receive the optionee’s certificates for purchased shares. On

July 13, 2000, petitioner opened an asset management account at

Piper Jaffray. Petitioner stated on the application that his

annual income was $150,000, that his net worth, excluding his

home, was more than $999,000, and that his liquid net worth

(e.g., his cash and securities holdings) totaled $500,000. The

account gave petitioner “automatic access to credit extension

(pre-approved loans at competitive rates).” Petitioner’s account

at Piper Jaffray was subject to an Asset Management Account

Agreement, Disclosure Statement, and Application (PJ account
 -6-

agreement). The PJ account agreement stated, in part, that

petitioner’s account included a “ready purchase credit feature”.

That feature allowed petitioner to purchase securities on credit

of up to 50 percent of the current market value of eligible

securities in his account. If petitioner used this feature, any

securities in his Piper Jaffray account became collateral for the

extended credit and, in the event of a default by petitioner in

repaying the extension of credit, could be sold by Piper Jaffray

to reduce or to liquidate entirely any debit balances in his

account.

As to any order that petitioner placed with Piper Jaffray

for the purchase of securities, the PJ account agreement stated:

When I buy securities, you will first apply any cash in
my Account on the settlement date to pay for the
purchase. If there is insufficient cash, you will then
redeem Fund shares at net asset value to pay the amount
due.

If there are not enough Fund shares in the Account
to pay this amount, the trade will be treated as a
credit transaction. You may extend credit to me on the
terms and conditions set forth in this Agreement. Any
credit you extend to me will be automatically
collateralized by eligible securities in my account.
If there are not sufficient eligible securities in the
Account, I must deposit additional cash or eligible
securities into my Account within the timeframes
required by regulations and your policies. If cash or
eligible securities are not deposited on time, you may
liquidate the securities at market risk and exposure to
me.
 -7-

Stock Option Notice of Exercise and Exercise

In order for petitioner to exercise his stock options from

Primus, Piper Jaffray used a 1-page form (notice). The notice

was drafted on Piper Jaffray letterhead and was entitled “Stock

Option Notice of Exercise”. The top half of the notice allowed

petitioner to advise Primus that he was exercising his stock

options and to instruct Piper Jaffray on the manner in which he

would pay for the exercise by checking one of three boxes with

corresponding instructions.3 The top half of the notice also

advised Primus that Piper Jaffray was enclosing its check (or

checks) payable to Primus as “the TOTAL PAYMENT amount

representing the exercise price due as a result of the stock

option exercise”, instructed Primus to deposit into petitioner’s

Piper Jaffray account the shares he purchased by exercising his

stock options, and contained lines on which petitioner should

enter certain specified personal information and sign his name

with a date of signature. The bottom half of the notice

contained a statement that Primus verified the information set

forth on the top half of the notice and that it would deliver the

requested shares to Piper Jaffray within 3 business days or a

reasonable time thereafter. The bottom half of the notice also

3
The respective instructions to the three boxes were:
“SAME DAY SALE: Exercise your stock options by selling all
shares immediately”; “CASHLESS EXERCISE: Exercise your stock
options by selling enough shares to cover exercise cost”; and
“EXERCISE AND HOLD: Margin stock to exercise options and hold at
US Bancorp Piper Jaffray. Interest rates will be charged
according to current margin rates”.
 -8-

contained a space that Piper Jaffray desired Primus to sign to

acknowledge its verification.4

On July 13, 2000, petitioner signed his notice, and either

he or Piper Jaffray faxed the notice to Primus after Primus’s

close of business. The notice stated that petitioner was

exercising his options to purchase 44,791 shares and that the

total due was $369,525.75.5 In payment of those shares,

petitioner checked the box corresponding to “SAME DAY SALE:

Exercise your stock options by selling all shares immediately.”

At 7:30 a.m., of the next day, July 14, 2000, Piper Jaffray faxed

Primus a second notice that consisted of the notice faxed the day

before with two alterations; the first alteration crossed out the

election of the same day sale, and the second alteration checked

the box corresponding to “EXERCISE AND HOLD” and circled that box

and the related instructions. The notice faxed on July 14, 2000,

was accompanied by a cover sheet that explained that the first

notice was incorrect in that petitioner was exercising and

holding his shares rather than selling them. The cover sheet

also explained that petitioner on that day was wiring $369,525.75

to Piper Jaffray and that Piper Jaffray would forward those

proceeds to Primus when received. On July 14, 2000, $370,000 was

4
It does not appear that Primus signed the statement on
petitioner’s notice.
5
44,791 shares multiplied by a per share exercise price of
$8.25 equals $369,525.75.
 -9-

transferred by wire from petitioner’s account at Charles Schwab

to petitioner’s account at Piper Jaffray.

Piper Jaffray sent Primus two checks drawn on petitioner’s

Piper Jaffray account. The first check, in the amount of

$369,525.75 and dated July 18, 2000, was for payment of the

exercise price. The second check, in the amount of $385,711.80

and dated July 20, 2000, was for payment of withholding tax on

the exercise of petitioner’s nonqualified stock options.

Petitioner used credit from Piper Jaffray to fund $385,170.74 of

the $385,711.80.

On July 20, 2000, Primus prepared three confirmations. The

confirmations reported that petitioner, on July 14, 2000, had

exercised his first, second, and third options in purchase of

24,432 shares, 5,208 shares, and 15,151 shares, respectively, at

a market value per share of $52.4375. On each weekday from

Friday, July 14 through Thursday, July 20, 2000, shares of Primus

common stock had a closing price and an average high/low price as

follows:

Closing Price High/Low Average

July 14 $52.31 $52.4375
17 46.25 49.25
18 38.00 41.28
19 40.0625 40.685
20 40.00 41.375
 -10-

Form W-2 Issued to Petitioner and Petitioners’ 2000 Return

Petitioner received from Primus a 2000 Form W-2, Wage and

Tax Statement, reporting income of $1,449,373.65 from wages,

tips, and other compensation. Primus reported that $1,309,717.50

of this amount was attributable to the exercise of petitioner’s

stock options.6 In calculating petitioner’s 2000 income from the

exercise of his stock options, Primus used a market value per

share of $52.4375, which amount is the shares’ high/low average

on July 14, 2000.

On their joint 2000 Federal income tax return, petitioners

reported income from wages, salaries, tips, etc. of $1,474,374,

which amount represents all of the income reported as paid to

petitioner on the Forms W-2 issued by Primus and the Illinois

Institute of Technology.7 On line 21 (“Other income”) of their

return, petitioners reduced their gross income by $366,795. This

amount reflects a per share value of $40.0625 for Primus stock

purchased by the exercise of petitioner’s nonqualified stock

options, which value was the closing price for Primus common

stock on July 19, 2000.

6
This figure equals the 29,640 shares purchased through the
exercise of the first and second options multiplied by the
high/low average of $52.4375, less the 29,640 shares multiplied
by the $8.25 per share exercise price; in other words, (29,640 x
$52.4375) - (29,640 x $8.25) = $1,309,717.50.
7
In addition to the Form W-2 issued by Primus, a Form W-2
was issued to petitioner by the Illinois Institute of Technology
in the amount of $25,000.
 -11-

Discussion

Section 83(a) generally provides that when property is

transferred to a person in connection with the performance of

services, the fair market value of the property at the first time

the rights of the person having the beneficial interest in the

property are transferable or not subject to a substantial risk of

forfeiture, less the amount paid for the property, is includable

in the gross income of the person who performed the services.

See Tanner v. Commissioner, 117 T.C. 237, 241 (2001), affd.

65 Fed. Appx. 508 (5th Cir. 2003). In general, an employee who

receives a nonstatutory stock option without a readily

ascertainable fair market value is taxed not on the receipt of

the option, but at the time, pursuant to the employee’s exercise

of the option, the shares have been transferred to, and become

substantially vested in, the employee. See sec. 83(a), (e)(3);

Tanner v. Commissioner, supra at 242; sec. 1.83-1(a)(1), Income

Tax Regs. Shares become substantially vested in the employee

when the shares are either transferable or not subject to a

substantial risk of forfeiture. See Racine v. Commissioner, T.C.

Memo. 2006-162; Facq v. Commissioner, T.C. Memo. 2006-111; sec.

1.83-3(b), Income Tax Regs.

The parties do not argue that the disputed shares were

nontransferrable or that petitioner’s right to full enjoyment of

the shares was conditioned upon the future performance of
 -12-

substantial services. Resolution of the issue before us turns on

the date of the transfer of the shares to petitioner. See sec.

1.83-3(a), Income Tax Regs. For purposes of section 83 and the

regulations thereunder, a transfer of property occurs when a

person acquires a beneficial ownership interest in the property.

See sec. 1.83-3(a)(1), Income Tax Regs.

Petitioner’s rights in the Primus stock subject to option

are fixed by the terms of the 1995 Plan and the stock option

letter agreements. Thus, the determination of when petitioner

acquired a beneficial interest in the Primus stock requires an

analysis of the contract provisions set forth in those documents.

These provisions define and establish when the exercise is

complete, so as to constitute a transfer of a beneficial interest

to petitioner.

We read those documents to conclude that petitioner acquired

a beneficial ownership interest in his Primus stock on the day

the notice became effective; i.e., on July 14, 2000.

Petitioner’s notice was first faxed to Primus after the close of

business on July 13, 2000, and was superseded by the second

notice faxed to Primus the next morning. The transmission of the

notice, as superseded, satisfied the requirements for exercising

the options set forth in section 7.4 of the 1995 Plan: It was a

written notice, delivered to Primus, specifying the number of

shares to be purchased, and accompanied by payment in full as
 -13-

described in section 7.5 of the 1995 Plan. Both the writing of a

check to Primus and the crediting of the shares to petitioner’s

brokerage account were but ministerial acts done in furtherance

of his exercise of July 14, 2000.

Petitioners argue that the exercise of the stock options did

not occur until July 18, 2000, because that is when full payment

of the exercise price of the shares took place in the form of the

issuance and delivery by Piper Jaffray of a check in full payment

of the exercise price. Petitioner’s notice, as superseded,

provided for payment in a method, as an alternative to a cash

payment, that was permitted by section 7.5(iii) of the 1995 Plan

and was sufficient to validate and make effective the notice on

July 14, 2000. Petitioners argue that this method was

unavailable to petitioner as a means by which to exercise his

options because it was not expressly provided for in the stock

option letter agreements entered into between petitioner and

Primus. We disagree. It was not necessary for that method to be

expressly provided for in those agreements because the agreements

specifically state that the terms of the options are as set forth

in the 1995 Plan and the stock option letter agreements, that the

agreements are subject to and in accordance with the express

terms and conditions of the 1995 Plan and are in all respects

limited by and subject to the express terms and provisions of the

1995 Plan, and that the terms set forth in the agreements are a
 -14-

summary of the most important terms set forth in the 1995 Plan.

A copy of the 1995 Plan was attached to and expressly

incorporated by reference into each of the stock option letter

agreements.

Although not mentioned by petitioners, we recognize that

section 7.5(iii) of the 1995 Plan states that irrevocable

instructions shall be given to pay not only the option price but

any withholding obligations as well and that the total amount

shown as due on the notice does not include any withholding tax.

We do not believe that this fact means that petitioner’s exercise

of his options was not effective on July 14, 2000. To be sure,

Primus considered petitioner to have met (and treated petitioner

as having met) all of the requirements to have exercised his

options in purchase of the stock on July 14, 2000. Primus issued

to petitioner the confirmations reporting that he had exercised

his options on that date, and it issued to him the Form W-2

valuing the stock as of that date. Primus’s view on the date on

which petitioner exercised his options is especially probative

here where, notwithstanding the applicability of section 7.5(iii)

of the 1995 Plan, section 7.5(iv) of the 1995 Plan allowed the

plan administrator to accept in exercise of the options any form

of consideration that it desired.

Moreover, by way of the notice, petitioner on July 14, 2000,

gave irrevocable instructions to Piper Jaffray to purchase Primus
 -15-

stock through an exercise of his options and directed Primus to

issue the stock to him by placing the stock in his Piper Jaffray

account. Petitioner also directed Piper Jaffray to hold the

stock and to purchase the stock on margin to generate any funds

necessary to pay for the purchase. The fact that the notice did

not state specifically that Primus was also instructed to forward

to Primus any withholding obligation connected to the exercise of

the options does not necessarily mean that Primus as of that date

was not obligated to do so. Given petitioner’s instructions to

Piper Jaffray and his PJ account agreement with Piper Jaffray,

Piper Jaffray was required to pay promptly to Primus all costs

related to petitioner’s exercise of his options in purchase of

the Primus stock, and such costs would have included the prompt

depositing of the withholding taxes if and when required. In

this regard, section 7.5(iii) of the 1995 Plan did not require

that the option exercise price or any withholding obligation be

tendered with the exercise notice in order to make the notice

effective; it simply stated that the optionee must instruct the

brokerage firm to deliver the option exercise price and any

withholding tax obligations “promptly”. Nor do the stock option

letters require that petitioner actually pay the withholding tax,

just that he “make such arrangements as the Company may require

for the satisfaction” of any withholding obligations connected to

the exercise.
 -16-

Petitioners further argue that even if petitioner had been

authorized to pay the exercise price by the method set forth in

section 7.5(iii) of the 1995 Plan, such attempt was ineffective

because petitioner gave irrevocable instructions neither to

Primus nor to Piper Jaffray. We find petitioners’ arguments on

this point unavailing. On July 14, 2000, Primus became obligated

to issue the shares, and Piper Jaffray became obligated to pay

for them, either by selling the shares or advancing funds on

margin. Petitioner’s July 14, 2000, notice constitutes his

unconditional acceptance of Primus’s offer under the stock option

grants and created a contract between Primus and petitioner for

the sale of the exercised shares of stock. Petitioner could not

revoke or withdraw his acceptance of Primus’s offer. Moreover,

petitioners have not shown that petitioner’s exercise was

conditional or that he reserved the right to revoke the notice.

A “beneficial owner” is one who does not have legal title to

property but has rights in the property which are the normal

incidents of owning property. Miller v. United States, 345 F.

Supp. 2d 1046, 1050 (N.D. Cal. 2004). Such rights include the

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

dispose of the shares as the beneficial owner sees fit, and the

right to use the shares as collateral. See United States v.

Tuff, 359 F. Supp. 2d 1129, 1133 (W.D. Wash. 2005); Miller v.

United States, supra at 1050. Another indication that a transfer
 -17-

has occurred is the extent to which the transferee incurs the

risk that the value of the property at the time of transfer will

decline. Sec. 1.83-3(a)(6), Income Tax Regs.

As of July 14, 2000, petitioner could dispose of his Primus

stock as he saw fit. In fact, according to his notice,

petitioner provided for the sale on July 14, 2000, of all of the

Primus shares he obtained by exercising his stock options. This

sale would have taken place if petitioner had not again exercised

control over those shares by changing his sell order. Petitioner

also evidenced his beneficial ownership interest in the Primus

shares by using at least some of those shares as collateral for

the funds he borrowed from Piper Jaffray. Petitioner used credit

from Piper Jaffray to fund $385,170.74 of the $385,711.80 paid to

Primus for withholding taxes on the exercise of the stock

options. Under petitioner’s PJ account agreement, petitioner’s

use of credit caused the securities in his account (consisting

largely of the Primus stock he purchased by exercising his stock

options) to become collateral for that credit.

Also on July 14, 2000, petitioner incurred the risk of a

beneficial owner that the value of his Primus stock would

decline. According to his notice, petitioner determined to

eliminate this risk by electing to sell all of his Primus stock

immediately after exercise. When petitioner changed his mind and
 -18-

canceled his sell order, he chose to hold his Primus stock and to

bear the risk of a decline in its value.

We hold for respondent. We have considered all arguments

made by petitioners for a contrary holding and found those

arguments not discussed herein to be without merit. To reflect

the foregoing,

Decision will be entered

under Rule 155.