Moore v. Comm'r

T.C. Memo. 2007-123

UNITED STATES TAX COURT

WALTER AND SUSAN MOORE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12106-05. Filed May 17, 2007.

Brian Isaacson and Duncan Turner (specially recognized), for

petitioners.

Kirk M. Paxson and Julie Payne, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioners petitioned the Court to

redetermine respondent’s determination of a $810,805 deficiency

in their 2002 Federal income tax and a $162,161 accuracy-related
 -2-

penalty under section 6662(a).1 We decide primarily whether

Susan Moore (petitioner) realized income in 2002 when she

exercised stock options received from her employer Cell

Therapeutics, Inc. (CTI). We hold she did. We also decide

whether petitioners are liable for the accuracy-related penalty

determined by respondent under section 6662(a). We hold they are

not.

FINDINGS OF FACT

Some facts were stipulated or contained in the exhibits

submitted therewith. We find the facts accordingly. Petitioners

are husband and wife, and they resided in Hansville, Washington,

when their petition was filed.

A. Petitioner’s Relationship With CTI Before January 13, 2001

CTI hired petitioner as a compensation consultant in January

1993, and she continued to work for CTI as a full-time employee

through January 12, 2001. Before working for CTI, petitioner had

earned a bachelor’s degree in business administration, and she

had worked for more than 10 years in various capacities (e.g.,

compensation manager, director of human resources) for various

other employers. Petitioner is certified by the American

Compensation Society as a professional in the field of

compensation.

1
Unless otherwise indicated, section references are to the
applicable versions of the Internal Revenue Code.
 -3-

Two months after petitioner began working for CTI, CTI

promoted her to its office of vice president of human resources.

In 1995, CTI promoted her further to its office of executive vice

president of human resource development. In 1999, CTI expanded

petitioner’s responsibilities as executive vice president to head

CTI’s corporate communications department in addition to its

human resource department. Petitioner reported directly to CTI’s

chief executive officer (CEO), Dr. James Bianco (Dr. Bianco), and

she served on CTI’s strategic management team. The strategic

management team was the top level of CTI, and it consisted of the

CEO and all of the executive vice presidents of CTI’s major

functional areas.

CTI was a private corporation when petitioner first began

working for it, and it later became a public corporation while

she was affiliated with it. During each year that petitioner was

affiliated with CTI, CTI employed between 100 and 500

individuals.

1. Stock Option Grants

As part of her compensation package, CTI gave petitioner

options to purchase CTI common stock. Each option allowed

petitioner to purchase a specified number of shares of CTI common

stock at a specified price.
 -4-

a. First Options

Petitioner was granted options to purchase 20,000 shares and

10,000 shares of CTI common stock at $4.50 per share under the

CTI 1992 Stock Option Plan Incentive Stock Option Agreement

entered into as of December 20, 1993. The agreement pertaining

to these options contained the following recital:

Termination of Option.

A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:

(i) ten (10) years from the date of grant; or
12/20/03;

(ii) the expiration of ninety (90) days from the
date of Optionee’s termination of employment with the
Company for any reason other than death or disability
(as defined in the Plan), (unless the exercise period
is extended by the Plan Administrator until a date not
later than the expiration date of the Option) * * *

b. Second Options

Petitioner was granted options to purchase 70,000 shares and

75,000 shares of CTI common stock at $3.35 per share under the

CTI 1994 Equity Incentive Plan Incentive Stock Option Agreements

entered into as of December 5, 1995, and November 7, 1996,

respectively. The agreement pertaining to the grant of the

option to purchase the 70,000 shares contained the following

recital:
 -5-

Termination of Option.

A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:

(i) ten (10) years from the date of grant; or
12/05/05;

(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment or service
with the Company for any reason other than death or
because Optionee becomes disabled (within the meaning
of Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *

The agreement pertaining to the grant of the option to purchase

the 75,000 shares contained the following recital:

Termination of Option.

A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:

(i) ten (10) years from the date of grant; or
11/07/06;

(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment or service
with the Company for any reason other than death or
because Optionee becomes disabled (within the meaning
of Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *

c. Third Option

Petitioner was granted an option to purchase 27,500 shares

of CTI common stock at $16.0625 per share under the CTI 1994

Equity Incentive Plan Incentive Stock Option Agreement entered
 -6-

into as of December 9, 1997. The agreement pertaining to this

option contained the following recital:

Termination of Option.

A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:

(i) ten (10) years from the date of grant; or
12/09/07;

(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment with the
Company for any reason other than death or because
Optionee becomes disabled (within the meaning of
Section 22(e)(3) of the Code) (unless the exercise
period is extended by the Committee until a date not
later than the expiration date of the Option) * * *

d. Fourth Option

Petitioner was granted an option to purchase 35,000 shares

of CTI common stock at $2.969 per share under the CTI 1994 Equity

Incentive Plan Incentive Stock Option Agreement entered into as

of December 10, 1998. The agreement pertaining to this option

contained the following recital:

Termination of Option.

A vested Option shall terminate, to the extent not
previously exercised, upon the occurrence of one of the
following events:

(i) ten (10) years from the date of grant; or
December 10, 2008;

(ii) the expiration of three (3) months from the
date of Optionee’s termination of employment with the
Company for any reason other than death or because
Optionee becomes disabled (within the meaning of
Section 22(e)(3) of the Code) (unless the exercise
 -7-

period is extended by the Committee until a date not
later than the expiration date of the Option) * * *

B. Petitioner’s Relationship With CTI After January 12, 2001

1. Board of Directors’ Resolution

In or about the end of 2000, petitioner advised Dr. Bianco

that she was going to terminate her employment with CTI because

she was having a personality conflict with a key member of the

staff. Dr. Bianco asked petitioner to remain affiliated with CTI

for approximately 1 year longer to establish a transition plan

for CTI. Petitioner agreed to do so, agreeing with CTI to enter

into a consulting agreement under which she would work for CTI in

a nonemployee capacity.

In connection therewith, CTI’s Board of Directors’

Compensation Committee adopted a resolution that stated that

petitioner ceased to be employed by CTI as of January 12, 2001,

that CTI continued to need petitioner’s services, and that

petitioner and CTI would enter into a consulting agreement to

obtain petitioner’s services.2 The resolution resolved:

cti shall enter into a consulting agreement with Ms.
Moore which incorporates at a minimum the following
terms and conditions:

For a period of one-year Ms. Moore may be
called upon to perform Corporate
Communications and Human Resource Development
duties and responsibilities as determined by
the CEO. It is expected Ms. Moore will

2
The resolution does not state the date of its making.
 -8-

devote approximately one-half the number of
hours of a full-time equivalent.

As compensation for this agreement, Ms. Moore
will receive:

a salary of $175,000

company-paid health and welfare benefits

As of January 12, 2001, the date of
termination, Ms. Moore held 112,788 vested
options and 35,000 unvested options to
purchase cti Common Stock granted in
accordance with the Corporation’s 1994
Employee Stock Option Plan (the “1994 Plan”),
which vested options would have been
exercisable for a period of up to three
months after the date of her termination with
the Corporation, as provided in the 1994
Plan.

The Compensation Committee deems it
appropriate and in the best interests of the
Corporation to continue vesting of the
unvested options according to the current
vesting schedule and whereas the remaining
unvested options would vest on December 10,
2000 and December 22, 2000, and extend the
exercise period for vested and unvested
options to 90 days after Ms. Moore completes
this consulting arrangement.

2. Consulting Agreement

Petitioner and CTI entered into the referenced consulting

agreement with an effective date of January 13, 2001, and a

termination date of January 12, 2002 (unless terminated earlier

or extended longer by agreement of the parties thereto). The

agreement stated that petitioner would report to Dr. Bianco and

would oversee and manage the corporate communications and human

resource development departments; attend senior management team
 -9-

meetings as mutually agreed upon by petitioner and Dr. Bianco;

conduct staff meetings as needed for corporate communications and

human resource development personnel; prepare the annual report

for CTI, including coordinating the annual shareholder meeting

and activities related thereto; manage and oversee CTI’s Internet

and Intranet websites; provide weekly contact with public

relations groups in the industry; interview and hire additional

staff for the corporate communications department; and perform

additional services as agreed upon by petitioner and CTI. The

agreement specified that “The parties hereto are acting as

independent contractors. Consultant will be responsible for and

will pay all taxes related to the receipt of payments hereunder

and shall give reasonable proof and supporting documents, if

reasonably requested, to verify the payment of such taxes.”

The agreement stated that petitioner would be paid for her

services at the rate of $175 per hour and that she would work no

more than 1,000 hours during the 1-year term of the agreement

unless she and CTI agreed otherwise. The agreement also stated

that CTI would pay for petitioner’s participation in health and

dental plans for the term of the agreement; CTI paid for that

participation under a plan that covered former employees. The

agreement also stated that petitioner was entitled to receive

reimbursement of her preapproved reasonable out-of-pocket

business expenses (e.g., food, lodging, air and ground travel)
 -10-

incurred in providing services to CTI. Petitioner was required

to submit to CTI invoices for her hourly pay, and she was

required to submit with those invoices documentation supporting

her claim to reimbursement for out-of-pocket expenses.

The consulting agreement shortened the vesting period of

petitioner’s stock options. It stated:

Options. Consultant and CTI are parties to the
1997 Option Agreement (“Option Agreement”) and the 1994
CTI Equity Incentive Option Plan (“Option Plan”) in
which Consultant vests in CTI incentive stock options.
In lieu of Consultant vesting in CTI incentive options
according to the Option Agreement, the parties agree
that Consultant shall vest in CTI incentive options for
the term of this Agreement as provided hereunder and in
the Option Plan.

Type
Option Option of Old Vest New Vest
No. Date Option Shares Price Date Date

P000698 12/10/98 ISO 8,750 2.969 12/10/01 4/12/01
P000698 12/10/98 ISO 2,916 2.969 12/10/01 7/12/01
C000892 12/22/99 ISO 5,834 3.063 12/22/01 7/12/01
C000892 12/22/99 ISO 5,833 3.063 12/22/01 10/12/01
C000892 12/22/99 ISO 2,917 3.063 12/22/02 10/12/01
C000892 12/22/99 ISO 8,749 3.063 12/22/02 1/12/02

For avoidance of any doubt whatsoever, Consultant shall
vest in each set of options provided this Agreement is
in effect as of the vesting date for that respective
set of options as described above (i.e. if Consultant
terminates this Agreement on 8/12/01 she would be
entitled to 17,500 vested options; she would not be
entitled to the remaining 17,499 unvested options).
Consultant would then have ninety (90) days from the
date of termination of this Agreement to exercise the
vested options.

Petitioner read the consulting agreement, thought she

understood it, signed it, and did not ask any questions regarding

it. She believed that by entering into the agreement she would
 -11-

work less. She understood that she would be responsible for

filing her own tax returns and paying her related taxes and that

CTI would not pay or withhold any taxes for her benefit. She

knew her employment status with CTI was changing. On or about

May 24, 2001, petitioner informed CTI’s section 401(k) plan that

she had terminated her employment with CTI on January 12, 2001,

and was electing to roll over her balance in that plan to her

individual retirement account at CIBC Oppenheimer.

After January 12, 2001, petitioner was neither an officer,

director, or 10-percent stockholder of CTI. She continued to

provide CTI with essentially the same types of services that she

had provided to CTI before January 13, 2001, but she worked fewer

hours after January 12, 2001, than she did before, and she was

not paid a salary but was paid in accordance with the hours that

she claimed on the invoices she submitted to CTI. After January

12, 2001, petitioner continued to report to Dr. Bianco, but she

was evaluated through verbal feedback and not as formally as

before. After January 12, 2001, she also could hire or

subcontract third parties to perform most of the services listed

in the consultation agreement, and she could have worked for

companies other than CTI. After August 2001, petitioner no

longer headed or was responsible for CTI’s human resource

department.
 -12-

CTI paid petitioner a bonus in 2001 for the work she had

performed for CTI while employed by it in 2000. Petitioner did

not receive a bonus in 2002 for the work she performed for CTI in

2001.

At or about the beginning of 2002, the parties to the

consulting agreement agreed that the term of the agreement should

be extended through March 3, 2002, so that petitioner could

review the performance of CTI’s employees. The consulting

agreement was so extended, and it terminated on March 3, 2002.

C. Exercise of Stock Options

On March 5, 2002, petitioner exercised some of her options

to buy CTI common stock. On that date, each of her purchased

shares had a fair market value of $23.19. As to one option,

petitioner paid an exercise price of $46,496 to purchase (at

$2.906 per share) 16,000 shares of CTI common stock with a total

fair market value of $371,040. Upon exercise of that option, she

also paid $97,596.57 to CTI so CTI could withhold and pay Federal

income, Social Security, and Medicare taxes associated with the

exercise. As to another option, petitioner paid an exercise

price of $58,120 to purchase (at $2.906 per share) 20,000 shares

of CTI common stock with a total fair market value of $463,800.

Upon exercise of that option, she also paid $115,415.96 to CTI so

CTI could withhold and pay Federal income, Social Security, and

Medicare taxes associated with the exercise. As to another
 -13-

option, petitioner paid an exercise price of $9,467.75 to

purchase (at $2.906 per share) 3,258 shares of CTI common stock

with a total fair market value of $75,553.02. Upon exercise of

that option, she also paid $18,801.26 to CTI so CTI could

withhold and pay Federal income, Social Security, and Medicare

taxes associated with the exercise. As to another option,

petitioner paid an exercise price of $95,094.10 to purchase (at

$2.969 per share) 32,029 shares of CTI common stock with a total

fair market value of $742,752.51. Upon exercise of that option,

she also paid $184,258.82 to CTI so CTI could withhold and pay

Federal income, Social Security, and Medicare taxes associated

with the exercise. As to another option, petitioner paid an

exercise price of $107,205 to purchase (at $3.063 per share)

35,000 shares of CTI common stock with a total fair market value

of $811,650. Upon exercise of that option, she also paid

$200,414.60 to CTI so CTI could withhold and pay Federal income,

Social Security, and Medicare taxes associated with the

exercise.3

After exercising her options, petitioner had legal title to,

was the beneficial owner of, had the right to receive dividends

on, and had the right to vote her purchased stock. At no time

3
In full, petitioner paid $316,382.85 to purchase 106,287
shares with a total fair market value of $2,464,795.53.
Petitioner also paid CTI $616,487.21 with respect to the
withholding taxes.
 -14-

after exercising the options was she obligated to return any of

that stock to CTI. During 2002 and thereafter, petitioner did

not sell any of the purchased shares. Those shares were in

electronic form.

D. Petitioners’ Agreement With CIBC Oppenheimer

Petitioners entered into a “Client Agreement” and an

“Investment Management Agreement” with their stockbroker, CIBC

Oppenheimer. The client agreement stated:

I agree to pay on demand any balance owing with
respect to any of my accounts, including interest and
commissions and any costs of collection (including
attorneys fees, if incurred by you). I understand that
you may demand full payment of the balance due in my
accounts plus any interest charges accrued thereon, at
your sole option, at any time without cause and whether
or not such demand is made for your protection. In
addition, Margin Loans are not made for any specific
term or duration but rather are due and payable at your
discretion upon demand * * *

The investment management agreement stated that “Client

represents that Client is the beneficial owner of any securities

Client may deliver to the Custodian and that there are no

restrictions on the transfer, sale and/or public distribution

thereof.” The investment management agreement also stated that

“Client understands and agrees that all transactions shall be for

Client’s account and risk and that neither CIBC WM [CIBC World

Markets Corp., the program manager of the assets of petitioners’

account at CIBC Oppenheimer] nor any Portfolio Manager is

guaranteeing, or otherwise making representations with respect
 -15-

to, the performance of the Account and that CIBC WM shall not be

liable for any losses in the Account”.

E. Payment of the Exercise Price and Withholding Taxes

CTI received payment in full for the exercise price and

withholding taxes due upon petitioner’s exercise of her options.

Petitioner borrowed $932,870.06 from CIBC Oppenheimer to pay the

total of the options’ exercise price ($316,382.85) and CTI’s

withholding obligation ($616,487.21). CIBC Oppenheimer wired the

$932,870.06 ($316,382.85 + $616,487.21) to CTI, and CIBC

Oppenheimer treated the wired funds as a borrowing that

petitioner had made on her margin account at CIBC Oppenheimer.

Petitioners were personally liable for the repayment of that

borrowing and any interest that accrued with respect thereto.

On July 29, 2002, petitioner repaid the principal of the

borrowing after she received margin calls from CIBC Oppenheimer.

She obtained the funds for repayment by selling stocks and bonds,

using available cash, borrowing money, and selling her house. On

July 29, 2002, the fair market value of petitioner’s CTI stock

(106,287 shares) was $3.175 per share or $337,461.23 in total.

F. CTI’s Insider Trading Policy and Trading Windows

According to CTI’s Insider Trading Policy Statement:

An Insider or Temporary Insider is permitted to
trade CTI stock only during certain specified periods
(the “Trading Window”) and only if the Insider or
Temporary Insider is not at the time in possession of
material, non-public information. CTI’s Trading Window
will be opened only upon written notification from
 -16-

CTI’s Chief Financial Officer (“CFO”). In general, the
Trading Window opens (i.e., trading is permissible) on
the third business day after CTI releases information
to the financial community about the prior quarter
results, and closes (i.e., trading is prohibited) at
the close of business on the fifteenth (15th) day of
the last month of a fiscal quarter. If the fifteenth
day of the month falls in a weekend, the window shall
close on the last business day preceding the fifteenth
day of the month.

The trading window was closed when petitioner exercised her

options on March 5, 2002. The trading window remained closed

until the third business day after May 13, 2002.

G. Petitioners’ 2002 Federal Income Tax Return

Petitioner received from CTI a 2002 Form 1099 in the amount

of $21,787.50. Petitioner also received from CTI a 2002 Form

W-2, Wage and Tax Statement, that reported that petitioner had

received $2,156,436.35 as wages, tips, or other compensation.

The Form W-2 listed $582,066.18 as the amount of Federal income

tax withheld. The wages reported by CTI on the Form W-2 included

the spread between the strike prices and the fair market value of

the stock received when petitioner exercised her stock options on

March 5, 2002.

On or about April 15, 2003, petitioners filed their 2002

Federal income tax return. They reported the following relevant

information on that return: $29,404 in wages, salaries, tips

etc.; business income of $19,324 ($21,788 in gross receipts less

$2,464 in expenses consisting of travel ($2,335) and meals and

entertainment ($129)); total adjusted gross income of $80,730;
 -17-

taxable income of $54,073; tax of $7,889; and Federal income tax

withheld of $582,148. They claimed on that return that they were

entitled to a refund of overpaid Federal income tax in the amount

of $574,259 ($582,148 - $7,889).

Attached to the return was a Form 4852, Substitute for Form

W-2, Wage and Tax Statement, or Form 1099-R, Distributions From

Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,

Insurance Contracts, Etc., on which petitioners reported that CTI

had paid petitioner $29,102.05 in wages or compensation. Also

attached to petitioners’ 2002 return were a “Form 4852

Calculation” prepared by The Issacson Law Firm and a “(Form 8275

Disclosure Statement) Memorandum of Law” prepared by petitioners’

tax return preparer and counsel herein Brian Isaacson (Isaacson).

The “Form 4852 Calculation” reported that petitioners had made a

$2,127,334.31 negative adjustment to petitioner’s wages as

reported on the 2002 Form W-2 to calculate petitioner’s wages as

$29,102.05 ($2,156,436.35 - $2,127,334.31 = $29,102.04). The

memorandum of law (memorandum of law) stated as facts that

petitioner “was granted stock options as part of taxpayer’s

employment contract”, that “taxpayer exercised employee stock

options using margin debt secured by the stock exercised”, and

that “taxpayer has not risked taxpayer’s own capital in the

transaction”. The memorandum of law concluded that “Under the

facts and circumstances test in Section 1.83(a)(2) [sic], it
 -18-

appears that the transfer to the taxpayer may be treated as

similar to the grant of an option”. This is so, the memorandum

of law rationalizes (without any coherent explanation), because

petitioner would not have to use her personal assets to pay the

margin debt were her CTI stock to be insufficient to satisfy the

debt in full. The memorandum of law stated that Isaacson was

trying to get CTI to change the referenced 2002 Form W-2 to

report the lower amount of wages but that “It is anticipated that

Cell Therapeutics, Inc. will not correct the taxpayer’s Form W-2

absent a ruling from the Internal Revenue Service”.

OPINION

A. Statutory Framework for Stock Options

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); see also United States v.

Tuff, 469 F.3d 1249, 1251-1252 (9th Cir. 2006). In general, an

employee who receives a nonstatutory stock option without a

readily ascertainable fair market value is taxed not on receipt
 -19-

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 United States v. Tuff,

supra at 1252; Racine v. Commissioner, T.C. Memo. 2006-162;

Facq v. Commissioner, T.C. Memo. 2006-111; sec. 1.83-3(b), Income

Tax Regs.

Section 83 does not apply to a “statutory” stock option;

i.e., an “incentive stock option” (ISO) within the meaning of

section 422(b), that meets the requirements of sections 421

through 424. As relevant herein, section 421(a) provides that if

the requirements of section 422(a) are met,4 a taxpayer does not

recognize income either upon the granting to the taxpayer of an

ISO or when the taxpayer receives stock upon the ISO’s exercise.

Recognition of income is deferred until disposition of the stock.

Sec. 421(a). Section 422(b) defines an ISO as a stock option

granted to an individual for any reason connected to his or her

employment, if granted by a corporate employer (or its parent or

4
Sec. 422(a) requires in relevant part that the option
holder be an employee of the company granting the option at all
times from the granting of the option until 3 months before the
date of exercise.
 -20-

subsidiary) to purchase the stock of the employer (or parent or

subsidiary), but only if the requirements of section 422(b)(1)

through (6) are met.

B. Whether Petitioner’s Stock Options Were ISOs

Petitioners argue that petitioner’s stock options were ISOs.

Respondent argues that petitioner’s options were not ISOs in that

they failed the requirements of section 422(b)(1) through (6).5

Respondent argues alternatively that the options do not qualify

for ISO treatment because petitioner was not an employee of CTI

during the 3 months before their exercise, as required by section

422(a)(2). We agree with respondent in both regards.

1. Requirements of Section 422(b)

Section 422(b) generally sets forth six requirements that

must be met for a stock option to qualify as an ISO. First, the

option must be granted pursuant to a plan. Sec. 422(b)(1).

Second, the option must be granted within 10 years from the date

of the plan’s adoption. Sec. 422(b)(2). Third, the option by

5
Respondent argues primarily that the options failed the
sec. 422(b) requirements upon their issuance. Respondent also
argues that petitioner’s consulting agreement with CTI caused the
options to be modified, see sec. 424(h)(1), and that the options
as modified failed those requirements as well. While petitioners
assert in their reply brief that the issue of whether the options
as originally granted were ISOs is a new issue improperly raised
on brief, we disagree. Among other things, we note that
petitioners’ petition (before amendment at trial) alleged that
“The Commissioner erred by failing to determine that the stock
options were classified as incentive stock options by Cell
Therapeutics, Inc.”
 -21-

its terms may not be exercisable more than 10 years after the

date the option is granted. Sec. 422(b)(3). Fourth, the option

price must not be less than the fair market value of the stock at

the time the option is granted. Sec. 422(b)(4). Fifth, the

option by its terms may not be transferable except by will or

laws of descent and distribution and must be exercisable during

the optionee’s lifetime only by the optionee. Sec. 422(b)(5).

Sixth, when the option is granted, the optionee cannot own stock

possessing more than 10 percent of the total combined voting

power of all classes of stock of the employer (or its parent or

subsidiary).

We agree with respondent that all of the section 422(b)

requirements were not met as to the options as originally issued.

To this end, we are unable to conclude that the options met the

requirements of section 422(b)(1) through (4). We are unable to

find on the basis of the credible evidence in the record that the

options were issued pursuant to a specific plan, that CTI’s

shareholders approved such a plan, or the date on which a plan

was adopted or approved. Nor are we able to find that the option

price was at or above the fair market value of the related stock

at the time of the options’ issuance. We also note that the

consulting agreement allowed petitioner to exercise her options

within 90 days after the consulting agreement expired, a date

that could have been more than 10 years after the grant date.
 -22-

We also agree with respondent that the options as originally

issued were later modified and that the options as modified also

failed the requirements of section 422(b). Section 424(h)(1)

provides that “if the terms of any option to purchase stock are

modified, extended, or renewed, such modification, extension or

renewal shall be considered as the granting of a new option.” In

this context, a “modification” denotes “any change in the terms

of the option which gives the employee additional benefits under

the option,” except that the term does not include a change in

the terms of an option “in the case of an option not immediately

exercisable in full, to accelerate the time at which the option

may be exercised.” Sec. 424(h)(3).

The consulting agreement modified the original options and

caused petitioner to receive a grant of new options pursuant to

section 424(h). In this regard, the consulting agreement set new

vesting dates for petitioner’s options and gave her 90 days from

the date of termination of the agreement to exercise the vested

options. Petitioner benefited from this change in that she was

given the right to exercise her options even if she ceased to be

an employee of CTI for more than 90 days; under the original

option agreements, the options would have expired 3 months or 90

days (depending upon the particular agreement) from the date of

her termination of employment with CTI for any reason other than

death or disability. Stated differently, as a result of the
 -23-

modification, petitioner could still exercise her options if she

ceased to be an employee of CTI for more than 90 days, as long as

the consulting agreement had not been terminated for more than 90

days.

The options as modified failed the requirements of section

422(b). There is no plan in the record, and the option prices on

the dates of grant were not shown to be equal to or greater than

the fair market value of the CTI stock on those dates. The

options also failed the requirement of section 422(b)(3) in that

the options could be exercised up to 90 days after the

termination of the consulting agreement, the term of which could

have been extended by agreement of the parties. The effect of

the modification was to give the options an indefinite term, so

that each option was not limited “by its terms” as required by

section 422(b)(3).

2. Requirement of Section 422(a)(2)

Respondent also argues that the options are not entitled to

ISO treatment because petitioner was not an employee of CTI “at

all times during the period beginning on the date of the granting

of the option and ending on the day 3 months before the date” she

exercised her options as required by section 422(a)(2). We

agree. We apply the common law rules of employment to decide

whether petitioner ceased to be an employee of CTI on December 5,

2001; i.e., 3 months before the exercise date of March 5, 2002.
 -24-

See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323-325

(1992); Weber v. Commissioner, 103 T.C. 378, 386 (1994), affd.

60 F.3d 1104 (4th Cir. 1995); sec. 1.421-1(h), Income Tax Regs.;

see also sec. 3401(c). Our decision is a question of fact, see

Profl. & Executive Leasing, Inc. v. Commissioner, 862 F.2d 751,

753 (9th Cir. 1988), affg. 89 T.C. 225 (1987); Ellison v.

Commissioner, 55 T.C. 142 (1970), and we are guided by certain

factors, none of which is dispositive in and of itself. These

factors are: (1) The degree of control exercised by the

principal over the details of the work, (2) the taxpayer’s

investment in the facilities used in the work, (3) the taxpayer’s

opportunity for profit or loss, (4) the permanency of the

relationship between the parties to a working relationship,

(5) the principal’s right of discharge, (6) whether the work

performed is an integral part of the principal’s business,

(7) what relationship the parties to a working relationship

believe they are creating, and (8) the provision of employee

benefits. See Nationwide Mut. Ins. Co. v. Darden, supra; NLRB v.

United Ins. Co., 390 U.S. 254, 258 (1968); Profl. & Executive

Leasing, Inc. v. Commissioner, supra; Ewens & Miller, Inc. v.

Commissioner, 117 T.C. 263, 270 (2001); Weber v. Commissioner,

supra. We analyze these factors seriatim.
 -25-

a. Degree of Control

The “degree of control” or “right to control” test is the

most important factor to consider in deciding the nature of a

working relationship. Matthews v. Commissioner, 92 T.C. 351, 361

(1989), affd. 907 F.2d 1173 (D.C. Cir. 1990). Consideration is

given not only to the control exercised by an alleged employer,

but also to the degree to which the alleged employer may

intervene to impose control. Radio City Music Hall Corp. v.

Commissioner, 135 F.2d 715, 717 (2d Cir. 1943); Weber v.

Commissioner, 103 T.C. at 387.

Before January 13, 2001, petitioner was a member of CTI’s

strategic management team, she was expected to work at the office

full time, and she was required to be readily available to work

for CTI. Beginning on January 13, 2001, as a result of the

consulting agreement, petitioner was no longer required to work

(nor did she work) as many hours as she did beforehand, she no

longer had to be available to CTI at all times, and she was

allowed to conduct her work for CTI at any location she pleased.

In addition, in contrast with her work for CTI before January 13,

2001, petitioner afterwards did not receive written evaluations,

she had the right to work for other companies, and she had the

right to subcontract CTI business to third parties. Although

petitioner’s job was substantially similar to the one she did

before she began working for CTI pursuant to the consulting
 -26-

agreement, there were significant changes after the agreement

that call into question the level of CTI’s control over

petitioner. This factor favors a nonemployee relationship.

b. Investment in Facilities

After petitioner entered into the consulting agreement with

CTI, she continued to use her CTI office. She was able, had she

wanted, to work anywhere she pleased after entering into the

agreement. This factor is neutral.

c. Opportunity for Profit or Loss

Beginning on January 13, 2001, petitioner had more

flexibility and time to seek other employment. She also was able

to subcontract the consulting work she did for CTI; this provided

her more time to seek other opportunities. This factor favors a

nonemployment relationship.

d. Permanency of the Relationship

The consulting agreement contemplated that petitioner would

provide services to CTI for only one year, and it permitted the

parties to the agreement to terminate it with 30 days’ written

notice. After entering into the agreement, petitioner worked

fewer hours than she had before and by August 2001 no longer had

responsibility over CTI’s human resource department. This factor

favors a nonemployee relationship.
 -27-

e. Principal’s Right of Discharge

Petitioner’s consulting agreement was nonexclusive, and

either party could terminate the agreement with 30 days’ written

notice. This factor favors a nonemployee relationship.

f. Work as an Integral Part of Principal’s Business

After petitioner entered into the consulting agreement, she

was no longer as integral to CTI’s business as she was

beforehand. She worked fewer hours for CTI, the agreement lasted

only one year, she could pursue other consulting opportunities,

and she gave up all responsibility for CTI’s human resource

department. This factor favors a nonemployee relationship.

g. Relationship of the Parties

Petitioner and CTI entered into a nonexclusive

consulting agreement that stated specifically that petitioner was

an independent contractor. In addition, CTI calculated

petitioner’s income from her exercise of the stock options

pursuant to section 83, as if she was not a CTI employee for the

3 months before the date of that exercise. Further, petitioner

notified CTI’s section 401(k) plan that she had ceased working

for CTI as an employee on January 12, 2001. This factor favors a

nonemployee relationship.

h. Employee Benefits

During the period covered by the consulting agreement, CTI

paid petitioner’s health benefits pursuant to a plan for its
 -28-

former employees. Petitioner did not receive a bonus in 2002 for

the work she performed in 2001. Petitioner caused CTI’s section

401(k) plan to distribute her account balance to her broker as a

direct rollover into her individual retirement account. This

factor favors a nonemployee relationship.

i. Conclusion

The factors listed above support a finding that petitioner

worked for CTI on and after December 5, 2001, as an independent

contractor, and we make such a finding on the basis of the record

at hand. Accord Humphrey v. Commissioner, T.C. Memo. 2006-242.

We conclude that petitioner’s stock options, even if they were

otherwise ISOs within the meaning of section 422(b), did not

qualify under section 422(a)(2) for ISO treatment.

C. Whether Petitioner Received Income on Exercise of Options

We decide whether petitioner received income when she

exercised her options in 2002. Petitioners rely upon section

1.83-3(a)(2), Income Tax Regs., and argue that no transfer

occurred upon petitioner’s exercise of her options because, they

state, she paid for the exercise using nonrecourse debt.

According to petitioners, petitioner did not place any of her own

capital at risk until July 29, 2002, when she used petitioners’

resources to pay her borrowing from CIBC. We disagree with this

argument, which is the same argument that the Court of Appeals

for the Ninth Circuit recently considered and labeled
 -29-

“nonsense”.6 United States v. Tuff, 469 F.3d at 1253. As was

true in the case of the taxpayer there, petitioner exercised her

options and purchased her CTI stock with cash. While the cash

may not have come directly from her assets, but was borrowed from

CIBC Oppenheimer, she was personally liable to CIBC for repayment

of that borrowing. We also note that she owned her CTI stock

after the exercise and had all of the rights of ownership related

thereto.

Apparently seeing the illogic of their just-rejected

argument, petitioners in their petition and in their briefs

expand their position as set forth in the memorandum of law by

arguing that the shares obtained through the exercise of the

stock options were subject to a substantial risk of forfeiture or

were nontransferable due to CTI’s insider trading policy. Most

specifically, petitioners argue, petitioner exercised her options

during the corporate blackout period; thus, they conclude, the

shares were subject to a substantial risk of forfeiture and were

nontransferable until May 17, 2002, the day the restricted

windows under the corporate insider trading policy ended. We

disagree with this argument.

6
This argument has been previously considered and rejected
by this Court and others. See Facq v. Commissioner, T.C. Memo.
2006-111; Hilen v. Commissioner, T.C. Memo. 2005-226; see also
Palahnuk v. United States, 70 Fed. Cl. 87 (2006), affd. 475 F.3d
1380 (Fed. Cir. 2007); 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), affd. 209 Fed. Appx. 690 (9th Cir. 2006).
 -30-

As was true in the case of petitioners’ previous argument,

this argument was considered and rejected by the Court of Appeals

for the Ninth Circuit in United States v. Tuff, supra at 1255-

1257. We do likewise here. A taxpayer’s rights in property

generally are subject to a substantial risk of forfeiture if the

taxpayer’s rights to full enjoyment of the property are

conditioned upon the future performance (or refraining from

performance) of substantial services, sec. 1.83-3(c)(1), Income

Tax Regs.; a taxpayer’s rights in property are transferable only

if the rights in such property of any transferee are not subject

to a substantial risk of forfeiture, sec. 83(c)(2). Petitioners

make no claim that petitioner’s rights to retain her CTI stock

were conditioned upon the future performance (or nonperformance)

of any services or the occurrence of any condition related to a

purpose of the transfer. In fact, petitioner’s consulting

agreement had terminated when she exercised the options, so her

rights to retain the shares were not conditioned on the future

performance or nonperformance of services. Nor do petitioners

argue that petitioner was subject to any risk, substantial or

otherwise, that she would have to return the stock to CTI at any

time after she exercised her options on March 5, 2002. To the

contrary, petitioners stipulated that at no time after exercising

her CTI stock options was petitioner under any obligation to

return the stock to CTI and that during 2002 and thereafter,
 -31-

petitioner did not sell any shares of CTI she obtained through

the March 5, 2002, exercise of stock options. See Merlo v.

Commissioner, T.C. Memo. 2005-178. While petitioner might have

violated CTI’s insider trading policy had she sold her CTI stock

to a third party upon receiving it, the possibility of such a

violation does not create a substantial risk of forfeiture within

the meaning of section 83. See United States v. Tuff, supra at

1255-1256.

D. Accuracy-Related Penalty

Respondent determined that petitioners are liable for an

accuracy-related penalty under section 6662(a) and (b)(2) for a

substantial understatement of income tax. In part, section

6662(a) and (b)(2) imposes a 20-percent accuracy-related penalty

for any portion of an underpayment that is attributable to a

substantial understatement of income tax. An “understatement” is

the excess of the amount of tax required to be shown on the

return for the taxable year over the amount of tax imposed that

is shown on the return, reduced by any rebate. Sec. 6662(d)(2).

A substantial understatement of income tax exists for any taxable

year for purposes of section 6662 if the amount of the

understatement for the taxable year exceeds the greater of 10

percent of the tax required to be shown on the return for the

taxable year or, in the case of an individual, $5,000. Sec.

6662(d)(1)(A).
 -32-

Respondent concedes that he bears the burden of production

under section 7491(c) and must come forward with sufficient

evidence indicating that it is appropriate to impose an

accuracy-related penalty on account of a substantial

understatement of income tax. See Higbee v. Commissioner,

116 T.C. 438, 446-447 (2001). In that we discern from the record

that petitioners’ understatement is in excess of $5,000, and of

10 percent of the amount required to be shown on the return, we

conclude that respondent has met this burden of production.

Petitioners bear the burden of proving that the accuracy-related

penalty does not apply because of reasonable cause, substantial

authority, or the like. Id.

In an attempt to meet their burden of proof, petitioners

argue in brief that they are not liable for the accuracy-related

penalty because they acted reasonably and in good faith by

relying on their tax adviser to prepare their 2002 Federal income

tax return correctly. Petitioners also try to prove that they

acted reasonably and in good faith by noting that the taxpayer in

Facq v. Commissioner, T.C. Memo. 2006-111, was in a similar

setting. There, the Court declined to sustain respondent’s

determination of an accuracy-related penalty for (among other

reasons) substantial understatement of income tax, stating that
 -33-

the issue was novel as of the time that the taxpayers filed their

tax return for the year at issue there.7

We agree with petitioners that they are not liable for the

accuracy-related penalty at issue. Such an accuracy-related

penalty is not imposed upon any portion of an underpayment as to

which a taxpayer acted with reasonable cause and in good faith.

Sec. 6664(c)(1). Whether the taxpayer satisfies those tests is a

factual determination, where the taxpayer’s effort to assess the

taxpayer’s proper tax liability is a very important

consideration. Sec. 1.6664-4(b)(1), Income Tax Regs. Reliance

on the advice of a tax professional may constitute reasonable

cause and good faith if, under all facts and circumstances, the

reliance is reasonable and the taxpayer acted in good faith. See

Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98

7
Petitioners also argue at length that respondent’s
determination of the accuracy-related penalty is “null and void”.
This is so, petitioners assert, because the notice of deficiency
neither shows specifically that respondent considered the
reasonable cause exception of sec. 6664, nor explains why that
exception was determined not to be applicable to this case. As
petitioners see it, such a showing and explanation in the notice
of deficiency is required by the Omnibus Budget Reconciliation
Act of 1989 (OBRA), Pub. L. 101-239, 103 Stat. 2106, as discerned
from the legislative history thereunder (specifically, H. Rept.
101-247, at 1393 (1989)). We disagree with this argument. We
read nothing in OBRA that requires that the inclusion of an
accuracy-related penalty in a notice of deficiency, to be valid,
must be accompanied by a specific showing that respondent
considered the reasonable cause exception of sec. 6664 and an
explanation as to why that exception was determined to be
inapplicable. See also Facq v. Commissioner, T.C. Memo.
2006-111.
 -34-

(2000), affd. 299 F.3d 221 (3d Cir. 2002); sec. 1.6664-4(c)(1),

Income Tax Regs.; see also Catalano v. Commissioner, 240 F.3d

842, 845 (9th Cir. 2001), affg. T.C. Memo. 1998-447. Reasonable

cause and good faith also may be found where a position taken on

a return involves an issue that is novel as of the time that the

return was filed. See Williams v. Commissioner, 123 T.C. 144,

153-154 (2004); Mitchell v. Commissioner, T.C. Memo. 2000-145;

cf. Van Camp & Bennion v. United States, 251 F.3d 862, 868 (9th

Cir. 2001) (“Where a case is one ‘of first impression with no

clear authority to guide the decision makers as to the major and

complex issues,’ a negligence penalty is inappropriate” (quoting

Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985),

affg. in part and vacating as to an addition to tax for

negligence 80 T.C. 34 (1983))).

We find reasonable cause on the basis of the fact that the

issue at hand was novel at the time petitioners filed their tax

return. To be sure, while the Court of Appeals for the Ninth

Circuit in United States v. Tuff, 469 F.3d at 1253, rejected the

taxpayer’s margin debt argument as “nonsense”, the court stated

that the issue was “A question of first impression in this

circuit”, id. at 1251. Given this statement, and the absence

when petitioners filed their 2002 Federal income tax return of

any “clear authority to guide the decision makers as to the major

and complex issues”, Foster v. Commissioner, supra at 1439, we
 -35-

decline to sustain respondent’s determination that petitioners

are liable for an accuracy-related penalty for substantial

understatement of income tax. Accord Montgomery v. Commissioner,

127 T.C. 43, 67 (2002); Racine v. Commissioner, T.C. Memo. 2006-

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

E. Holdings

We hold that petitioner realized income in 2002 when she

exercised her stock options received from CTI. We also hold that

petitioners are not liable for the accuracy-related penalty

determined by respondent under section 6662(a) and (b)(2). We

have considered all arguments made by petitioners for a contrary

holding as to the deficiency, and we have considered all

arguments made by respondent for a contrary holding as to the

accuracy-related penalty. As to the arguments that we have

considered but not discussed herein, we have rejected those

arguments as without merit.

Decision will be entered

for respondent as to the

deficiency; decision will be

entered for petitioners as to

the accuracy-related penalty.