UNITED STATES TAX COURT

117 T.C. No. 20

UNITED STATES TAX COURT

PAUL A. TANNER, SR. AND BEVERLY N. TANNER,

Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5738-00.

Filed December 10, 2001.

P planned to acquire control of C, a corporation.

C required P to sign a lockup agreement, which

restricted P’s sale of any C stock. The agreement

provided that, if P sold the stock within 2 years of

its acquisition, he would be subject to sec. 16(b) of

the Securities Exchange Act of 1934.

On July 9, 1993, P received a nonstatutory

employee stock option from C. On Sept. 7, 1994, P

exercised this stock option. P pledged some of this

stock as collateral for a loan, and the stock was sold

by the lender.

C issued P a Form 1099 for 1994 reporting income

from P’s exercise of the stock option. On the basis of

the Form 1099, R issued a notice of deficiency for 1994

determining that P received “other income” of $728,000

--the difference between the option price and the price

- 2 the stock was selling for on the date the option was

exercised.

Held: Sec. 83(c)(3), I.R.C., is inapplicable

because the 6-month restricted period under sec. 16(b)

of the Securities Exchange Act of 1934 commenced on the

date of grant of the option and expired by the date of

exercise.

Held, further, for purposes of sec. 83(c)(3),

I.R.C., the 6-month period provided by sec. 16(b) of

the Securities Exchange Act of 1934 cannot be extended.

Held, further, upon the exercise of his option, P

realized income in the amount of the difference between

the fair market value of the shares received over the

amount paid as the exercise price. Sec. 83(a), I.R.C.

Held, further, the assessment of a deficiency is

not barred by the statute of limitations because there

was a substantial omission of income. Sec. 6501(e),

I.R.C.

Claude R. Wilson, Jr., for petitioners.

Audrey M. Morris, for respondent.

VASQUEZ, Judge:

Respondent determined a deficiency of

$286,659 in petitioners’ 1994 Federal income tax.

On their 1994

tax return, petitioners reported income from wages of $161,067.

The issues for decision are:

(1) Whether petitioners had

unreported income of $728,000 in 1994 from the exercise of an

employee nonstatutory stock option; and (2) whether respondent

- 3 proved a substantial omission of income under section 6501(e)1 to

extend the period of limitations to 6 years.2

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

their petition, Paul Tanner (hereinafter, petitioner) and Beverly

Tanner resided in Dallas, Texas.3

At the time of trial, petitioner was 70 years old and

retired.

Before his retirement, petitioner bought, sold, and

invested in private and public companies.

In 1992, petitioner

planned to acquire control of Polyphase Corp. (Polyphase).

Before Polyphase entered into negotiations with petitioner,

it required petitioner to sign a “lockup agreement”.

This lockup

agreement was a contractual obligation that restricted for 2

years petitioner’s ability to dispose of any Polyphase stock that

he might acquire while he had more than 5 percent beneficial

ownership in the corporation.

1

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue.

2

Petitioners also argue that they are entitled to a

deduction for personal exemptions of $4,900. As the deduction

for personal exemptions is computational, we leave it for the

parties to compute in accordance with this decision.

3

year.

Petitioners filed a joint return for the 1994 taxable

- 4 On September 21, 1992, petitioner signed the lockup

agreement.

The lockup agreement further provided:

Should I sell these shares I agree that such sale will

be subject to Section 16b of The Securities Act of 1934

(Disgorgement of Insider Short-Swing Profits) and

further I will be subject to any additional damages

incurred by Polyphase Corporation, its directors or

shareholders.

The lockup agreement provided that, after the 2-year period,

petitioner would be allowed to sell his shares if permitted under

rule 144 of the Securities Exchange Act.

Additionally, the

lockup agreement provided that the sale restriction could be

altered only by the unanimous action of the board of directors.

The lockup agreement, however, allowed petitioner to use the

shares as collateral if the sale restriction also applied to the

lender.

By December 1992, while owning, directly and indirectly,

approximately 65 percent of Polyphase, petitioner became chairman

of the board, chief executive officer, and president of

Polyphase.

On July 9, 1993, petitioner received a nonstatutory employee

stock option from Polyphase.

The stock option agreement gave

petitioner the right to purchase up to 182,000 shares of

Polyphase common stock at an exercise price of 75 cents per

share.

The stock option agreement contained several restrictions

upon the exercise of the option:

The option would terminate if

petitioner voluntarily terminated his employment with Polyphase;

- 5 the option was nonassignable and nontransferable; and only

petitioner could exercise the option.

On September 7, 1994, petitioner exercised the stock option

and paid Polyphase $136,500 (i.e., 182,000 shares at 75 cents

each).

In order to finance the exercise of the option,

petitioner obtained a loan from a friend, Mr. Don Ruben, and

pledged 122,000 Polyphase shares as collateral for the loan.

Sometime after the pledge of stock, Mr. Ruben sold the stock.

Of the remaining 60,000 shares, in December 1994, petitioner

gave 40,000 shares to his son and 20,000 shares to his brotherin-law.

On February 21, 1996, Polyphase issued a Form 1099 to

petitioner reporting “other income” of $728,000 for the 1995

taxable year.

The amount is the difference between the option

price of 75 cents per share and the price the stock was selling

for on the date that the option was exercised.

On January 15,

1999, respondent issued a notice of deficiency for the 1995

taxable year which determined that petitioner received additional

income of $728,000.

On April 19, 1999, petitioner filed a

petition with the Court to dispute, among other items, this

additional income.

After respondent’s determination for 1995, on October 21,

1999, Polyphase issued a corrected Form 1099 for the 1995 taxable

year reporting “other income” as “None”.

In addition, on the

- 6 same day, Polyphase issued a Form 1099 to petitioner for the 1994

taxable year reporting “other income” of $728,000.

On April 7, 2000, respondent issued a notice of deficiency

to petitioner for the 1994 taxable year, determining that

petitioner received “other income” of $728,000.4

Respondent

conducted no examination of petitioner’s books and records before

issuing the notice of deficiency for 1994.

The sole basis for

the proposed adjustment was the Form 1099 from Polyphase to

petitioner.

On May 22, 2000, petitioner filed a petition with

the Court disputing that he had “other income” of $728,000 for

1994.5

OPINION

A.

Is the Exercise of the Polyphase Stock Option Subject To

Taxation Under Section 83(a)?

Petitioner argues that his exercise of the stock option was

not subject to taxation under section 83(a).

Petitioner contends

that the exercise was exempted under section 83(c)(3) because a

sale of the stock would have given rise to suit under section

16(b) of the Securities Exchange Act of 1934, ch. 404, 48 Stat.

896, 15 U.S.C. sec. 78p(b) (1994) (hereinafter, section 16(b)).

4

In addition, respondent disallowed a deduction of $4,900

for personal exemptions. With the addition of the “other income”

of $728,000, respondent determined that petitioners had too much

income to qualify for the deduction.

5

On May 25, 2000, a stipulated decision was entered

dismissing the petition for the 1995 taxable year (docket No.

7281-99).

- 7 Petitioner further argues that the stock purchased from the

option exercise was nontransferable and subject to a substantial

risk of forfeiture because petitioner was subject to section

16(b) for a period of 2 years under the lockup agreement.

Respondent argues that, upon exercise of the stock option,

petitioner recognized compensation income under section 83.

Respondent counters that the shares were not subject to section

83(c)(3) when petitioner exercised the option on September 7,

1994, because the section 16(b) limitation had expired.

Respondent contends that the 6-month period in which petitioner

was prohibited from selling the securities under section 16(b)

began when the option was granted, not exercised.

Respondent

argues that, under a 1991 amendment to section 16(b), any

acquisition of an option involves a “purchase” for section 16(b)

purposes, and section 16(b) liability is triggered by either a

“purchase and sale” or a “sale and purchase”.

Because the

option was granted on July 9, 1993, respondent contends that the

6-month period of section 16(b) liability would have expired by

the time petitioner exercised the stock option (i.e., September

7, 1994).

Therefore, respondent argues that the section 83(c)(3)

exception does not apply and that exercise was subject to

taxation under section 83(a).

Respondent further argues that petitioner and Polyphase may

not extend the statutory 6-month period of section 16(b)

- 8 liability through their lockup agreement.

Respondent contends

that there is no provision that allows individuals or

corporations to voluntarily extend section 16(b) liability.

1.

Is the Burden of Proof on Respondent?

As a preliminary matter, petitioner argues that the burden

of proof is on respondent because respondent issued a notice of

deficiency based solely upon a Form 1099 issued by Polyphase,

rather than conduct an examination of petitioner.

Petitioner

argues that Portillo v. Commissioner, 932 F.2d 1128 (5th Cir.

1991), revg. T.C. Memo. 1990-68, and 988 F.2d 27 (5th Cir. 1993),

revg. T.C. Memo. 1992-99, and sections 7491(a) and 6201(d) place

the burden on respondent.

We do not find that the resolution of this case depends on

which party has the burden of proof.

We resolve the issues on

the basis of a preponderance of evidence in the record.

Assuming

arguendo that respondent does have the burden of proof, we still

conclude, on the basis of evidence in the record, that petitioner

had $728,000 of additional income, for the reasons outlined

below.

2.

Section 83(a)

Section 83(a) generally provides that when property is

transferred to a taxpayer in connection with the performance of

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

the taxpayer’s rights in the property are transferable or not

- 9 subject to a substantial risk of forfeiture, less the amount paid

for the property, is includable in the taxpayer’s gross income.

Kolom v. Commissioner, 71 T.C. 235, 241 (1978).

Therefore,

property must be substantially vested for the transferee to be

regarded as the owner of the property, and, thus, taxed upon its

receipt.

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

Under the regulations, property is substantially vested

“when it is either transferable or not subject to a substantial

risk of forfeiture”.

Sec. 1.83-3(b), Income Tax Regs.

Property

is transferable:

if the person performing the services or receiving the

property can sell, assign, or pledge (as collateral for

a loan, or as security for the performance of an

obligation, or for any other purpose) his interest in

the property to any person other than the transferor of

such property and if the transferee is not required to

give up the property or its value in the event the

substantial risk of forfeiture materializes.

Sec. 1.83-3(d), Income Tax Regs.

Property is subject to a

substantial risk of forfeiture “if such person’s rights to full

enjoyment of such property are conditioned upon the future

performance of substantial services by any individual.”

Sec.

83(c)(1); sec. 1.83-3(c), Income Tax Regs.

The grant of the option at issue was not a taxable event.

See Commissioner v. LoBue, 351 U.S. 243, 249 (1956); McDonald v.

Commissioner, 764 F.2d 322, 326 (5th Cir. 1985), affg. T.C. Memo.

1983-197.

The exercise of an option, however, may subject the

- 10 holder of the option to taxation under section 83(a) if the

holder’s rights in the purchased stock are transferable or are

not subject to a substantial risk of forfeiture.

Sec. 83(a);

sec. 1.83-7(a), Income Tax Regs., infra p. 15.

Under certain

circumstances, however, section 83(c)(3) prevents taxation under

section 83(a) when the sale of the property at a profit could

subject a person to suit under section 16(b).

If the seller

could be subject to suit under section 16(b), then “such person’s

rights in such property are (A) subject to a substantial risk of

forfeiture, and (B) not transferable”.

3.

Section 16(b)

Section 16(b) provides that a corporate insider who sells

any equity security of the issuer within 6 months after the date

of issuance of any equity security of the issuer to the insider

for a profit must return that profit to the issuing corporation

(“short-swing profit rule”).

15 U.S.C. sec. 78p(b); see Gresham

v. Commissioner, 79 T.C. 322, 328 (1982), affd. 752 F.2d 518

(10th Cir. 1985); Kolom v. Commissioner, supra at 237 n.3; Davis

v. Commissioner, 17 T.C. 549, 550 (1951).

Section 16(b), in

relevant part, provides:

For the purpose of preventing the unfair use of

information which may have been obtained by such

beneficial owner, director, or officer by reason of his

relationship to the issuer, any profit realized by him

from any purchase and sale, or any sale and purchase,

of any equity security of such issuer (other than an

exempted security) within any period of less than six

- 11 months, unless such security was acquired in good faith

in connection with a debt previously contracted, shall

inure to and be recoverable by the issuer, irrespective

of any intention on the part of such beneficial owner,

director, or officer in entering into such transaction

of holding the security purchased or of not

repurchasing the security sold for a period exceeding

six months. * * *

15 U.S.C. sec. 78p(b).

The purpose of the section is to

eliminate trading on insider information and eliminate conditions

that would give rise to possibilities for such trading.

Keller

Indus. v. Walden, 462 F.2d 388, 389 n.4 (5th Cir. 1972).

4.

When Does the 6-month Restricted Period Under Section

16(b) Begin To Run?

We find that the 6-month restricted period under section

16(b) commences on the date of grant.

In 1991, the Securities

and Exchange Commission adopted amendments to the section 16(b)

rules to clarify how the section applies to derivative

securities, including options.6

Magma Power Co. v. Dow Chem.

Co., 136 F.3d 316, 321 (2d Cir. 1998).

The amendments recognized

that holding options is “functionally equivalent” to holding the

underlying equity securities for section 16(b) purposes because

the value of the option is related to the value of the underlying

security.

6

Final rules and solicitation of comments:

Ownership

A “derivative security” is defined to include options

with a fixed exercise price, like the one in issue. Final rules

and solicitation of comments: Ownership Reports and Trading by

Officers, Directors and Principal Security Holders, 56 Fed. Reg.

7242, 7252 (Feb. 21, 1991).

- 12 Reports and Trading by Officers, Directors and Principal Security

Holders, 56 Fed. Reg. 7242, 7248 (Feb. 21, 1991).

Similar to how

an insider’s opportunity for profit begins when he purchases

stock, the opportunity for profit begins when an insider

purchases or acquires an option because the insider knows at what

price he can obtain stock and can determine the extent of his

profit.7

Id.

As a result, the amendments require that the acquisition of

the option, not its exercise, be deemed the significant event to

commence the 6-month restricted period under section 16(b).

Id.

The commentary explains that the exercise of an option merely

changes the form of beneficial ownership from indirect to direct,

representing “neither the acquisition nor the disposition of a

right affording the opportunity to profit”.

Id. at 7249.

The parties dispute when the restricted 6-month period of

section 16(b) commences.

Respondent argues that, because of the

1991 amendments to the regulations for section 16(b), the 6-month

period begins at the date of the grant of the option.

Petitioner

concedes that if the 1991 amendment to the regulations for

7

The rules explain that the amendments adopted do not

distinguish between options that are purchased and other options,

such as those granted in this case. Final rules and solicitation

of comments: Ownership Reports and Trading by Officers,

Directors and Principal Security Holders, 56 Fed. Reg. at 7251.

Not to treat the employee option grant as a “purchase” for sec.

16(b) purposes would “provide a significant opportunity for the

short-swing transactions Congress wished to eliminate.” Id.

- 13 section 16(b) is applicable, then respondent “would be correct,

at least insofar as the granting of the option being deemed to be

a purchase is concerned”.

Petitioner’s only argument that the

1991 amendment does not apply is that the exercise of the option

is a “discretionary transaction”.

The language to which petitioner refers regarding

discretionary transactions is found in 17 C.F.R. sec. 240.16b3(d), which provides:

Any transaction involving a grant, award or other

acquisition from the issuer (other than a Discretionary

Transaction) shall be exempt if: * * * (3) The issuer

equity securities so acquired are held by the officer

or director for a period of six months following the

date of such acquisition, provided that this condition

shall be satisfied with respect to a derivative

security if at least six months elapse from the date of

acquisition of the derivative security to the date of

disposition of the derivative security (other than upon

exercise or conversion) or its underlying equity

security. [Emphasis added.]

Final Rule:

Ownership Reports and Trading by Officers,

Directors, and Principal Security Holders, 61 Fed. Reg. 30376,

30393 (June 14, 1996).

This rule exempts a transaction from

section 16(b) (i.e., the transaction would not be subject to

section 16(b) liability) if the option is not a discretionary

transaction and is held for 6 months from the date of grant

before it is disposed of.

We note that this regulation became

effective in 1996 and does not apply to petitioner’s 1994 taxable

- 14 year.8

Id. at 30376.

We, therefore, find petitioner’s argument

to be without merit.

We conclude that the 6-month period of section 16(b) began

at the “purchase” date--the date of the grant of the option.

If

we consider solely the liability created by section 16(b), the

section 16(b) period expired before the option was exercised, and

section 83(c)(3) is not applicable.

5.

Does the Lockup Agreement Extend the 6-month Period of

Section 16(b) to 2 Years?

Petitioner further argues that the lockup agreement provided

by contract that petitioner would be subject to section 16(b) for

2 years instead of only the statutory period of 6 months.

Respondent argues that there is no provision in section 16(b)

that allows individuals to voluntarily subject themselves to

liability under the statute.

Section 83(c)(3) applies only “So long as the sale of the

property at a profit could subject a person to suit under section

16(b)”.

Section 1.83-3(j)(1), Income Tax Regs., provides:

For purposes of section 83 and the regulations

thereunder if the sale of property at a profit within

six months after the purchase of the property could

subject a person to suit under section 16(b) of the

Securities Exchange Act of 1934, the person’s rights in

8

We note that discretionary transactions are not excluded

in the 1991 version of this regulation. See Final rules and

solicitation of comments: Ownership Reports and Trading by

Officers, Directors and Principal Security Holders, 56 Fed. Reg.

at 7270.

- 15 the property are treated as subject to a substantial

risk of forfeiture and as not transferable until the

earlier of (i) the expiration of such six-month period,

or (ii) the first day on which the sale of such

property at a profit will not subject the person to

suit under section 16(b) of the Securities Exchange Act

of 1934. * * *

This specific language was included because the notice for the

final regulations rejected a proposal to extend the initial 6month period under section 16(b), even if a suit is still

maintainable after the 6-month period.

See Final Regulations:

Property Transferred in Connection with the Performance of

Services, 50 Fed. Reg. 31712, 31713 (Aug. 6, 1985).

The notice

explained that the legislative history to section 83(c)(3)

provided only for the 6-month period during which the section

16(b) restriction applies.

See id.; H. Rept. 97-201, at 263

(1981), 1981-2 C.B. 352, 404.

Given the background of the

regulation and its language, we conclude that section 83(c)(3)

does not apply beyond the initial 6-month period provided in the

section 16(b) restriction.

6.

Effect of Section 83(a) on Exercise of Option

The regulations provide:

If section 83(a) does not apply to the grant of such an

option because the option does not have a readily

ascertainable fair market value at the time of grant,

sections 83(a) and 83(b) shall apply at the time the

option is exercised or otherwise disposed of, even

though the fair market value of such option may have

become readily ascertainable before such time. If the

option is exercised, sections 83(a) and 83(b) apply to

- 16 the transfer of property pursuant to such exercise, and

the employee or independent contractor realizes

compensation upon such transfer at the time and in the

amount determined under section 83(a) or 83(b). * * *

Sec. 1.83-7(a), Income Tax Regs.

The employee stock option issued to petitioner, because of

its lack of transferability, had no ascertainable market value

when granted.

See McDonald v. Commissioner, 764 F.2d at 326.

Section 83(e)(3) provides that section 83 “shall not apply to the

transfer of an option without a readily ascertainable fair market

value”.

Therefore, in accordance with this regulation and

section 83(a), because the option had no readily ascertainable

value when granted, upon the exercise of his option, petitioner

realized compensation in the amount of the difference between the

fair market value of the shares received and the amount paid as

the exercise price--$728,000.

B.

Is the Assessment of a Deficiency Barred by the Statute of

Limitations?

The parties stipulate that the assessment of a deficiency in

this case is barred by the 3-year period of limitations under

section 6501(a) unless respondent proves a substantial omission

of income under section 6501(e).

Under section 6501(e), the 3-year limitation period is

extended to 6 years when a taxpayer omits properly includable

income from his or her return in an amount greater than 25

- 17 percent of the amount of gross income stated on the return.

See

sec. 6501(e)(1)(A).

Petitioner reported gross income of $161,067 on his joint

return for the 1994 tax year.

In accord with our holding that

petitioner did not report $728,000 from the exercise of his stock

option, petitioner’s omitted gross income exceeded 25 percent of

the gross income reported on the return, and the 6-year

assessment period is applicable.

We conclude that the assessment

period had not expired at the time respondent mailed the notice

of deficiency for petitioner’s 1994 taxable year.

In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not herein

discussed, we find them to be irrelevant or without merit.

To reflect the foregoing,

Decision will be

entered for respondent.