UNITED STATES TAX COURT

T.C. Memo. 2005-178

UNITED STATES TAX COURT

ROBERT J. MERLO, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21538-03.

Filed July 20, 2005.

Brian G. Isaacson and Don Paul Badgley, for petitioner.

Sandra Veliz, for respondent.

MEMORANDUM OPINION

HAINES, Judge:

This case is before the Court on the

parties’ cross-motions for partial summary judgment pursuant to

Rule 121.1

The issues for decision are:

(1) Whether

petitioner’s rights to shares of stock of Exodus Communications,

1

Unless otherwise indicated, Rule references are to the Tax

Court Rules of Practice and Procedure, and section references are

to the Internal Revenue Code, as amended.

- 2 Inc. (Exodus) he acquired during 2000 as a result of exercising

an incentive stock option (ISO) were subject to a substantial

risk of forfeiture; and (2) whether petitioner is entitled to an

alternative tax net operating loss (ATNOL) deduction under

section 56(d).

Background

At the time he filed his petition, petitioner resided in

Dallas, Texas.

On July 2, 1999, petitioner commenced work for Service

Metrics, Inc. (SMI), as Vice President of Marketing.

On July 14,

1999, SMI granted petitioner a stock option to purchase 275,000

shares of SMI common stock.

On November 19, 1999, petitioner entered into an employment

agreement with Exodus.

SMI.

On November 23, 1999, Exodus acquired

Pursuant to the reorganization agreement, petitioner’s SMI

stock option was assumed by Exodus and was converted into an

option to purchase shares of Exodus common stock.

According to the Exodus prospectus entitled “Stock Options

Granted Under the Service Metrics, Inc. 1998 Stock Option Plan

Assumed by Exodus Communications, Inc.”:

The Service Metrics Plan generally does not impose

any restrictions on the resale of shares of Common

Stock purchased under the Service Metrics Plan. * * *

In accordance with federal law and Exodus’ policy

prohibiting insider trading, you [petitioner] are

always prohibited from trading in Exodus securities

when you [petitioner] have inside information.

- 3 The Exodus Procedures and Guidelines Governing Securities

Trades by Company Personnel (Exodus Procedures) states in

pertinent part:

It is illegal for any Director, officer or employee of

Exodus communications, Inc. (the “Company”), to trade

in the securities of the Company while in the

possession of material nonpublic information about the

Company. * * *

*

*

*

*

*

*

*

Violation of this policy or federal or state insider

trading or tipping laws by any Director, officer or

employee may subject a Director to dismissal

proceedings and an officer or employee to disciplinary

action by [Exodus] up to and including termination for

cause.

The Exodus Procedures contain no requirement that petitioner

return the stock to Exodus if he attempted to sell his stock in

violation of its insider trading policy.

On August 28, 2000, petitioner and Exodus entered into a

Settlement Agreement and General Release, effective as of August

4, 2000, under which petitioner ceased to hold the position of

Vice President, Marketing of Exodus.

On December 21, 2000,

petitioner exercised his ISO to purchase 46,125 shares of Exodus

common stock. Petitioner’s employment with Exodus terminated on

December 31, 2000.

- 4 Exodus filed bankruptcy on September 26, 2001.

In a press

release dated November 12, 2001, Exodus announced that the

company’s common stock had no value.

On his 2000 Form, 1040, U.S. Individual Income Tax Return,

petitioner included in his alternative taxable income for

alternative minimum tax (AMT) purposes $452,025, the excess of

the price for Exodus common stock reported on NASDAQ on April 15,

2001, over the price he paid for the stock.

Petitioner did not

use the stock’s fair market value on the December 21, 2000, ISO

exercise date.

Instead, petitioner filed Form 8275-R, Regulation

Disclosure Statement, disclosing that he relied on proposed

legislation H.R. 2794, 107th Cong., 1st Sess. (2001), then

pending in Congress, to use the stock’s fair market value on

April 15, 2001.

The proposed legislation would have allowed

taxpayers to use the difference between the amount paid for

shares purchased pursuant to the exercise of an ISO during 2000

and the fair market value of such shares on April 15, 2001, for

purposes of computing their AMT.

H.R. 2794, 107th Cong., 1st

Sess. (2001), was never enacted.

On November 13, 2003, respondent mailed petitioner a notice

of deficiency, in which respondent determined a deficiency of

$4,833 in petitioner’s 1999 Federal income tax and a deficiency

of $169,510 in petitioner’s 2000 Federal income tax.

notice of deficiency respondent stated:

In the

- 5 The fair market value of Exodus Communications, Inc.

common stock, at the date that certain stock options

were exercised (December 21, 2000) was $23.25 per share

instead of the amount used to compute the

adjustments/preferences on [F]orm 6251 of the income

tax return. Therefore, the amount of the

adjustment/preference is $1,057,415.00 instead of the

$452,025.00 reported on the return. * * *

On December 4, 2003, prior to filing a petition for

redetermination of the notice of deficiency, petitioner filed a

Form 1040X, Amended U.S. Individual Income Tax Return for 2000,

reducing his alternative taxable income for AMT purposes by

$452,025, the excess of the price for Exodus common stock

reported on NASDAQ on April 15, 2001, over the price he paid for

the stock, thereby eliminating the $116,973 of AMT reported on

his 2000 Federal income tax return and claiming a tax refund of

$149,757.

Under Part II, Explanation of Changes to Income,

Deductions, and Credits, of the 2000 amended Federal income tax

return, petitioner stated:

“Return adjusted to reflect shares

subject to substantial risk of forfeiture and non-transferable.”

Petitioner filed a petition for redetermination of the

notice of deficiency for the year 2000 with the Court on December

18, 2003.

On December 27, 2004, respondent filed a motion for partial

summary judgment on the issue of whether petitioner’s rights to

shares of stock of Exodus he acquired during 2000 as a result of

exercising an ISO were subject to a substantial risk of

forfeiture.

- 6 On December 28, 2004, petitioner filed with the Court a

cross-motion for partial summary judgment in petitioner’s favor

that:

(1) Petitioner’s rights to shares of stock acquired during

2000 as a result of exercising an ISO were subject to a

substantial risk of forfeiture; and (2) petitioner is entitled to

an ATNOL deduction under section 56(d).

Discussion

Summary judgment is intended to expedite litigation and

avoid unnecessary and expensive trials.

Fla. Peach Corp. v.

Commissioner, 90 T.C. 678, 681 (1988).

The Court may grant

partial summary judgment when there are no genuine issues of

material fact and a decision may be rendered as a matter of law.

Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520

(1992), affd. 17 F.3d 965 (7th Cir. 1994); Zaentz v.

Commissioner, 90 T.C. 753, 754 (1988).

We conclude that there is

no genuine issue of material fact as to whether petitioner’s

right to shares of Exodus stock was subject to a substantial risk

of forfeiture and that a decision may be rendered as a matter of

law.

We also conclude there is a material issue of fact as to

whether petitioner is entitled to an ATNOL deduction under

section 56(d).

Petitioner admits that petitioner’s stock option meets the

requirements of section 422 and qualifies as an ISO.

Under

section 421(a), a taxpayer is allowed to defer regular tax on

- 7 income resulting from a stock option meeting the requirements of

section 422 or 423 until the taxpayer sells the shares of stock.

Were our inquiry to end here petitioner would not have been

required to recognize any gain until he disposed of the shares of

stock he acquired by exercising his ISO.

Our inquiry cannot end

here because of the application of the AMT.

Under section 56(b)(3), “Section 421 shall not apply to the

transfer of stock acquired pursuant to the exercise of an

incentive stock option (as defined in section 422).”

Therefore,

for AMT purposes, shares of stock acquired by exercising a stock

option that qualifies as an ISO under section 422 are treated as

shares of stock acquired by means of exercising a nonqualified

stock option under section 83.

See sec. 56(b)(3); sec. 1.83-

7(a), Income Tax Regs.; see also Speltz v. Commissioner, 124 T.C.

(2005) (slip op. at 22-23).

Under section 83, a taxpayer generally must recognize income

when he exercises a compensatory stock option to the extent that

the fair market value of the shares of stock transferred to him

exceeds the price he pays at the time he exercises the option if

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

subject to a substantial risk of forfeiture.2

2

Sec. 83(a); Tanner

Section 83(a) provides:

SEC. 83(a) General Rule.–-If, in connection with

the performance of services, property is transferred to

(continued...)

- 8 v. Commissioner, 117 T.C. 237, 242 (2001), affd. 65 Fed. Appx.

508 (5th Cir. 2003); sec. 1.83-7(a), Income Tax Regs.

Caselaw establishes that a restriction on the

transferability of property does not affect the timing of income

inclusion or the amount of income required to be included under

section 83 if the property is not subject to a substantial risk

of forfeiture.

See Pledger v. Commissioner, 71 T.C. 618 (1979),

affd. 641 F.2d 287 (5th Cir. 1981); Sakol v. Commissioner, 67

T.C. 986 (1977), affd. 574 F.2d 694 (2d Cir. 1978); Koss v.

Commissioner, T.C. Memo. 1989-330, affd. 908 F.2d 962 (3d Cir.

1990).

Under section 83(c)(3), if a taxpayer selling his shares of

stock could be subject to a suit under section 16(b) of the

2

(...continued)

any person other than the person for whom such services

are performed, the excess of-(1) the fair market value of such property

(determined without regard to any restriction other

than a restriction which by its terms will never lapse)

at the first time the rights of the person having the

beneficial interest in such property are transferable

or are not subject to a substantial risk of forfeiture,

whichever occurs earlier, over

(2) the amount (if any) paid for such property,

shall be included in the gross income of the person who

performed such services in the first taxable year in

which the rights of the person having the beneficial

interest in such property are transferable or are not

subject to a substantial risk of forfeiture, whichever

is applicable. * * *

- 9 Securities Exchange Act of 1934, ch. 404, 48 Stat. 896, “such

person’s rights in such property are (A) subject to a substantial

risk of forfeiture”.

Section 83(c)(3) does not apply beyond the

initial 6-month period provided in section 16(b) of the

Securities Exchange Act of 1934.

Tanner v. Commissioner, supra

at 245-256.

Petitioner does not claim that he would have been subject to

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

1934.

A taxpayer’s right to his shares of stock may be subject to

a substantial risk of forfeiture if his rights to full enjoyment

of the shares of stock is conditioned upon the future performance

of substantial services.

Sec. 83(c)(1).

The record is devoid of

any facts that show petitioner’s right to full enjoyment of his

shares of Exodus stock was conditioned upon the future

performance of substantial services.

Petitioner alleges his shares of Exodus stock were subject

to a substantial risk of forfeiture and not freely transferable

because they were blacked out from trading by reason of Exodus’s

insider trading policy.

In his brief, petitioner relies on

Robinson v. Commissioner, 805 F.2d 38 (1st Cir. 1986), revg. 82

T.C. 444 (1984).

The Court of Appeals for the First Circuit in Robinson v.

Commissioner, supra at 40-41, held that a taxpayer’s shares of

- 10 stock were subject to a substantial risk of forfeiture until a

1-year sellback provision lapsed.

The employer in Robinson could

have compelled its employee to sell the shares of stock back to

it at the price the employee paid at the time he exercised his

stock option if the employee attempted to sell the shares of

stock within a year of exercising his stock option.

Robinson is distinguishable from the instant case on its

facts.

Petitioner has not shown that Exodus could have ever

compelled him to return his shares of stock.

The remedy chosen

expressly by Exodus to enforce its insider trading policy was not

a forfeiture of the shares, but disciplinary proceedings against

the offending employee, up to and including involuntary

termination of employment.

The Court of Appeals for the Ninth Circuit, citing section

1.83-3(c)(1), Income Tax Regs., has noted that “The risk of

forfeiture analysis requires a court to determine the chances the

employee will lose his rights in property transferred by his

employer.”

Theophilos v. Commissioner, 85 F.3d 440, 447 n.18

(9th Cir. 1996), revg. on another issue T.C. Memo. 1994-45.

The evidence in the instant case shows that petitioner had

no substantial risk of losing the rights to his shares of Exodus

stock.

There is no evidence that Exodus could have ever

compelled petitioner to return his shares after he exercised his

ISO; no sellback provision is present; nor is there any evidence

- 11 that Exodus could have compelled petitioner to forfeit his shares

of stock.

In consequence of the foregoing, we hold that petitioner’s

rights to his shares of Exodus stock were not subject to a

substantial risk of forfeiture.

We therefore shall grant

respondent’s motion for partial summary judgment.

Petitioner also alleges that he is entitled to an ATNOL

deduction under section 56(d).

An ATNOL deduction is the net

operating loss deduction allowable for the taxable year under

section 172 and is computed by taking into consideration all the

adjustments to taxable income under sections 56 and 58 and all

the preference items under section 57 (but only to the extent

that the items increased the net operating loss for the year for

regular tax purposes).

Sec. 56(d)(1).

Section 172 defines the

net operating loss as “the excess of the deductions allowed by

this chapter over the gross income.”

Sec. 172(c).

In the case

of a noncorporate taxpayer, the amount deductible on account of

losses from sales or exchanges of capital assets shall not exceed

the amount includable on account of gains from sales or exchanges

of capital assets.

Sec. 172(d)(2)(A).

In addition, where

deductions are not attributable to the taxpayer’s trade or

business, the deductions generally will be allowed only to the

extent of the amount of the gross income not derived from the

taxpayer’s trade or business.

Sec. 172(d)(4).

- 12 Determination of whether petitioner is entitled to such

deduction is based upon facts and circumstances which are not

before the Court.

Granting of the motion for summary judgment

with respect to this issue would be premature, because material

issues of fact exist, not the least of which is whether

petitioner was engaged in his activity as an investor or trader.

We therefore shall deny petitioner’s motion for summary judgment

as to whether he is entitled to an ATNOL deduction under section

56(d).

In reaching our holdings herein, we have considered all

arguments made, and to the extent not mentioned above, we

conclude that they are moot, irrelevant, or without merit.

To reflect the foregoing,

An appropriate order

will be issued.