Petition — Aaron L. Kolom, Et Ux. v. Commissioner of Internal Revenue

Supreme Court brief1981

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IN THE

Supreme Court of the United States

October Term 1981

AARON L. KOLOM and SERITA KOLOM.,

Petitioners,

vs.

COMMISSIONER OF INTER:JAL REVENUE,

Respondent.

Petition for Writ of Certiorari to the United States Court

of Appeals for the Ninth Circuit.

RAYMOND C. FISHER,

Counsel of Record,

JEFFREY L. GRAUSAM,

JOSEPH BANKMAN,

TUTTLE & TAYLOR INCORPORATED,

609 South Grand Avenue,

Los Angeles, Calif. 90017,

(213) 683-0600,

Attorneys for Petitioners,

Aaron L. Kolom and Serita Kolom.

Parker & Son, Inc., Law Printers, Los Angeles. Phone 724-6622

Questions Presented for Review.

1. Whether for purposes of the minimum tax on tax

preferences imposed by Sections 56 and 57 of the Internal

Revenue Code, the ‘‘fair market value’’ of a share of stock

transferred pursuant to the exercise of a qualified stock

option must be determined by taking into account the impact

of Section 16(b) of the Securities Exchange Act of 1934 on

the recipient of the shares.

2. Whether the incorporation of Section 83 of the In-

ternal Revenue Code into Section 57(a)(6) of the Internal

Revenue Code by Treasury Regulations Section 1.57-1(f)(3)

is invalid.

3. Whether Treasury Regulations Section 1.57-1(f)(3)

establishes an irrebuttabie presumption as to the value of

stock transferred in return for services that violates the Due

Process Clause of the Fifth Amendment to the Constitution.

TABLE OF CONTENTS

Page

Questions Presented for Review .................. i

MCLs Cee ce Ces ssbcececscesecsece l

I a l

MM ccs cheese cseossseccccecerse 2

Reasons for Granting the Writ ............ 6.000006. 6

The Opinion Below Creates a Conflict Among the

Circuits as to Whether the ‘‘Fair Market Value"’ of

Stock Received Through Exercise of a Stock Option

May Be Determined Without Taking Into Account

the Impact on the Recipient of Section 16(b).... 6

Il.

The Court Below Erred in Polding Valid Treasury

Regulations That Apply the Fair Market Value Prin-

ciples of Section 83 to Section 57(a)(6) in the Face

of Inconsistent Statutory Language and a Direct

EEE Secs ccvccccccccccccccces 10

Ill.

As Applied by the Court Below the Artificial and

Arbitrary Definition of Fair Market Value In-

corporated Into Section 57(a)(6) by the Treasury

Regulations Creates an Irrebuttable Presumption

That Violates the Due Process Clause of the Fifth

Amendment to the Constitution ............... 13

Nee ee cect c ccc cccccccces 18

eee

Page

INDEX TO APPENDICES

Appendix A. Opinion of the United Siates Court of

Appeals for the Ninth Circuit ........... App. p.

Appendix B. Opinion of United States Tax Court...

Appendix C. United States Constitution—Amendment

Appendix D. Internal Revenue Code Section 56(a) . .

Appendix E. Internal Revenue Code Section 57(a)(6)

Appendix F. Internal Revenue Code Section 83(a) . .

Appendix G. Internal Revenue Code Section 83i{e) . .

Appendix H. Internal Revenue Code Section 421(a) .

Appendix I. Internal Revenue Code Section 422(a)

Appendix J. Proposed Treasury Regulations Section

1.57(f)(3), as Proposed December 30, 1970.......

Appendix K. Treasury Regulations Section 1.57-

1(f)(3), as Adopted in Final Form September 11, 1978

0'S' 6. 9:60 8.8 08-6 'S 818.0 8)o SO 8.86.65 6 0.86.3:'68 6060 9 9 5.2:64' 9.9

SHRSCHOSCHBSOHOOSESSEOHRSESCHOCECTEOCOCOCEECHR PHC H E666 8 4°

Appendix M. Section 16(b) of the Securities Exchange

Act of 1934, 15 U.S.C. S7BpD) 0. cccsccccens

Appendix N. Rule 16b-6; 17 C.F.R. 240.16b-6 ....

TABLE OF AUTHORITIES

Cases Page

Bankers Trust Company v. United States, 284 F.2d 537

SME, De WeeeeGadcwa dveustachece cess a

Cleveland Bd. of Educ. v. LaFleur, 414 U.S. 632

NOs aga valceed wuss ies pevebeeestis 15,

Cohu v. Commissioner, 8 T.C. 796 (1947) ....... :

Goldwasser v. Commissioner, 47 B.T.A. 445 (1942),

aff'd 142 F.2d 556 (2d Cir. 1944), cert. denied, 323

Se EN ceca Ch os 4 1.4e beds oeerew iis cab 8,

Harrison v. United States, 475 F.Supp. 408 (E.D. Pa.

1979), aff'd, 620 F.2d 288 (3rd Cir. 1980) .......

Heiner v. Donnan, 285 U.S. 12 (1932) ............

Hoeper v. Tax Commission, 284 U.S. 206 (1931) ...

Sah Raabe sh oukae sx 6 a5,6-0585 14, 15, 16, 17,

MacDonald v. Commissioner, 230 F.2d 534 (7th Cir.

Ds Sh Seu cdN heen Stark Rhee ike. 6, 7, 8, 9,

Miriam Sakol v. Commissioner, 67 T.C. 986 (1977)

aff'd 574 Fed. 694 (2d Cir. 1978), cert. denied 439

I gs ace e ues an 13, 15,

National Muffler Dealers Ass'n. Inc. v. United States,

NINE coe oe ad hoes c's 0bees ewe e ae

Schlesinger v. Wisconsin, 270 U.S. 230 (1926) .....

Ly avule Gus wieey ewe Uae e se Fe bak wane 14, 15, 17,

Stanley v. Illinois, 405 U.S. 645 (1972) ........ 15,

United States v. Cartwright, 411 U.S. 546 (1973) . 7

U.S. Dept. of Agriculture v. Murry, 413 U.S. 508

SCA ats sete darceuhces cas cusnunhhaenn ws

Viandis v. Kline, 412 U.S. 441 (1973) ......... 15,

Weinberger v. Salfi, 422 U.S. 749 (1975)....... 15,

Constitution

United States Constitution, Fifth Amendment .. i, 13,

Page

Miscellaneous

H.R. Rpt. No. 91-413 (1969), 1969-3 C.B. 255..... 16

Statutes

Internal Revenue Code of 1954, Sec. 56 ...........

LHI Pe erie ag eA ORNS RO mm eee

Internal Revenue Code of 1954, Sec. 57 .. i, 3, 4, 5, 17

Internal Revenue Code of 1954, Sec. 57(a)(6).......

Aah A ape Pe ee Seana 3. @ i. i. tm

Internal Revenue Code of 1954, Sec. 83 ...........

Sf nek RS PREG SS rei SPREE LS BNL se

Internal Revenue Code of 1954, Sec. 83(a)(1).......

POPE TTT eee CT ETTORE we

Internal Revenue Code of 1954, Sec. 83(e) ......... 11

Internal Revenue Code of 1954, Sec. 83(e)(1).......

Internal Revenue Code of 1954, Sec. 421 .. 2, 3, 11, 12

Internal Revenue Code of 1954, Sec. 422 .......... 2

Internal Revenue Code of 1954, Sec. 6213 ......... 4

Internal Revenue Code of 1954, Sec. 7442 ......... 4

Internal Revenue Code of 1954, Sec. 7482 ......... 5

Revenue Act of 1926, Sec. 302(c) ..........--005- 14

Securities and Exchange Commission, Rule 16b-6 (17

C.P.R. S00. 16-6 (IGS) oc ccccccccvccveccens 2

Securities Exchange Act of 1934, Sec. 16(b) (15 U.S.C.

§78p(b)) ......... i, 2, 5, 6, 7, 8, 10, 13, 16, 17, 18

Tax Reform Act of 1969, Pub.L. 91-172 ........... 11

Treasury Regulation, Sec. 1.57-1(f)(3) ..........65.

Pe ere er eee eee he i, 3, 5, 11, 16, 17, 18

Treasury Regulation, Sec. 1.83-3(h) ...........0065 1}

United States Code, Title 28, Sec. 1254(1) ......... l

IN THE

Supreme Court of the United States

October Term 1981

AARON L. KOLOM and SERITA KOLOM,

Petitioners,

° vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Petition for Writ of Certiorari to the United States Court

of Appeals for the Ninth Circuit.

The Petitioners, Aaron L. Kolom and Serita Kolom, re-

spectfully pray that a writ of certiorari issue to review the

judgment and opinion of the United States Court of Appeals

for the Ninth Circuit entered on April 9, 1981.

Opinions Below.

The opinion of the United States Court of Appeals for

the Ninth Circuit is reported at 644 F.2d 1282. The opinion

of the United States Tax Court is reported at 71 T.C. 235.

These opinions are reprinted in Appendices A and B,

pp. 1-40.

Jurisdiction.

The decision of the Tax Court was entered on November

21, 1978. The judgment and opinion of the Court of Appeals

affirming the decision was entered on April 9, 1981. This

Court’s jurisdiction is invoked under 28 U.S.C. §1254(1).

we. en

Statement of the Case.

In 1968, 1970 and 1971, Petitioner Aaron L. Kolom

(“‘Kolom’’) was granted options to acquire Tool Research

and Engineering Corporation (*‘TRE’’) stock pursuant to

the TRE Employees’ Stock Option Plan (**Plan’’). The Plan

met the qualification requirements of Sections 421 and 422

of the Internal Revenue Code of 1954, as amended. All of

Kolom’s options were exercised in September and October

1972 when Kolom was an officer and director of TRE.

Kolom’s option exercise prices for the three blocks of

stock were 13%, 12 and 19%; the mean price per share of

TRE stock on the New York Stock Exchange (‘‘NYSE

Price’’) on the dates of exercise were, respectively, 51%,

44 and 44. However, because of Kolom’s status as a TRE

officer and director, the stock had no practical liquidity at

time of exercise. Pursuant to Section 16(b) of the Securities

Exchange Act of 1934 [15 U.S.C. §78p(b)],* as interpreted

by Securities and Exchange Commission Rule 16b-6 [17

C.F.R. §240.16b-6 (1980)], if Kolom sold a share of stock

acquired pursuant to the exercise of the options within six

months of its purchase, the amount by which the sales price

exceeded the greater of (a) the option exercise price and

(b) the lowest market price of the stock within six months

before or after the date of sale would ‘“‘inure to and be

recoverable by’’ TRE. Testimony in the Tax Court estab-

lished that the watch dog function played by the plaintiff's

bar would assure automatic repayment of such amount to

TRE.

Six months after the date of exercise of the first block

of stock, the NYSE Price of the stock had dropped over

*All references herein to Section 16(b) are to Section 16(b) of the

Securities Exchange Act of 1934. All other section references are to

the Internal Revenue Code, unless otherwise indicated.

oadiiiags

50%, to 23%. Six months after the date of exercise of the

last two blocks of stock, the NYSE Price of the stock had

also dropped over 50%, to 20%. Kolom eventually sold

5,000 shares of the stock purchased upon exercise of the

options for an average price of $9.27 a share, realizing a

substantial loss on the transaction.

During the year 1972, Sections 56 and 57 imposed a tax

on items of *‘tax preference’’ in excess of certain amounts.

The definition of items of tax preference included the fol-

lowing at Section 57(a)(6):

Stock Options—With respect to the transfer of a

share of stock pursuant to the exercise of a qualified

stock option (as defined in section 422(b)) or a re-

stricted stock option (as defined in section 424(b)), the

amount by which the fair market value of the share at

the time of exercise exceeds the option price.

Proposed Treasury Regulations Section 1.57-1(f)(3) pro-

vided on the date of exercise of the option that, **{t}he fair

market value of a share of stock received pursuant to the

exercise of a qualified or restricted stock option is to be

determined . . . consistent with the principles applicable

under section 83(a)(1) and the regulations thereunder.”’

Appendix J, p. 48.

Section 83(a)(1) provides that fair market value shall be

**(determined without regard to any restriction other than

a restriction which by its terms will never lapse) .. . .”’

Appendix F, p. 44. However, Section 83(e)(1) provides that

**[t]his section shall not apply to . . . a transaction to which

section 421 applies .. . .”’ Appendix G, p. 45. Kolom’s

stock options were qualified options to which Section 421

applied. See Appendix H, p. 46.

The joint return for 1972 filed by Kolom and Petitioner

Serita Kolom did not report any liability for minimum tax

under Sections 56 and 57 with respect to the exercise of the

Giese

qualified stock options. The Petitioners fully disclosed the

exercise of their stock options on an attachment to the return

and indicated that the Petitioners did not regard minimum

tax as due as they could not sell the the acquired stock in

the year the option was exercised because all profits would

belong to TRE.

The 1972 return filed by Petitioners was audited by the

Internal Revenue Service and no adjustment was made with

respect to minimum tax liabilities. Subsequently, as a result

of an audit of TRE’s returns and information given to the

auditing agent by Kolom, Petitioners’ 1972 return was re-

opened on the minimum tax issue. On March 30, 1976, the

Commissioner of Internal Revenue (the ‘‘Commissioner’’)

issued a notice of deficiency to the Petitioners asserting a

Federal income tax deficiency of $42,489.00 for the tax

year ended 1972 based on the imposition of the minimum

tax pursuant to Sections 56 and 57 on the aggregate amounts

by which the closing price of TRE stock on the dates of

exercise of the options exceeded the option exercise prices.

The Petitioners timely filed a Petition in the United States

Tax Court asserting that the determination of tax as set forth

in the notice of deficiency was in error. Jurisdiction was

conferred on the Tax Court by Sections 7442 and 6213 of

the Internal Revenue Code. Subsequently, the Commis-

sioner’s answer was amended to increase the deficiency for

the taxable year 1972 to $43,792.00 reflecting the mean

prices instead of the closing prices on the New York Stock

Exchange on the dates the options were exercised. A stip-

ulation of facts was jointly submitted to the Tax Court by

the Petitioners and the Commissioner on September 27,

1977 and the case was tried on that same day.

The Tax Court upheld the deficiency in a decision re-

ported at 71 T.C. 235. A timely notice of appeal was filed

on January 26, 1979 with the United States Court of Appeals

for the Ninth Circuit. Jurisdiction was conferred on the

Court of Appeals by Section 7482 of the Internal Revenue

Code. In an opinion dated April 9, 1981 the Court of Ap-

peals affirmed the decision of the Tax Court. The Court of

Appeals’ decision is reported at 644 F.2d 1282.

Both the Tax Court and the Court of Appeals held that,

for purposes of Sections 56 and 57, the fair market value

of the stock received by the Petitioners pursuant to the

exercise of the qualified stock options could be determined

without reference to the impact of Section 16(b) on the value

of such stock to the Petitioners. Both courts also found that

Treasury Regulations Section 1.57-1(f)(3) is valid and con-

stitutional in its application of the principles of Section 83

to the determination of the fair market value of stock under

Sections 56 and 57.

REASONS FOR GRANTING THE WRIT.

The Opinion Below Creates a Conflict Among the Cir-

cuits as to Whether the ‘‘Fair Market Value’’ of

Stock Received Through Exercise of a Stock Option

May Be Determined Without Taking Into Account

the Impact on the Recipient of Section 16(b).

In holding that the ‘‘fair market value’’ of the stock ac-

quired pursuant to the exercise of the qualified stock options

may be determined without reference to the impact of Sec-

tion 16(b) on the Petitioners, the Ninth Circuit has placed

itself in conflict with the Seventh Circuit's earlier decision

in MacDonald v. Commissioner, 230 F.2d 534 (7th Cir.

1956).

In MacDonald, as in the present case, the issue before

the court was whether the ‘’fair market value’’ of stock

received pursuant to the exercise of a stock option should

be calculated in such a way as to reflect the impact of

Section 16(b) on the recipient of the stock. The taxpayer

in MacDonald was an officer of a corporation who had been

granted an option for 10,000 shares of company stock; at

the time that the taxpayer exercised the option the difference

between his option price and the New York Stock Exchange

price amounted to $15.05 a share. Because of his exposure

to Section 16(b) on any short term sale of the stock, and

because of an alleged oral agreement restricting the sale of

the stock, the taxpayer argued that no income had been

realized on the exercise of the option. The Service contended

that the taxpayer had received income in an amount equal

to $15.05 per share of acquired stock and the Tax Court

agreed.

The Seventh Circuit agreed with the Tax Court that the

taxpayer had realized income, but did not agree that the

amount of income could be measured with reference to the

pax TES

price of the shares on the New York Stock Exchange. In

reversing the Tax Court on this latter point, the Seventh

Circuit held that, while the New York Stock Exchange price

reflected the ‘‘fair market value’’ of the stock to other in-

dividuals, it did not reflect the ‘‘fair market value’’ of the

stock to an individual who because of Section 16(b) could

not profit from any short term fluctuation in market price.

The Seventh Circuit then remanded the matter to the Tax

Court for determination of the proper amount of discount

required to reflect the impact of Section 16(b) on *‘short-

swing”’ insider profits.

In ruling that the determination of the *‘fair market value’’

of a financial instrument must take into account restrictions

which affect the class of persons to which the taxpayer

belongs, the court in MacDonald accurately anticipated the

position taken by this Court in United States v. Cartwright,

411 U.S. 546 (1973). In that case, the Court held that the

determination of the ‘‘fair market value’’ of shares of a

mutual fund must be made with reference to restrictions

affecting the taxpayer's ability to realize income from such

shares. This Court ruled that the ‘‘fair market value’’ of

those shares was not the price of such shares on the open

market, but the amount the taxpayer could have realized on

resale of the shares. Indeed, the proposition that the *‘fair

market value’’ of a financial instrument is to be determined

in light of all relevant limitations on that instrument has

been the conclusion of a considerable number of individual

courts, both before and after this Court's decision in Cart-

wright. See, e.g., Mailloux v. Commissioner, 320 F.2d 60

(Sth Cir. 1963) (contractual restriction on resale of stock);

Bankers Trust Company v. United States, 284 F.2d 537

(2d Cir. 1960) (bonds worth more to estate than to market);

Cohu v. Commissioner, 8 T.C. 796 (1947) (resale restric-

tions on shares); Goldwasser v. Commissioner, 47 B.T.A.

445 (1942), aff'd, 142 F.2d 556 (2d Cir, 1944), cert. denied,

323 U.S. 765 (1944) (contractual restriction on resale of

stock).

It is especially appropriate to take the impact of Section

16(b) into account in Petitioners’ case since the value to an

employee of the compensation bargained for in the form of

stock is clearly adversely affected by the practical limitation

on liquidity represented by Section 16(b), That the relevant

market for determining the value of compensatory transfers

of property is the market that exists between employer and

employee for services is acknowledged by the concurring

judge in the Tax Court below:

A share of stock awarded as compensation to a per-

son who is subject to a legal requirement that he must

disgorge any gains on a sale thereof within 6 months

obvious|y provides significantly less compensation to

him than would an otherwise identical share awarded

to a person not so subject.

Appendix B, p. 39.

The opinion below attempts to distinguish MacDonald

on the ground that, in MacDonald, **|t)he court specifically

stated that it was not deciding whether section 16(b) had

an effect on the fair market value of the stock at the time

the option was exercised.’’ Appendix A, p. 14. The at-

tempted distinction is without merit. Although the court in

MacDonald did not attempt to determine the extent to which

Section 16(b) influenced the ‘‘fair market value"’ of the

shares, its reversal of the Tax Court was based on its con-

clusion that the combined effect of Section 16(b) and the

alleged oral restriction on resale did indeed affect the ‘*fair

market value"’ of the shares. The court explained its position

as follows:

Taxpayer acquired the corporate stock with an agree-

ment not to sell and, in addition, if he had violated thin

= ee

agreement and sold the stock, he probably would have

been required to account for the profits, Certainly he

would have been faced with a legal action to recover

such profits. This is not to say that he did not realize

economic gain upon the purchase of the stock but, even

so, the question remains as to the proper formula for

the ascertainment of the amount and extent of such

gain. The Tax Court has held that it is the difference

between the option price and the market value of the

stock on the New York Stock Exchange at the time of

its acquirement. We disagree with that conclusion.

230 F.2d at 54,

The opinion below attempts to distinguish Mailloux,

Cohu and Goldwasser by the alleged breadth of restrictions

considered therein, taking the position that such cases re-

quire ‘‘fair market value’’ determinations to take into ac-

count only restrictions which limit the taxpayer from selling

or transferring the property on the open market. Since the

property in the instant case is technically transferable, the

opinion below finds the holdings in Mailloux, Cohu and

Goldwasser inapplicable. Appendix A, p. 13.

Again, the attempted distinction is without merit, While

Maiiloux, Cohu and Goldwasser deal with limitations on

transferability, other cases, including Bankers Trust Com-

pany, deal with restrictions which do not prevent transfer-

ability, and affect only a class of persons to which the

taxpayer belongs. In Bankers Trust Company, for example,

the Second Circuit was faced with the task of valuing

**flower’’ bonds for purposes of calculating the decedent's

estate tax liability. The bonds were freely transferable and

salable on the open market. Nonetheless, the court there

held that the ‘‘fair market value’’ of the bonds should be

determined with reference to the specific class of persons

—10—

(death beneficiaries) to which the taxpayer belonged, and

not with reference to the open market.

In sum, the opinion below directly conflicts with the

Seventh Circuit's decision in MacDonald as to the impact

of Section 16(b) on *‘fair maket value’’ determinations.

That conflict has now been heightened by the recent case

of Harrison v. United States, 475 F. Supp. 408 (E.D,Pa,

1979), aff d, 620 F.2d 288 (3rd Cir. 1980), On substantially

the same facts as the instant case, the district court in Har-

rison cited the opinion below as authority in holding that

Section 16(b) does not affect the ‘‘fay. market value’ of

stock received pursuant to exercise of a qualified stock op-

tion. The Third Circuit affirmed that decision without dis-

cussion, Thus, the Court now faces a situation where the

Ninth and the Third Circuits are in conflict with the Seventh

Circuit as to whether the ‘*fair market value’’ of stock may

be determined without considering the effect on the stock-

holder of Section 16(b).

Il.

The Court Below Erred in Holding Valid Treasury Reg-

ulations That Apply the Fair Market Value Prin-

ciples of Section 83 to Section 57(a)(6) in the Face

of Inconsistent Statutory Language and a Direct

Statutory Prohibition.

Section 56 imposes a minimum tax on certain items of

‘tax preference.’’ Appendix D, p. 42. Section 57(a)(6)

defines as a tax preference for purposes of the minimum tax

the amount by which the ‘‘fair market value"’ of a share of

stock transferred pursuant to the exercise of a qualified stock

option at the time of such exercise exceeds the option price,

Appendix E, p. 43.

Section 83(a)(1) provides that for purposes of determining

the amount of gross income realized upon a transfer of

property in compensation for services, fair market value is

to be ‘(determined without regard to any restriction other

than a restriction that by its terms will never lapse),

...»'' Appendix F, p. 44. Treasury Regulations Section

1.83-3(h) provides in applicable part that **[]]imitations im-

posed by registration requirements of State or Federal se-

curity laws or similar laws imposed with respect to sales

or other dispositions of stock or securities are not nonlapse

restrictions."’ Section 83(e)(1), however, expressly states

that Section 83 shall not apply to ‘‘a transaction to which

Section 421 applies ....’" Appendix G, p. 45. Section

421 is the operative provision that sets out the consequences

of the grant and exercise of a qualified stock option such

us those exercised by Petitioner Kolom. Appendix H,

p. 46,

Sections 57(a)(6), 83(a)(1) and 83(e) were all enacted

simultaneously by the Tax Reform Act of 1969, Pub.L. 91-

172. In Sectioi, 57(a)(6) Congress used only the term *‘fair

market value"’ to describe the basis for the measure of

minimum tax while in Section 83(a)(1) Congress chose to

modify the term fair market value by requiring that ‘‘lapse”’

restrictions be ignored as a factor in its determination. Not

only did Congress use different statutory language in de-

scribing the principles to be applied in determining fair

market value under the two sections, but in Section 83(e)(1)

Congress also expressly prohibited application of Section

83's more limited definition of fair market value to trans-

actions involving qualified stock options.

Despite the clear intention of Congress, both express and

implied, in Treasury Regulations Section 1.57-1(f)(3) the

Treasury Department attempted by regulatory fiat to treat

the distinctions between the two sections as non-existent

and to ignore the statutory prohibition of Section 83(e)(1).

The regulation as finally adopted and as applied in this case

simply and boldly states that, in the context of Section

57(a)(6), ‘*{iJn accordance with the principles of Section

83(a)(1), the fair market value of a share of stock received

pursuant to the exercise of a qualified or restricted stock

option is to be determined without regard to restrictions

(other than non-lapse restrictions . . .)."’ Appendix K, p.

49.

The courts below held that Section 83(e)(1) merely solves

the conflict that would otherwise arise between the current

taxation required by Section 83 on the exercise of stock

options and the deferred taxation provided for by Section

421. The courts below further concluded that as the Treasury

Regulation merely used Section 83 principles for valuation

purposes and not to provide for inclusion of the value of

stock in income, the Treasury Regulations were not incon-

sistent with Section 83(e)(1). Appendices A, pp. 9-10 and

B, p. 27. However, to the extent that the valuation principles

of Section 83 result in a higher, artificial fair market value

for Petitioners’ stock, they do result in an increase in tax

on transactions subject to Section 421 and violate the direct

prohibition of Section 83(e)(1).

In general, a Treasury Regulation may be invalidated only

if it is unreasonable and clearly inconsistent with the statute.

National Muffler Dealers Ass'n, Inc. v. United States, 440

U.S. 472, 488 (1979). Nonetheless, where a regulation is

unreasonable, this Court does not extend the Treasury un-

fettered authority and has not hesitated to invalidate Treas-

ury Regulations:

[I}t does not follow that, because [the Commissioner]

has a choice of alternatives, his choice should be sus-

tained where the alternative chosen is unrealistic. in

such a situation the regulations embodying that choice

should be held to be unreasonable... .

United States v. Cartwright, 411 U.S. 546, 557 (1973)

(citations omitted).

Section 16(b) had a direct and adverse impact on the fair

market value of stock transferred to the Petitioners. Under

the clear statutory language the measure of the minimum

tax imposed on Petitioners should reflect the impact of Sec-

tion 16(b) and the attempt by the Treasury to incorporate

Section 83 valuation principles into Section 57(a)(6) should

be found invalid. By upholding the validity of the regulation,

the court below has created a serious federal question of

statutory construction that should be resolved by this Court.

Il.

As Applied by the Court Below the Artificial and

Arbitrary Definition of Fair Market Value

Incorporated Into Section 57(a)(6) by the Treasury

Regulations Creates an Irrebuttable Presumption

That Violates the Due Process Clause of the Fifth

Amendment to the Constitution.

The substance and impact of the definition of fair market

value set forth in Section 83(a)(1) is substantially the same

as a conclusive presumption of value. Miriam Sakol v. Com-

missioner, 67 T.C. 986, 992 (1977), aff'd, 574 F.2d 694

(2d Cir. 1978), cert. denied, 439 U.S. 859 (1978). The

conclusive value irrebuttably presumed by Section §3(a)(1),

however, is inconsistent with true fair market value as af-

fected by the limitations on retention of profit imposed by

Section 16(b). Consequently, the Treasury Regulations’

application to the Petitioners of the artificial and irrebuttable

fair market value standard of Section 83(a)(1) has deprived

them of their property in violation of the Due Process Clause

of the Fifth Amendment to the Constitution by imposing an

income tax measured in part by an amount which has no

economic benefit to Petitioners.

salle

This result is in direct conflict with the long-established

principle enunciated by this Court in Heiner v. Donnan,

285 U.S. 12 (1932); Hoeper v. Tax Commission, 284 U.S.

206 (1931); and Schlesinger v. Wisconsin, 270 U.S. 230

(1926), that a statute which imposes a tax on an amount

which provides no economic benefit to the taxpayer based

upon an assumption of fact which the taxpayer is forbidden

to controvert is so arbitrary and unreasonable that it cannot

stand under the Due Process Clause.

In Schlesinger v. Wisconsin, the petitioner challenged a

Wisconsin statute that provided that every gift of a material

part of a decedent’s estate made by him within six years of

death ‘‘shall be construed to have been made in contem-

plation of death’’ (270 U.S. at 236) for death tax purtoses.

This Court held that the statute established an invalid con-

clusive presumption and declared it to be in violation of the

Due Process and Equal Protection Clauses. In Heiner v.

Donnan, this Court considered a challenge to the consti-

tutionality of a similar federal estate tax statute (Section

302(c) of the Revenue Act of 1926) providing that gifts

made within two years of death of the donor shall *‘be

deemed and held to have been made in contemplation of

death’’ (285 U.S. at 320). In ruling the statute unconsti-

tutional this Court held that the conclusive presumption

established by the statute ‘‘constitutes an attempt, by leg-

islative fiat, to enact into existence a fact which here does

not, and cannot be made to exist in actuality’’ (285 U.S.

at 329). In Hoeper v. Tax Commission, a Wisconsin statute

measured a husband’s income with reference to his wife’s

income for state income tax purposes. Under Wisconsin law

a married woman’s earnings were her separate property.

This Court struck down the state income tax statute which

measured an income tax on an amount that was not an

economic benefit to the taxpayer. A tax statute which, in

effect, presumed a fictitious amount to be an economic

benefit was held to violate due process.

This Court has recently approved the rationale of these

three tax cases in Viandis v. Kline, 412 U.S. 441, 446

(1973). See also Cleveland Bd. of Educ. v. LaFleur, 414

U.S. 632, 644 (1974); U.S. Dept. of Agriculture v. Murry,

413 U.S. 508, 512 (1973); and Stanley v. Illinois, 405 U.S.

645 (1972). In Viandis v. Kline the Court made the following

statement:

Statutes creating permanent irrebuttable presump-

tions have long been disfavored under the Due Process

Clause of the Fifth and Fourteenth Amendments. In

Heiner v. Donnan, 285 U.S. 312 (1932), the Court

was faced with a constitutional challenge to a federal

statute that created a conclusive presumption that gifts

made within two years prior to the donor's death were

made in contemplation of death, thus requiring pay-

ment by his estate of a higher tax. In holding that this

irrefutable assumption was so arbitrary and unreason-

able as to deprive the taxpayer of his property without

due process of law, the Court stated that it had ‘‘held

more than once that a statute creating a presumption

which operates to deny a fair opportunity to rebut it

violates the due process clause of the Fourteenth

Amendment.’’ /d., at 329, see, ¢.g., Schlesinger v.

Wisconsin, 270 U.S. 230 (1926); Hoeper v. Tax

Comm'n, 284 U.S. 206 (1931).

412 U.S. at 446,

This Court’s opinion in Weinberger v. Salfi, 422 U.S.

749 (1975), has been cited in support of the assertion that

the broad scope of the irrebuttable presumption doctrine

evidenced in Viandis and Donnan has been narrowed to a

test based only on a rational nexus between the criteria set

forth in the statutory mandate and a legitimate congressional

purpose. Sakol v. Commissioner, 574 F.2d 694, 697-98

(2d Cir. 1978), cert. denied, 439 U.S. 859 (1978). How-

ever, this Court did not reject the Donnan, Schlesinger and

Hoeper rationale in Salfi. Instead, the Court was careful to

distinguish two cases that followed that rationale (Stanley

and LaFleur) on the ground that Salfi involved merely a

claim for a non-contractual government benefit. The Court

also distinguished Viandis, which like Salfi, did involve a

government benefit program (in the form of reduced college

tuition for instate residents) on the ground that, since the

Connecticut statute tested its benefit by the factual question

of residency, it could not at the same time deny to one

seeking to meet the residency test the opportunity to show

factors clearly bearing on that issue. Neither Sa/fi distinction

is applicable in the instant case as (1) imposition of tax

under the Internal Revenue Code is essentially the opposite

of a claim for a non-contractual government benefit, and

(2) Section 57(a)(6) and Treasury Regulations Section 1.57-

1(f)(3), like the Connecticut statute in Viandis, first makes

a fact — fair market value — relevant in determining the

measure of tax and then precludes the taxpayer from show-

ing the effect of Section 16(b) on fair market value.

Even if the Sa/fi test of rational nexus between a statutory

mandate and legitimate congressional purpose is applied to

the facts of this case, the Treasury Regulations must still

be found unconstitutional as applied. The congressional

purpose in enacting the Section 83 standard for fair market

value was to prevent the use of contractual restrictions on

sale *‘designed to achieve deferral for tax savings purposes"’

H.R. Rpt. No. 91-413 (1969), 1969-3 C.B. 255. See Sakol

v. Commissioner, 574 F.2d at 699. That is, Congress’ le-

gitimate purpose was to prevent the use of cooperatively

imposed restrictions that were intended to provide a tax

benefit to the employee rather than to advance purely em-

ployer purposes and that could be waived by the employer

at will. /d. Although, arguably, there is a rational nexus

— oe

between this purpose and Section 83's fair market value in

the case of contractual restrictions, the nexus breaks down

in the case of the limitation on value imposed by Section

16(b) which is imposed by federal statute rather than by

consensual contractual restrictions and as to which the em-

ployer has no practical power of waiver. More to the point,

there is no suggestion in the legislative history underlying

Sections 56 or 57 that Congress had a similar concern with

tax avoidance schemes with respect to qualified stock op-

tions, nor does the clear language of Section 57(a)(6) suggest

that Congress felt the need to ignore restrictions that ad-

versely impacted fair market value in measuring the mini-

mum tax. There is, in the end, no rational basis for dragging

Petitioners into a net designed to defeat tax avoidance

schemes totally unrelated to them, the employer or the sta-

tutorily imposed limitations on the fair market value of the

stock received by them.

The tax statutes involved in Donnan and Schlesinger

made the existence of a particular fact relevant to a deter-

mination of tax and then foreclosed the taking of evidence

as to that fact. In a similar fashion, Section 57(a)(6) of the

Internal Revenue Code makes the fair market value of stock

relevant to a determination of minimum tax and Treasury

Regulations Section 1.57-1(f)(3), by application of the lim-

iting language of Section 83(a)(1), then bars the taxpayer

from demonstrating the substantial adverse effect of Section

16(b) on fair market value. As in Hoeper, to the extent that

minimum tax is imposed on a value that ignores the impact

of Section 16(b) on Petitioners, it is imposed on an amount

that has never been realized as an economic benefit by the

Petitioners, The injustice and unfairness of this result is

especially harsh in this case as the Petitioners could not

have retained the NYSE Price had the stock been sold on

the date acquired and in fact suffered a loss when they were

finally able to sell free of the Section 16(b) limitation, Under

these circumstances, the application by Treasury Regula-

tions Section 1.57-1(f)(3) of the Section 83(a)(1) fair market

value standard to measure the minimum tax on Petitioners

clearly violates the long standing constitutional principles

enunciated in Donnan, Schlesinger and Hoeper and is un-

constitutional,

Conclusion.

For the foregoing reasons, a Writ of Certiorari to the

Court of Appeals for the Ninth Circuit should be granted.

Respectfully submitted,

RAYMOND C, FISHER,

Counsel of Record,

JEFFREY L. GRAUSAM,

JOSEPH BANKMAN,

TUTTLE & TAYLOR INCORPORATED,

Attorneys for Petitioners,

Aaron L, Kolom and Serita Kolom.

APPENDIX A.

Opinion of the United States Court of Appeals for the

Ninth Circuit.

Aaron L. Kolom and Serita Kolom, Petitioners-Appel-

lants, v. Commissioner of Internal Revenue, Respondent-

Appellee. No, 79-7077,

United States Court of Appeals, Ninth Circuit,

Argued and Submitted Dec, 4, 1980, Decided April 9,

1981,

Petition to Review a Decision of the Tax Court of the

United States.

Before WALLACE, SKOPIL and REINHARDT, Circuit

Judges.

WALLACE, Circuit Judge:

Aaron L. Kolom and Serita Kolom' appeal from a de-

cision of the United States Tax Court determining a defi-

ciency in their federal income tax for the taxable year 1972

in the amount of $43,792. The issue before us is whether

restrictions placed upon the sale of stock by section 16(b)

of the Securities Exchange Act of 1934 (the Act) affect the

valuation of stock for purposes of asserting a minimum tax

when stock options are exercised, We affirm.

During the taxable year 1972, Kolom was an officer and

director of Tool Research and Engineering Corporation

(Tool Research), Kolom had received options to purchase

shares of Tool Research stock pursuant to an employees’

stock option plan, The plan met the qualification require-

ments of sections 421 and 422 of the Internal Revenue Code

'Serita Kolom is a party by reason of having filed a joint return with

her husband,

ay Sn

of 1954 (the Code).? In 1972, Kolom exercised some of

these options. The dates of exercise, the number of shares

received, the mean price of the stock on the New York

Stock Exchange on the date of exercise, and Kolom’s option

price were as follows:

Date Number Mean Price Option Total

of of Per Share Price Option

Exercise Shares onN.Y.S.E. Per Share Price

9/15/72 6,678 $52.00 $13.25 $88,464

10/5/72 4,174 45.25 12.00 50,088

10/5/72 1,575 45.25 19.625 39,909

*Section 421, GENERAL RULES.

(a) EFFECT OF QUALIFYING TRANSFER.—If a share of stock

is transferred to an individual in a transfer in respect of which the

requirements of section 422(a), 423(a), or 424(a) are met—

(1) except as provided in section 422(c)(1), no income shall result

at the time of the transfer of such share to the individual upon his

exercise of the option with respect to such share;

(2) no deduction under section 162 (relating to trade or business

expenses) shall be allowable at any time to the employer corpo-

ration, a parent or subsidiary corporation of such corporation, or

a tion issuing or assuming a stock option in a transaction

to which section 425(a) applies, with respect to the share so

transferred, and

(3) no amount other than the price paid under the option shall be

considered as received by any of such corporations for the share

so transferred.

Section 422, QUALIFIED STOCK OPTIONS.

(a) IN GENERAL,—-Subject to the provisions of subsection

(c)(1), section 421(a) shall apply with respect to the transfer of

a share of stock to an individual pursuant to his exercise of a

qualified stock option if-—

(1) no disposition of such share is made by such individual

within the 3-year oor beginning on the day after the day of the

transfer of such . and

(2) at all times during the period beginning with the date of the

me of the option and ending on the day 3 months before the

te of such exercise, such individual was an employee of either

the corporation =— such option, a parent or subsidiary cor-

poration of such corporation, or a corporation or a parent or

subsidiary corporation of such corporation issuing or assuming

a stock option in a transaction to which section 425(a) applies

The stock received by Kolom could have been resold on

the New York Stock Exchange at the price quoted above

on the date the option was exercised, If Kolom had sold the

stock on that date (or at any time within six months of that

date), however, he would have been subject to the provisions

of section 16(b) of the Act, 15 U.S.C. § 78p(b)' and he

could have been required to give up any profit he made on

such sales,

On September 15, 1972, when Kolom exercised the first

of his options, the closing market price of Tool Research

stock on the New York Stock Exchange was 51%, Six

months later the mean price of the stock on the exchange

was 23%. On October 5, 1972, when Kolom exercised his

remaining options, Tool Research stock closed at 44. Six

months later the mean price of the stock on the exchange

was 20%.

When Kolom filed his income tax return for 1972, he

completed and filed Form 4625, ‘*Computation of Minimum

Tax.’’ Kolom showed tax preference items totaling $111,398,

including accelerated depreciation and capital gains. The

stock options, however, were not reflected in the minimum

tax computation, On the last sheet of his return, Kolom

included the following statement:

Statement 9—Form 4625 Footnotes

During 1972 taxpayer exercised his option to pur-

chase Tool Research Co, stock. The taxpayer is not

‘Section 16(b) of the Securities Exchange Act of 1934 provides in

part;

For the purpose of preventing the unfair use of information which

_ have been obtained by such beneficial owner, director, or

officer by reason of his relationship to the issuer, eo profit re-

alized by him from any purchase and sale, or any sale and pur-

chase, of any equity security of such issuer. . . within any period

of less than six months . . . shall inure to and be recoverable by

the issuer... .

15 U.S.C. § 78p(b).

a oe

treating this as preference income for the following

reason:

Income Tax Regulation | .57-1(f)5(i) states that there

is no tax preference if the stock is disposed of in the

year the option is exercised. By law, the taxpayer could

not sell the stock in the year the option was exercised

because all of his profit would belong to the corpo-

ration. The stock is being sold the year in which the

taxpayer is first able to sell the stock. Because of the

above reason and because the nature of the tax con-

sequences are the same whether the taxpayer sold the

stock in the year the option was exercised or the suc-

ceeding year, the item is not being treated as a tax

preference item in 1972,

Kolom’s return for 1972 was examined and audit changes

were made with respect to adjustments other than the min-

imum tax. He received a ietter dated January 15, 1975, from

the District Director stating that the revenue agent's report

had been reviewed and accepted. Approximately a year

later, Kolom received a telephone call from a revenue agent

regarding his liability for minimum tax in 1972. After an

examination of Tool Research's books and records, revenue

agent Beal had submitted a written request for approval to

reopen Kolom's 1972 tax liability. The reasons stated for

the request were a ‘‘substantial error’’ and a ‘‘serious ad-

ministrative omission resulting in criticism, undesirable

precedent or inconsistent treatment.’’ The request for re-

opening was approved, and Kolom was so notified in

January 1976.

The Commissioner determined a deficiency of $42,489

on the basis of the imposition of the minimum tax on the

aggregate amounts by which the fair market values of the

shares of stock acquired pursuant to the qualified stock

options exceeded their option prices on the dates of exercise.

Subsequently, the Commissioner asserted an additional de-

ficiency of $1,303, making the total deficiency $43,792.

This increased deficiency resulted from a recomputation of

the market value-option price differential, on the basis of

the mean price on the New York Stock Exchange on the

date of exercise, rather than the closing price on the date

of exercise,

On appeal, Kolom contends that (1) the Tax Court erred

in determining that the bargain element of the options for

the purpose of computing the minimum tax is the difference

between the mean New York Stock Exchange price on the

date of exercise and the option price without regard to sec-

tion 16(b) profit restrictions, and (2) the Tax Court im-

properly concluded that Kolom was not subjected to an

impermissible second examination in determining his 1972

tax deficiency.

This case deals primarily with the tax consequences of

Kolom’s exercise of stock options that qualify for special

tax treatment provided in sections 421 and 422 of the Code,

The Code provides that a qualified stock option may be

granted to an individual in connection with this employment,

enabling that employee to acquire stock of his employer at

prices less than the market value of the stock, without re-

sulting in a realization of taxable income to the employee

either when the option is granted, or when it is exercised,

As long as the taxpayer holds the shares of stock for at least

three years and meets the other technical requirements, he

will be taxed only when he ultimately sells or otherwise

disposes of the shares of stock. At the time of disposition,

the gain is taxed at favorable long-term capital gains rates,

As a result, the ‘bargain element’’ of the option present

at the time of exercise (the difference between the fair mar-

ket value and the option price at the time of exercise) re-

ceives the same deferred capital gains treatment that the

underlying shares receive.

Because many high income taxpayers could use the tax

preference provisions to avoid significant tax liability, see-

tions 56 and 57 of the Code were enacted.’ These sections

impose a minimum tax on taxpayers with large amounts of

income from stock options, capital gains, and other sources

receiving preferential tax treatment. Section 57(a)(Q) states

that there shall be included as an item of tax preference with

respect to the transfer of a share of stock pursuant to the

exercise of a qualified stock option, ‘‘the amount by which

the fair market value of the share at the time of exercise

exceeds the option price.’’ Thus, these sections impose a

tax on a portion of the *‘bargain clement’ of the transaction.

The primary issue in this dispute is the method by which

this bargain element subject to minimum taxation is w be

determined, The parties disagree about the fair market value

of the shares at the time Kolom exercised his option, Kolom

‘Section 56, IMPOSITION OF TAX.

(a) IN GENERAL.—-In addition to the other taxes imposed by this

chapter, there is hereby imposed for each taxable year, with respect to

the income of every person, a tax equal to 10 percent of the amount

(if any) by which—

(1) the sum of the items of tax preference in excess of $30,000,

is greater than

(2) the sum of—

(A) the taxes imposed by this chapter for the taxable year. . .

reduced by the sum of the credits allowable . . . [and]

(B) the tax we to the taxable year. Section 57. ITEMS OF

TAX PREFERENCE,

(a) IN GENERAL.-—For purposes of this part, the items of tax pref-

erence are—

(6) STOCK OPTIONS—With respect to the transfer of a share

of stock pursuant to the exercise of a qualified stock option (as

defined in section 422(b)) or a restricted stock option (as defined

in section 424(b)), the amount by which the fair market value of

the share at the time of exercise exceeds the option price,

comtends that section 16(b) of the Act is relevant to the

determination of fair market value. As an officer and director

of Tool Research, if Kolom had sold the stock within six

months of the date he exercised the options, he could have

been required to turn over any profits to Tool Research. He

asserts, therefore, that the fair market value of the stock at

the time of exercise was equal to the option price, because

that is the amount he would have been able to retain if the

stock had been sold on that day.

The Commissioner maintains, however, that the fair mar-

ket value of the stock was its mean price on the New York

Stock Exchange on the date of exercise. The Commissioner

further contends that section 16(b) is totally irrelevant to the

determination of fair market value for purposes of section

57(a)(6). For this argument, he relies upon Income Tax

Regulation 1.57-1(f)(3) which states:

In accordance with the principles of section 83(a)(1),

the fair market value of a share of stock received pur-

suant to the exercise of a qualified or restricted stock

option is to be determined without regard to restrictions

(other than nonlapse restrictions within the meaning

of § 1.83-3(h)). Notwithstanding any valuation date

given in section 83(a)(1), for purposes of this section,

fair market value is determined as of the date the option

is exercised,

(Emphasis added). Regulation 1.83-3(h) provides that

**[L]imitations imposed by registration requirements of State

or Federal security laws or similar laws imposed with respect

to sales or other dispositions of stock or securities are not

nonlapse restrictions.’’ Thus, the Commissioner asserts that

because section 16(b) is a limitation imposed by federal

security law, section 16(b) does not affect the fair market

value of the stock.

— =

On appeal, Kolom advances three separate arguments

with respect to the determination of fair market value. First,

he argues that Income Tax Regulation 1.57-1(f)(3) is in-

consistent with section 57(a)(6) as applied in this case be-

cause it applies section 83 to the qualified stock option

section of the minimum tax provisions when section 83(e)(1)

specifically prohibits the application of section 83 to stock

acquired pursuant to a qualified stock option. Second, he

asserts that the minimum tax imposed on the difference

between the trading price of the stock and the option price

on a taxpayer subject to section 16(b) is unconstitutional

because it results in double taxation and income taxation

on a transaction in which there has been an economic loss.

Third, he contends that the long established definition of

fair market value takes section 16(b) into account to satisfy

the *‘willing seller’’ requirement of that definition.

Kolom contends that regulation 1.57-1(f)(3), which uses

the principles of section 83 to compute fair market value

for purposes of the minimum tax, is inconsistent with the

section 83(e)(1) express exclusion of section 421 stock.

Under section 83, the acquisition of stock in connection

with the performance of services is subject to tax in the

amount of the difference between the fair market value of

the stock, “‘determined without regard to any restriction

other than a restriction which by its terms will never lapse,”’

and the amount paid for the stock by the taxpayer. I.R.C.

§ 83(a)(1). Section 83(e) states that **[t}his section shall not

apply to .. . a transaction to which section 421 applies

....’ Kolom argues that sections 56 and 57 do not state

that section 83 or any of the regulations thereunder shall

apply to section 57. Only the Treasury Regulations, which

are established thereunder shall apply to section 57. Only

eta ces

the Treasury Regulations, which are established by the Com-

missioner and not by the Congress, mention the applicability

of section 83. Therefore, he argues, section 83 and all the

regulations thereunder do not apply to qualified stock op-

tions. He further contends that regulation 1.57-1(f)(3), as

it relates to section 83, is inconsistent with section 57(a)(6)

as it applies to qualified stock options and, therefore, it is

invalid. ~

Kolom has attempted to show the invalidity of regulation

1.57-1(f)(3) by examining the legislative history of section

83. He argues that Congress intended section 83 to govern

restricted stock plans but not qualified stock option plans

like the one involved in the instant case.* Although we find

that the legislative history of section 83 does indicate a

Congressional intent to attach different tax benefits to re-

stricted stock plans than to qualified stock option plans, we

have been unable to find any Congressional intent to dis-

tinguish between the plans with respect to the method by

which fair market value is to be determined. We agree with

the Tax Court that:

[t]he regulations do not provide for inclusion in a tax-

payer's taxable income of the value of the stock re-

ceived upon exercise of a qualified stock option.

Rather, the regulations apply the valuation principles

of section 83 in determining the fair market value of

stock received by a taxpayer upon exercise of a qual-

ified stock option. Therefore, we see no merit in pe-

titioners’ assertion that section 1.57-1(f)(3) of the reg-

‘Qualified stock option plans are generally considered a means to

provide employees with a stake in the business, whereas restricted stock

plans are considered merely deferred compensation arrangements. Sen-

ate Committee on Finance, Tax Reform Act of 1969, S.Rep. No.552,

9ist Cong., Ist Sess. 120 (1969), U.S. Code Cong. & Admin. News

1969, 1645.

— Se

ulations is invalid because of an inconsistency with

section 83(e)(1).

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

lation 1.57-1(f)(3) does not have any effect upon qualified

stock option plans from the standpoint of income taxation.

Rather, the regulation merely defines the bargain realized

by the taxpayer upon the exercise of the qualified stock

option, in order to subject that bargain to an entirely different

tax treatment, the minimum tax. Harrison v. United States,

475 F.Supp. 408, 412 (E.D. Pa. 1979).

Kolom further contends that the minimum tax is uncon-

Stitutional as applied in the instant case, because it results

in double taxation and income taxation on a transaction in

which he has suffered an economic loss. He argues that

when a taxpayer is subject to section 16(b), the minimum

tax is imposed on a gain that cannot be realized until at least

six months after the date of exercise. the gain realized,

therefore, cannot be recognized until the ultimate disposition

of the stock. He alleges that a mere deferral of a realized

gain, which could be completely eliminated by a decline

in the value of the stock before the time of sale, is not

income and therefore should not be subject to taxation.

In response to Kolom’s argument, the Tax Court found

that:

[t]he flaw in this argument is that a gain is realized

upon exercise of the option itself. At that time petitioner

acquired property the value of which substantially ex-

ceeded the price paid for the property. Were a gain not

realized at this time, the nonrecognition provisions of

sections 421 and 422 would be superfluous. See Com-

missioner v. LoBue, 351 U.S. 243 [76 S.Ct. 800, 100

L.Ed. 1142] (1956); Commissioner v. Smith, 324 U.S.

177 [65 S.Ct. 591, 89 L.Ed. 830] (1945). It is true that

within the 6-month period following exercise of the

options, petitioner may not be able to reduce his re-

alized gain to cash without disgorging part or all of the

profit to the corporation. It is also true that a decline

in market value during the 6-month period in which

the provisions of section 16(b), Securities Exchange

Act of 1934 are applicable could eliminate any gain

on the sale of the stock during that period. That risk,

however, is one the petitioner assumed when he chose

to exercise the stock options. It does not follow, how-

ever, that merely because petitioner could not reduce

his gain to cash for 6 months without incurring a section

16(b) liability, he had no gain.

Kolom v. Commissioner, supra, 7\ T.C. at 250.

We agree with the Tax Court that at the time Kolom

exercised the option he did realize an economic benefit.

Kolom himself testified that he could have pledged the stock

as collateral against a loan based upon the fair market value

of the stock on the New York Stock Exchange. In addition,

Kolom received other rights incident to ownership of the

stock, such as voting rights and the right to receive divi-

dends, See Sakol v. Commissioner, 574 F.2d 694, 700 (2d

Cir.) cert. denied, 439 U.S. 859, 99 §.Ct. 177, 58 L.Ed.2d

168 (1978).

Although we have never addressed this issue, the Second

Circuit has rejected a claim similar to Kolom’s that the

valuation of stock without regard to a temporary restriction

is constitutionally improper. In Sakol v. Commissioner,

supra, the court upheld the constitutional validity of sub-

jecting a taxpayer of restricted stock to income taxation

without regard to the temporary impact the restrictions

would have on the value of the stock. The court found that

the rule of section 83(a) that temporary restriction should

be ignored for valuation purposes might appear arbitrary but

=—

that **. . . aworkable, practical system of taxing employees’

restricted stock options can overlook, at least temporarily,

a speculative decrease in value in ascertaining the amount

of compensation received in the form of restricted stock

where the employee has obtained both voting power and

dividend rights." /d. at 700 (footnotes omitted). The court

went on to state:

Congress is not required to take each and every re-

striction into account in combating tax-avoidance, or

to make equally difficult individual evaluations which

depend upon the parties’ subjective intentions. Rather,

the Sixteenth, and Fifth, Amendments permit the line

drawn to be a rough one, in the interest of realistically

solving a practical problem... .

Id. We are convinced that the valuation principles involved

in the instant case in computing the minimum tax require

the same types of lines to be drawn as the valuation prin-

ciples involved in Sakol required. Accordingly, we find that

the minimum tax is not unconstitutional as applied to a

taxpayer subject to section 16(b).

Kolom’s final challenge to the determination of fair mar-

ket value is that the established definition of fair market

value includes the notion of a willing seller, and that as a

result of the section 16(b) restriction on the stock, Kolom

could not have been a willing seller. Fair market value has

been defined as ‘* ‘the price at which the property would

change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or to sell and

both having reasonable knowledge of relevant facts.’ ”

United States v. Cartwright, 411 U.S. 546, 551, 93 S.Ct.

1713, 1716, 36 L.Ed.2d 528 (1973), quoting Treas. Reg.

§20.2031-1(b). The Tax Court decided that the willing

buyer/willing seller test does not refer to Kolom’s own un-

willingness to sell under the particular circumstances of his

case. Rather, the test concerns hypothetical buyers and sell-

ers in the market place. See Estate of Reynolds v. Com-

missioner, 55 T.C. 172, 195 (1970). We are persuaded by

the Commissioner's argument that Kolom’s unwillingness

to sell his stock on the date he exercised the options is

irrelevant to the determination of fair market value.

Kolom has attempted to support his contention that sec-

tion 16(b) operates as an exception to the use of the quoted

market price as fair market value by relying upon cases in

which the owner of the stock was actually restricted from

selling or transferring the property on the open market.

Mailloux v. Commissioner, 320 F.2d 60 (Sth Cir. 1963)

(agreement that required the approval of the principal pro-

moter before sale); Cohu v. Commissioner, 8 T.C. 796

(1947) (shares could not be sold without written consent of

Commissioner of Corporations); Goldwasser v. Commis-

sioner, 47 B.T.A. 445 (1942), aff'd, 142 F.2d 556 (2d

Cir.), cert. denied, 323 U.S. 765, 65 S.Ct. 119, 89 L.Ed.

612 (1944) (contract provision requiring no public offering

of stock). These cases all involve situations in which the

owner could not legally dispose of the stock. The case before

us is different: the stock was freely tradeable on the market

at the market price. We are therefore not persuaded that

these cases support Kolom’s position.

Kolom also attempts to show that section 16(b) liability

is to be an adjustment to the listed price of the stock in

determining the fair market value by relying upon Cummings

v. Commissioner, 506 F.2d 449 (2d Cir. 1974), cert. denied,

421 U.S. 913, 95 S.Ct. 1571, 43 L.Ed.2d 779 (1975);

Anderson v. Commissioner, 480 F.2d 1304 (7th Cir. 1973);

and MacDonald v. Commissioner, 230 F.2d 534 (7th Cir.

1956). Both Anderson and Cummings involved the question

of the tax treatment of the disgorging of profits required by

section 16(b). We agree with the Commissioner that these

cases are not helpful. Here Kolom never had any 16(b)

liability because he did not sell or dispose of any of the

stock within the six month period following the exercise of

the options.

in MacDonald v, Commissioner, supra, the taxpayer had

exercised an option to purchase stock of the corporation of

which he was an officer and director. The court found that

the stock options exercised by the taxpayer had been granted

with the intent of compensating the taxpayer for services

to be rendered, and that, therefore, the taxpayer had received

compensation income at the time of the exercise of the stock

options. The case was remanded to the Tax Court, however,

for a reconsideration of the proper formula for determining

the amount of compensation income realized by the tax-

payer, in light of the effect of section 16(b) and the tax-

payer's agreement not to sell the stock. MacDonald v. Com-

missioner, supra, 230 F.2d at 5 40-41. The court specifically

stated that it was not deciding whether section 16(b) had

an effect on the fair market value of the stock at the time

the option was exercised, /d. at 540. Any statements in the

opinion concerning the effect of 16(b) on the market value

of the shares are therefore dicta. Nevertheless, we are un-

persuaded by the MacDonald court's statement that:

[Neither the taxpayer nor any other person under sim-

ilar circumstances would be a willing seller, with

knowledge that all profits realized might inure to the

benefit of the corporation, and it is doubtful if any

person cognizant of the circumstances would become

a willing buyer.

Id. at 541. As we have said, although we recognize that

section 16(b) may have discouraged Kolom from selling his

stock, it would have no demonstrable effect upon the market

value of the shares. Section 16(b) affects only the seller's

ability to keep the profits after disposing of the stock, not

the marketability of the stock itself,

Kolom also argues that the deficiency asserted by the

Commissioner resulted from a prohibited second exami-

nation of his books and records under section 7605(b) of

the Code.® The Tax Court found that the reopening of Ko-

lom's case had not resulted from a second examination of

his books and records. In fact, no second examination had

ever taken place. The reopening instead resulted from an

examination of the books and records of Tool Research, On

appeal, Kolom now argues that there was an oral agreement

between the Internal Revenue Service (IRS) and Kolom on

the original audit of his tax return, and that this agreement

precludes the IRS from reopening his case.

Section 7121 of the Code provides for binding closing

agreements between the IRS and a taxpayer with respect to

any taxable liability.’ Section 7121, however, requires a

"Section 7605(b) provides:

(b) RESTRICTIONS ON EXAMINATION OF TAXPAYER -

No taxpayer shall be subjected to unnecessary examination or

investigations, and only one inspection of a taxpayer's books of

account shall be made for each taxable year unless the taxpayer

requests otherwise or unless the Secretary or his delegate, after

investigation, notifies the taxpayer in writing that an additional

inspection is necessary.

(Emphasis added).

‘Section 7121 provides in part:

CLOSING AGREEMENTS.

(a) AUTHORIZATION. — The Secretary or his delegate is

authorized to enter into an agreement in writing with any person

relating to the liability of such — (or of the person or estate

for whom he acts) in respect of any internal revenue tax for any

taxable period,

(footnote continued on following page)

written closing agreement authorized or approved by the

Secre .7y. We have no evidence of such 4 written agreement

in this case. Section 7122 of the Code allows for the IRS

to compromise any case prior to referring the case to the

Department of Justice for prosecution or defense. Treasury

Regulation 301.7122-1(d)(3) provides that such an offer to

compromise shall be accepted only when the taxpayer is

notified in writing. We find no such evidence of notification

in the instant case. The audit report sent by the revenue

agent to Kolom contained no mention of any such closing

agreement or offer to compromise. As a result we find the

reopening of Kolom’s case was not prohibited.

Affirmed.

(b) FINALITY. — If such agreement is approved by the Sec-

retary or his delegate (within such time as may be stated in such

agreement, or later agreed to) such agreement shall be final and

conclusive, and, except upon a showing of fraud or malfeasance,

or misrepresentation of a material fact —

(1) case shall not be reopened as to matters agreed

upon... .

(Emphasis added).

APPENDIX B.

Opinion of the United States Tax Court.

Aaron L. Kolom and Serita Kolom, Petitioners, vs. Com-

missioner of Internal Revenue, Respondent.

November 21, 1978

S. Zachary Samuels, for the petitioners, Kenneth G. Gor-

don, for the respondent.

Scott, Judge: Respondent determined a deficiency of

$42,489 in petitioners’ Federal income tax for the calendar

year 1972. By amendment to answer, respondent claimed

an increased deficiency of $1,303, making the total defi-

ciency in issue $43,792. The increased deficiency resulted

from a recomputation of income subject to the minimum

tax based on the mean price of stock with respect to which

options were exercised rather than the closing price on the

New York Stock Exchange. The increased deficiency is not

an issue separate from the issues with respect to the defi-

ciency as determined in the notice of deficiency.

The issues presented for decision are:

(1) What is the fair market value of stock acquired by

petitioner Aaron L. Kolom pursuant to his exercise of qual-

ified stock options;

(2) Whether the minimum tax provisions of sections 56

and $7(a)(6), I.R.C. 1954,' are unconstitutional as applied

to the facts of this case;

(3) Whether the deficiency was determined as a result

of a second examination of petitioners’ records; and

‘Unless otherwise indicated, all section references are to the Internal

Revenue Code of 1954, as amended and in effect during the year in

issue,

(4) Whether respondent should be required to pay pe-

titioners’ attorney's fees incurred in connection with this

case.

FINDINGS OF FACT

Some of the facts have been stipulated and are found

accordingly.

Petitioners Aaron L. Kolom and Serita Kolom, husband

and wife, resided in Los Angeles, Calif., at the time they

filed the petition in this case. They timely filed their Federal

income tax return for the calendar year 1972. Petitioners

signed their 1972 return on April 5, 1973.

During the year 1972, Aaron L. Kolom (hereinafter pe-

titioner) was an officer and director of Tool Research &

Engineering Corp. (hereinafter Tool Research), a corpora-

tion duly formed and organized under the laws of the State

of Delaware. As of 1972, Tool Research was a corporation

registered under section 12, Securities Exchange Act of

1934, 15 U.S.C. sec. 78/.

On November 6, 1968, Tool Research's Stock Option

Committee, pursuant to the employees’ stock option plan

which met the qualification requirements of section 422,

granted petitioner an option to purchase 2,000 shares of

$1 par value Tool Research capital stock at an option price

of $44 per share. The option continued for a term of 5 years,

and was exercisable in whole or in part in installments of

25 percent at the time the option was granted, 25 percent

at the end of the first year, 25 percent at the end of the

second year, and the final 25 percent at the end of the third

year. If petitioner did not exercise the full 25 percent in any

one year, his rights the following years were to be cumu-

lative. In accordance with the terms of Tool Research's

Employees’ Stock Option Plan, the option could not be

exercised more than 5 years from the date of the grant

thereof. In addition, the option could not be exercised if

there were outstanding any qualified stock option granted

before the grant of the option of November 6, 1968. On

February 23, 1970, petitioner was granted an additional

option for the purchase of 5,000 shares of Tool Research

stock at an option price of $13,375 per share. On January

29, 1971, petitioner was granted another option for the

purchase of 3,000 shares of Tool Research stock at an option

price of $20.625 per share. The terms of these latter two

options were substantially the same as the terms of the

option granted petitioner on November 6, 1968.

in 1972, petitioner exercised certain qualified stock op-

tions he had in Tool Research's qualified stock option plan.

The dates of the exercise, the numbers of shares received,

the mean price of the stock on the New York Stock Exchange

on the date of exercise, and petitioner's option price were

as follows:

Date Number Mean price Option Total

of of per share price option

exercise shares onN.Y.S.E. per share price

9/15/72 6,678 $52.00 $13.25 $88,484

10/5/72 4,174 45.25 12.00 50,088

10/5/72 1,575 45.25 19.625 30,909

The stock received by petitioner was registered under Form

S(8) of the applicable Securities and Exchange Regulations.

The stock could have been resold on the New York Stock

Exchange at the price quoted at the time of sale on the date

the option was exercised but had it been sold on that date

petitioner, as a director and officer of Tool Research, would

*Because of stock splits and stock dividends, the number of shares

subject to options was increased and the per share price decreased. The

— which were exercised were the three options referred to in the

indings.

have been subject to the provisions of section 16(b), Se-

curities Exchange Act of 1934, 15 U.S.C. sec 78p(b).’

On September 15, 1972, when petitioner exercised the

first of his options, the closing market price of Tool Re-

search stock on the New York Stock Exchange was 51%

upon the expiration of 6 months, the stock closed at 23%.

On October 5, 1972, when petitioner exercised his remain-

ing options, Tool Research stock closed at 44; 6 months

later the stock closed at 20%. From March 15, 1972, to

September 15, 1972, the lowest price of Tool Research

stock on the New York Stock Exchange was 41. The price

did not go below 40 during the calendar year 1972. In

January 1973, the lowest price to which the stock dropped

was 32 and in February, 24. The price at which the stock

closed on April 5, 1973, was the lowest price the stock had

reached up to that time during the year 1973.

With his income tax form for 1972, petitioner completed

and filed Form 4625, *‘Computation of Minimum Tax.”’

This form shows tax-preference items totaling $111,398,

which consist of accelerated depreciation and capital gains.

Petitioner’s stock options are not reflected in the minimum

tax computation. On the last sheet attached to his tax return,

however, petitioner included the following statement:

‘Under the terms of sec. 16(b), Securities Exchange Act of 1934, the

profits realized by an officer or director of a corporation from the sale

of an equity security of that corporation within 6 months after its ac-

quisition inure to the benefit of, and are recoverable by, the corporation.

Generally, the measurement of the sec. 16(b) liability is the difference

between the price at which the shares were acquired and the sales price.

Under reg. 16(b)-5, Securities and Exchange Commission, 17 C.F.R.

sec. 240. 16b-6 (1977), however, when a stock option is exercised more

than 6 months after it was granted, the sec. 16(b) liability is subject to

a maximum limit, measured by the difference between the sales price

and the lowest quoted market price within 6 months before and after

the date of exercise of the option.

a a

Statement 9-Form 4625 Footnotes

During 1972 taxpayer exercised his option to pur-

chase Tool Research Co. stock. The taxpayer is not

treating this as preference income for the following

reason:

Income Tax Regulation 1.57-1(f)5(i) states that there

is no tax preference if the stock is disposed of in the

year the option is exercised. By law, taxpayer could

not sell the stock in the year the option was exercised

because all of his profit would belong to the corpo-

ration. The stock is being sold the year in which the

taxpayer is first able to sell the stock. Because of the

above reason and because the nature of the tax con-

sequences are the same whether the taxpayer sold the

stock in the year the option was exercised or the suc-

ceeding year, the item is not being treated as a tax

preference item in 1972.

Petitioner’s return for 1972 was examined and audit

changes were made with respect to adjustments other than

the minimum tax. Petitioner and respondent agreed to these

adjustments in November 1974. Subsequent to petitioner's

mecting with the revenue agent regarding his tax liability,

petitioner received a letter dated January 15, 1975, from the

District Director stating that the revenue agent's report had

been reviewed and accepted. Approximately a year later,

petitioner received a phone call from a revenue agent who

brought up the subject of petitioner's liability for minimum

tax in 1972. Petitioner gave the agent no information above

and beyond that which had been considered during the

course of the audit. As a result of an examination of Tool

Research’s books and records, in September of 1975, Rev-

enue Agent Lloyd E. Beal submitted a written request for

approval to reopen petitioner's 1972 tax liability, a closed

examined case. The reasons for the request were a ‘‘sub-

stantial error’’ and a ‘serious administrative omission re-

sulting in criticism, undesirable precedent or inconsistent

Dies

treatment."’ The reopening memorandum was approved by

Mr. Beal's group supervisor, the chief of the field audit

branch, the acting technical coordinator, the acting chief of

the audit division, and the acting district director. The ap-

proval to reopen petitioners’ examined year was obtained

in October 1975 and petitioners were so notified in January

1976.

On petitioners’ Federal income tax return for 1973, they

showed a minimum tax liability of $8,097 for stock options.

This figure was apparently calculated on the basis of the

difference between the option price of the stock and the

mean prices at which the stock was traded 6 months after

the date of exercise.

In his notice of deficiency, respondent determined the

$424,888 difference between the fair market value of the

stock at the time of exercise of the options and the option

price to be an item of tax preference subject to the minimum

tax.

OPINION

Section 56(a)* as applicable to the year 1972 imposed a

tax of 10 percent of the amount by which items of tax

preference in excess of $30,000 were greater than the sum

“Sec. 56(a), as effective in 1972, provided:

SEC. 56. IMPOSITION OF TAX.

(a) In General. — In addition to the other taxes imposed by this

chapter, there is hereby imposed for each taxable year, with respect to

the income of every person, a tax equal to 10 percent of the amount

(if any) by which —

(1) the sum of the items of tax preference in excess of $30,000,

is greater than

(2) the sum of —

(A) the taxes imposed by this chapter for the taxable year

(computed without regard to this part and without regard to the

taxes imposed by sections 531 and 541) reduced by the sum of

the credits allowable under —

(i) section 33 (relating to foreign tax credit),

(ii) section 37 (relating to retirement income),

(iii) section 38 (relating to investment credit),

(iv) section 40 (relating to expenses of work incentive program),

and

(v) section 41 (relating to contributions to candidates for public

office); and

(B) the tax carryovers to the taxable year.

of the income tax for the year computed without regard to

the tax imposed by section 56(a) and certain other sections

and reduced by certain specified credits. The items of tax

preference to which the minimum tax applies are set forth

in section 57. Where stock is transferred pursuant to the

exercise of a qualified or restricted stock option, under sec-

tion 57(a)(6)° the amount by which the fair market value

of the stock at the date of exercise of the option exceeds

the option price is a tax-preference item.

Respondent contends that the amount of the item of tax

preference subject to the minimum tax is, under section

57(a)(6), the mean price of the stock on the New York Stock

Exchange on the day of the exercise of each option less the

amount paid for, i.e., the option price of, the stock.

Petitioners argue that the fair market value of the stock

Mr. Kolom received upon the exercise of his options does

not exceed the option price and, therefore, he had no item

of tax preference. Petitioners’ argument is that had Mr.

Kolom sold the stock on the day he exercised the option or

within 6 months thereafter, his profit would have inured to

the benefit of the corporation under section 16(b), Securities

Exchange Act of 1934, and for this reason the option price

of the stock constitutes its fair market value. Petitioners

argue that, if section 57(a)(6) is not construed as they con-

tend, it is unconstitutional.

‘Sec, 57(a)(6) provides:

SEC. 57. ITEMS OF TAX PREFERENCE

(a) In General, — For purposes of this part, the items of tax preference

are —

* * * * * * *

(6) Stock Options, — With respect to the transfer of a share of stock

pursuant to the exercise of a qualified stock option (as defined in section

422(b)) or a restricted stock option (as defined in section 424(b)), the

amount by which the fair market value of the share at the time of

exercise exceeds the option price.

a,’

In support of his position that the fair market value of

the stock is its mean listed price on the New York Stock

Exchange on the dates the options were exercised, respon-

dent relies on section 1.57-1(f)(2)-(3)° Income Tax Regs.

At the time of the trial in this case, the regulations with

respect to the minimum tax were in proposed form. They

have since been adopted, T.D. 7564, 43 Fed. Reg. 40459

(Sept. 12, 1978). While there are some differences in lan-

guage in the proposed and final regulations, the substance

of the provisions with respect to the applicability of the

minimum tax to the exercise of qualified or restricted stock

options is the same. Section 1.57-1(f)(3), Income Tax

Regs., provides that the fair market value of stock received

upon the exercise of a qualified stock option is to be de-

termined in accordance with the principles of section

83(a)(1) without regard to restrictions other than nonlapse

restrictions within the meaning of section 1.83-3(h), income

Tax Regs. Petitioners contend that section 1.57-1(f)(3), In-

come Tax Regs., is invalid. They base this contention pri-

"Sec. 1.57-1(f)(2)-3, Income Tax Regs., provides:

(f) Stock options, * * *

(21) Definitions, See generally sec. 1.421-7(e), (f), and (g) for the

definiuons of ‘option price,"’ ‘‘exercise,’’ and ‘‘transfer,’’ respec-

tively; however, in the case of a transfer of a share of stock pursuant

to the exercise of a qualified stock option or a restricted stock option

after the death of an employee by the estate of the decedent (or by a

person who acquired the ry to exercise such option by bequest or

inheritance or by reason of the death of the decedent), the term *‘option

price’’ shail, for purposes of this paragraph, include both the consid-

eration paid by the estate (or such person) for such share of stock and

so much of the basis of the option as is attributable to such share of

stock. *° ©

(3) Fair market value, In accordance with the principles of section

83(a)(1), the fair market value of a share of stock received pursuant to

the exercise of a qualified or restricted stock option is to be determined

without regard to restrictions (other than nonlapse restrictions within

the meaning of sec. 1.83-3(h)). Notwithstanding any valuation date

given in section 83(a)(1), for oy wor of this section, fair market value

is determined as of the date the option is exercised.

marily on the ground that this regulation is contrary to sec-

tion 83(e)(1), which provides that section 83 is inapplicable

to section 421 transfers. The regulations do not provide for

inclusion in a taxpayers’s taxable income of the value of

the stock received upon exercise of a qualified stock option.

Rather, the regulations apply the valuation principles of

section 83 in determining the fair market value of stock

received by a taxpayer upon exercise of a qualified stock

option. Therefore, we see no merit in petitioners’ assertion

that section 1.57-1(f)(3), Income Tax Regs., is invalid be-

cause of an inconsistency with section 83(¢)(1). The balance

of petitioners’ argument as to the invalidity of section 1.57-

\(f)(3), Income Tax Regs., deals primarily with the appli-

cability of certain of the provisions of section 83(a)(1) and

section 1.83-3(h), Income Tax Regs., to this case, rather

than with the validity of the regulations.

Section 83(a) generally provides that when property is

transferred to a taxpayer in connection with the performance

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

rights of the taxpayer 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 taxpayer's gross

income. Under section 83(a)(1)’ the value of the property

is to be determined without regard to restrictions other than

those which, by their terms, will never lapse. Section 1.83-

"SEC. 83. PROPERTY TRANSFERRED IN CONNECTION WITH

PERFORMANCE OF SERVICES.

(a) General Rule. — If, in connection with the performance of ser-

6 rty is transferred to any person other than the person for

services are performed, the excess of —

“ “i 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,

* * *

idle

3(h)," Income Tax Regs., provides that a *‘nonlapse restric-

tion’’ is a permanent limitation on the transferability of

property which applies to the transferee or any subsequent

holder. This regulation states that limitations imposed by

registration requirements of State or Federal securities laws

or similar laws imposed with respect to sales or other dis-

positions of stock or securities are not nonlapse restrictions.

Respondent contends that section 16(b) of the Securities

Exchange Act of 1934 is not a ‘‘nonlapse restriction’’ within

the meaning of section 1.83-3(h), Income Tax Regs. Peti-

tiouers contend that section 16(b), Securities Exchange Act

of 1934, is not a registration requirement or a similar law

and conclude that the regulations are for this reason invalid

as applied to this case. While petitioners’ argument, if ac-

cepted, would go to the applicability of the regulations to

this case, it does not go to the validity of the regulations.

If section 16(b), Securities Exchange Act of 1934, is a

‘‘restriction’’ as that term is used in section 83(a)(1) and

section 1.83-3(h), Income Tax Regs., it clearly is not a

**nonlapse restriction’’ within the meaning of those regu-

"Sec. 1.83-3(h), Income Tax Regs., provides:

(h) Nonlapse restriction. For - ses of section 83 and the regu-

lations thereunder, a restriction w ich by its terms will never lapse (also

referred to as a ‘‘nonlapse restriction’’) is a permanent limitation on the

transferability of property —

(i) Which will require the transferee of the property to sell, or offer

to sell, such property at a price determined under a formula, and

(ii) Which will continue to apply to and be enforced against the

transferee or any subsequent holder (other than the transferor).

A limitation subjecting the property to a permanent right of first refusal

in a particular person at a price determined under a formula is a per-

manent nonl restriction. Limitations imposed by registration re-

quirements of State or Federal security laws or similar laws imposed

with respect to sales or other dispositions of stock or securities are not

nonl restrictions. An obligation to resell or to offer to sell property

transferred in connection with the performance of services to a specific

person or persons at its fair market value at the time of such sale is not

a nonlapse restriction. See sec. 1.83-Si(c) for examples of nonlapse

restrictions.

lations since under section 16(b), Securities Exchange Act

of 1934, the requirement of payment to the corporation of

profits upon sale of the stock expires 6 months after exercise

of the stock option.

While not specifically so stated, petitioners apparently

contend that respondent's regulations as applied to this case

are invalid since they change preexisting law as to the de-

termination of the fair market value of stock received upon

the exercise of qualified stock options by a taxpayer subject

to the provisions of section 16(b), Securities Exchange Act

of 1934. In our view, for reasons hereinafter stated, without

reference to section | .57-1(f)(2)-(3), Income Tax Regs., the

law is that the fair market value of stock received by a

taxpayer subject to section 16(b), Securities Exchange Act,

is its selling price on the New York Stock Exchange when

it is received. Therefore, section 1.57-1(f)(2)-(3), Income

Tax Regs., if applicable, is not invalid as applied to this

case. We express no opinion as to whether this regulation

would be valid in a situation in which it changed the criteria

for determining the fair market value of stock from that

under existing law.

The provisions of section 57(a)(6) refer to *‘the fair mar-

ket value’’ of the stock which is the subject of the exercise

of the qualified stock option at the date of the exercise of

the option. When Congress enacted this section, the term

**fair market value’’ had long had a clearly defined meaning,

United States v. Cartwright, 411 U.S. 546, 551 (1973).

Generally, where stock is traded on a national exchange,

the fair market value of relatively small quantities of the

stock on any date on which the stock is traded on that

exchange is the price at which the stock is sold. United

States v. Cartwright, supra; Freshman v. Commissioner,

33 B.T.A. 394, 402-403 (1935). The obvious reason for

using the exchange price as the fair market value of the

= =

stock is that this price is the best evidence of what a willing

buyer will pay a willing seller for the stock. However, there

are many exceptions to the use of the quoted exchange prices

as indicative of the value of stock. These cases all involve

unusual circumstances such as a restriction on sale of the

stock or a large block of stock being valued. Frizzelle

Farms, Inc. v. Commissioner, 61 T.C. 737, 743 (1974),

affd. 511 F.2d 1009 (4th Cir, 1975).

Applying the ordinary rules of determining the fair market

value of the number of shares of stock involved in each

transaction in this case, the mean price at which the stock

sold on the New York Stock Exchange on the date of the

transaction would be the fair market value of the stock. If

the stock had actually been sold, petitioners recognize that

the New York Stock Exchange price would have been the

price which would have been received for the stock. Peti-

tioners nevertheless contend that under the facts of this case

that amount is not the ‘‘fair market value’’ of the stock

within the meaning of section 57(a)(6).

Both parties agree that fair market value is ‘‘the price at

which property would change hands in a transaction between

a willing buyer and a willing seller, neither being under

compulsion to buy nor to sell and both being informed.”’

United States v. Cartwright, supra; Hamm v. Commis-

sioner, 325 F.2d 934, 937 (8th Cir. 1963), affg. a Mem-

orandum Opinion of this Court. Petitioners argue that in

this case on of the necesary elements, a willing seller, is

missing. This argument is not new. We have consistently

held that the definition is not a personalized one which

envisions a particular seller and a particular buyer. Rather,

the definition refers to hypothetical parties. As we said in

Estate of Reynolds v. Commissioner, 55 T.C. 172 (1970):

‘*Fair market value"’ is not an incantation whose

ritualistic use will immediately reveal the werth of

— Se

unusual types of property. The basis of the definition

of fair market value is the assumption that hypothetical

willing buyer and hypothetical willing seller, neither

being under compulsion to buy or sell and both having

reasonable knowledge of the relevant facts, will arrive

at some sale price for the property in question. * * *

In reality, no willing buyers or willing sellers may

exits. * * * [55 T.C. at 195.]

Petitioners argue that even though as a general rule the

willing buyer and willing seller may be hypothetical, under

the circumstances of this case the price to the seller at which

the property would change hands in any sale transaction is

the option price, because this is the amount that Mr. Kolom

would be permitted to retain, after paying his liability under

section 16(b), Securities Exchange Act of 1934.” They cite

Anderson v. Commissioner, 480 F.2d 1304 (7th Cir. 1973),

revg. 56 T.C. 1370 (1971); Cummings v. Commissioner,

506 F.2d 449 (2d Cir. 1974), revg. 61 T.C. 1 (1973); and

Kimbell v. United States, 490 F.2d 203 (Sth Cir. 1974), for

the proposition that section 16(b) payments are properly

“Petitioner may have been able to retain part of the profits upon sale

since it appears that reg. 16b-6, Securities and Exchange Commission,

17 C.F.R. sec. 240. 16b-6 (1977), is applicable. This regulation pro-

vides:

Sec. 240. 16b-6 Exemption of long term profits incident to sales within

six months of the exercise of an option.

(a) To the extent specified in paragraph (b) of this section the Com-

mission hereby exempts as not comprehended within the purposes of

section 16(b) of the act any transaction or transactions involving the

purchase and sale or sale and purchase of any equity security where

such purchase is pursuant to the exercise of an option or similar right

cither (1) acquired more than six months before its exercise, or (2)

acquired pursuant to the terms of an employment contract entered into

more than six months before its exercise.

(b) In respect of transactions specified in paragraph (a) of this section

the profits inuring to the issuer shall not exceed the difference between

the proceeds of sale and the lowest market price of any security of the

same class within six months before or after the date of sale. Nothing

in this section shall be deemed to enlarge the amount of profit which

would inure to the issuer in the absence of this section.

characterized as adjustments to the purchase price of stock

and that the sales price or market price should be reduced

by the amount of any potential section 16(b) liability. Kim-

bell v. United States, supra, did not involve the sale of

*‘insider’’ stock although cases involving this issue were

discussed therein (490 F.2d at 205). At issue in each of the

other two cases was whether section 16(b) repayments to

a corporation by an insider who had sold stock should be

characterized as ordinary and necessary business expenses

or as capital losses. In these cases, it was held that the

Arrowsmith" doctrine applied and the section 16(b) repay-

ments constituted capital losses. It is true that in these cases

the courts characterize the section 16(b) repayments as ef-

fectively being adjustments to the sales price of the stock

sold. However, this characterization was for the purposes

of showing the application of the Arrowsmith doctrine and

the relationship between the sales transaction and the pay-

ment of the section 16(b) liability. In our view these cases

do not hold, as petitioners argue, that the fair market value

of the stock is to be reduced by the potential section 16(b)

liability. Demonstrative of this fact is that in Cummings v.

Commissioner, supra, the sale resulting in the capita! gain

was in the year preceding the 16(b) repayment. No adjust-

ment was made to the gain in the prior year. The repayment

in the subsequent year was considered a capital loss in the

year in which made even though because of other capital

losses it resulted in no tax benefit in that year to the taxpayer.

In our view the cases dealing with the treatment of section

16(b) repayments are not helpful in resolving the issue pre-

sented in this case of the fair market values of the stock

when the options were exercised.

"Arrowsmith v. Commissioner, 344 U.S. 6 (1952).

Petitioners strongly rely on MacDonald v. Commissioner,

230 F.2d 534 (7th Cir. 1956), affg. in part and revg. in part

23 T.C. 227 (1954). In MacDonald, to induce a taxpayer

to accept employment, a corporation granted him stock op-

tions exercisable at less than the stock’s market value. This

Court held that upon exercise of the options, the bargain

element — the spread between the option price of the stock

and its fair market value —- was compensatory in nature and

therefore includable in the taxpayer's gross income. This

conclusion was sustained on appeal. This Court, however,

had also held that the measure of the fair market value of

the stock was its selling price on the New York Stock Ex-

change. In so concluding we did not recognize as binding

an oral agreement restricting the sale of the stock. The Court

of Appeals for the Seventh Circuit reversed this issue on

the ground that a restrictive agreement between the taxpayer

and the corporation prohibiting sale of the stock during the

course of the taxpayer's employment did exist and affected

the stock’s fair market value. After reaching this conclusion

the Court further stated:

We think that for our present purpose we are not

required to decide whether Sec. 16(b) is applicable.

The many cases cited in U.S.C.A. following the sec-

tion disclose that it has been a fruitful source of liti-

gation and that it has been given a liberal interpretation.

* * *

* + * * * * *

It is true that the section does not preclude the sale

of stock. As stated in Consolidated Engineering Corp.

v. Nesbit, D.C., 102 F.Supp. 112, 114:

‘It will be noted from the above that Section 78p

does not make the purchase and sale of stock unlawful

or irregular. It provides only that the profits, if any,

shail be recovered by the corporation.”’

The statute, however, does make the seller liable for

profits realized from such sale. * * *

Pa ye Se ee

Even though we find it unnecessary to decide the

question, we are strongly inclined to the view that the

Statute is applicable and that if the taxpayer had sold

the stock during the six-month period following its

acquisition, he would have been liable to account to

the corporation for all profits. And it can be said to a

certainty that if he had done so he would have laid

himself open to an action for the recovery of such

profits, with the probability that he could not have

defended successfully. * * *

* * * Taxpayer acquired the corporate stock with an

agreement not to sell and, in addition, if he had violated

this agreement and sold the stock, he probably would

have been required to account for the profits. Certainly

he would have been faced with a legal action to recover

such profits. This is not to say that he did not realize

economic gain upon purchase of the stock but, even

so, the question remains as to the proper formula for

the ascertainment of the amount and extent of such

gain. The Tax Court has held that it is the difference

between the option price and the fair market value of

the stock on the New York Stock Exchange at the time

of its acquirement. We disagree with that conclusion.

** *

The testimony of these expert witnesses clearly

shows that neither the taxpayer nor any other person

under similar circumstances would be a willing seller,

with knowledge that all profits realized might inure to

the benefit of the corporation, and it is doubtful if any

person cognizant of the circumstances would become

a willing buyer. [230 F.2d 540-541]

It is to be noted that the MacDonald case involved stock

options granted to the taxpayer as compensation. The state-

a ae

ments of the Circuit Court of Appeals as to the applicability

of section 16(b), of the Securities Exchange Act, were dicta.

However, the statements themselves show that the Circuit

Court did not contemplate that because of the provisions of

section 16(b), Securities Exchange Act, the option price

represented fair market value. ''

In Husted v. Commissioner, 47 T.C. 664, 679 (1967),

we held stock acquired by the taxpayer for less than its fair

market value represented additional compensation. The tax-

payer had paid $1 a share for most of the stock and $3 a

share for the remainder. Although small quantities of this

stock had been sold near the valuation date at $11 a share,

we concluded that the fair market value of the stock on the

date of its acquisition was $7. In reaching this conclusion

we stated at page 679."

"After the remand in MacDonald v. Commissioner, 230 F.2d 534

(7th Cir. 1956), affg. in part and revg. in part 23 T.C. 227 (1954),

respondent moved for a further hearing pursuant to the mandate of the

Court of Appeals and proposed alternative methods of computiry the

gain realized by the taxpayer. Unable to find any meritorious method

of computation other than that used in the original opinion, i.e., the

difference between the option price and the market price of the stock

as traded on the New York Stock Exchange, this Court denied respon-

dent's motion. MacDonald v. Commissioner, a Memorandum Sur Order

dated Oct. 18, 1956. An appeal was taken from our decision of no

deficiency thereafter entered. This decision of no deficiency was re-

versed and the case was remanded by the United States Court of Appeals

for the Seventh Circuit with instructions to hear additional evidence.

Commissioner v. MacDonald, 248 F.2d 552 (7th Cir. 1957).

"In Burns v. Commissioner, T.-C. Memo. 1974-220, we stated as

follows, with respect to Husted v. Commissioner, 47 T.C. 664, 679

(1967):

Although no restrictions were noted on the face of the certificate

received by the taxpayer in Husted, as is also true of the immediate

case, disposition of the stock was significantly restricted by the follow-

ing factors not found here: (1) the taxpayer executed an *“‘investment

letter’’ for each block of shares in which he warranted to Dorsey that

he was acquiring the stock for investment and *‘without any intention

of selling or distributing the same’*; (2) the 4.200 shares were subject

to a repurchase agreement in favor of Dorsey in the event the acquisition

was not completed; (3) taxpayer's stock represented a significant portion

of the outstanding stock of Dorsey and exceeded the amount of Dorsey

stock sold on the exchange in each of the six months following the

acquisition; and (4) there was a possibility that the taxpayer's resale of

the stock within six months of receipt could have violated section 16(b)

of the Securities and Exchange Act of 1934.

tind

We have examined all the circumstances surrounding

Husted’s stock holding. Although the investment letter,

as a practical matter, prevented Husted from selling

the stock publicly for some period of time. it did not

prevent him from selling the stock privately. Victorson

v. Commissioner, 326 F.2d 264 (C.A.-2, 1964), af-

firming a Memorandum Opinion of this Court; Jack

I. LeVant, 45 T.C. 185 (1965), on appeal (C.A. 7,

May 18, 1966). Thus, Husted’s situation differed from

that in the case of Harold H. Kuchman, 18 T.C. 154

(1952), acq. 1952-2 C.B. 2. Because of his position

with Dorsey, section 16(b) of the Securities and Ex-

change Act of 1934 (48 Stat. 881, 896) might apply

to any sale of the stock which he would make within

6 months of its acquisition. [Footnote omitted.} Al-

though there is some legal uncertainty as to the appli-

cability of section 16(b) in this situation, it is enough

for us to recognize that the possibility of its applying

constituted a deterrent to the sale of the stock within

6 months. Husted’s holding of 34,200 shares repre-

sented a significant portion of the outstanding stock

and exceeded the amount of stock sold on the exchange

in April or in any of the other 6 succeeding months.

However, we know that 150,000 shares were sold

through the underwriting in the last part of April and

the first part of May; and though there would no doubt

be some difficulty in finding a placement for another

34,000 shares, we are inclined to think that it would

not have been impossible. * * *

In the Husted case, as above stated, we determined that

the fair market value of the large block of restricted stock

was $7 a share, greatly in excess of the price the taxpayer

paid for the stock on the date the stock was acquired.

In arguing that the value of stock held by an insider is

limited to the price paid for the stock because of a potential

— =

section 16(b) liability, petitioners quote out of context lan-

guage from Bayley v. Commissioner, 69 T.C. 234 (1977),

a Court-reviewed case. The full statement from which that

language is extracted is —

We do not believe that Rev. Rul, 68-286 is contrary

to our decision in Hirsch since we believe it was based

on the premise that section 16(b) restrictions do not

**significantly’’ affect value rather than that the section

16(b) restrictions are not ‘‘restriction. ” within the

meaning of the applicable regulations. A buyer (unless

he, too, is an ‘‘insider’’) will take an ‘‘insider’s’’ stock

free from the restrictions of section 16(b) so that such

restrictions do not affect the value of such stock in the

eyes. of the purchaser. The value of such stock to the

selling ‘‘insider’’ will be reduced, not because its mar-

ket value is reduced, but only because he must return

any “‘insider profit’ tohiscompany.* * *|69T.C,

at 244; emphasis added. |

This language does not lend support to petitioners’ ar-

gument but rather recognizes that section 16(b) does not

affect market value, even though it might affect the value

to the insider of the stock held by the insider.

Petitioner’s argument that the *‘fair market value’’ of the

stock Mr. Kolom received on the exercise of his stock op-

tions as of the date the options were exercised was the option

price is tantamount to an argument that sections 56 and

57(a)(6) do not apply to a person subject to the provisions

of section 16(b), Securities Exchange Act'’ Since many

"The legislative history is clear that the tax imposed by sec. 56 was

intended to require the payment of some tax on ‘economic income”

which under the tax laws was not “taxable income.'’ However, there

is no discussion specifically of the intent of sec, 57(a)(6) which was

added to the House bill by the Senate. See H. Rept. 91-413 (1969),

1969-3 C.B. 200, 249; S. Rept. 91-552 (1969), 1969-3 CB. 423, 495,

Conf. Rept. 91-782 (1969), 1969-3 C.B. 644, 658, 659.

a Con

participants in qualified stock option plans are ‘‘insiders”’

subject to section 16(b) of the Securities Exchange Act, had

Congress intended so drastic a limitation of the application

of the sections, in our view the statute would have so stated.

Since in our view Congress did intend sections 56 and

57(a)(6) to apply to persons subject to the provisions of

section 16(b), Securities Exchange Act, we do not accept

petitioners’ argument that the fair market value of the stock

for which Mr. Kolom exercised his stock options in 1972

at the date of the exercise of those options was the option

price of the stock.

Petitioners on brief argue that even if their primary ar-

gument is not accepted, some adjustment to the value of

their stock must be made because of the provisions of section

16(b), Securities Exchange Act. Petitioners suggest that we

should use the market price of the stock on the date 6 months

following Mr. Kolom’s purchase of the stock. There is no

support for this position in the statute.'* Section 57(a)(6)

refers to fair market value at the date the option is exercised.

There is nothing in this record to show that section 16(b)

was a restriction which had a significant effect on the value

of the stock Mr. Kolom received when he exercised his

option under our holding of what constitutes ‘*fair market

value’’ in Bayley v. Commissioner, supra.

It should be noted that at the time the option is exercised there is

no way to determine whether the market price of the stock on the stock

exchange will increase or decrease in the ensuing 6 months. All that

can be n at that time is the value at dates prior to the exercise of

the option. This leaves as speculative whether an ‘‘insider’’ subject to

the provisions of sec. 16(b), Securities Exchange Act, who has held his

option for over 6 months at the time it is exercised would, even if he

sold the stock within 6 months, be liable to return to the corporation

any amount in excess of the price he received and the lowest price of

the stock in the 6 months prior to the date of the exercise of the option.

(See nn. 3 & 9 supra)

om} J ox

In our view, if we adhere to our holding in the Bayley

case we must conclude here that since section 16(b) does

not affect the value of the stock in the eyes of the purchaser

no adjustment is required to the quoted price of the stock

on the dates on which Mr. Kolom exercised his options

because of the provisions of section 16(b), Securities Ex-

change Act,

We therefore hold that respondent properly computed the

fair market value of the stocks here involved by use of the

mean prices at which those stocks sold on the New York

Stock Exchange on the dates Mr. Kolom exercised his

options.

Petitioners’ second argument is that the minimum tax

provisions of sections 56(a) and 57(a)(6) are unconstitu-

tionally confiscatory as applied to the exercise of a qualified

stock option by a person subject to section 16(b), Securities

Exchange Act of 1934.

The thrust of petitioners’ argument in this regard is that

a market decline during the 6-month period following ex-

ercise of the option could eliminate any profit Mr. Kolom

could have realized upon the sale of the stock acquired upon

exercise of the option. Accordingly, his argument continues,

the minimum tax may be imposed in the absence of any

realized gain. The flaw in this argument is that a gain is

realized upon exercise of the option itself. At that time,

petitioner acquired property the value of which substantially

exceeded the price paid for the property. Were a gain not

realized at this time, the nonrecognition provisions of sec-

tions 421 and 422 would be superfluous. See Commissioner

v. LoBue, 351 U.S. 243 (1956); Commissioner v. Smith,

324 U.S. 177 (1945). It is true that within the 6-month

period following exercise of the options, petitioner may not

be able to reduce his realized gain to cash without disgorging

part or all of the profit to the corporation, It is also true that

a decline in market value during the 6-month period in

which the provisions of section 16(b), Securities Exchange

Act of 1934, are applicable could eliminate any gain on the

sale of the stock during that period. That risk, however, is

one that petitioner assumed when he chose to exercise the

stock options. It does not follow, however, that merely

because petitioner could not reduce his gain to cash for 6

months without incurring a section 16(b) liability, he had

no gain. In fact, he had the very type of ‘economic in-

come,’’ which because of the provisions of sections 421

and 422 is not *‘taxable income,’’ to which sections 56 and

57 are directed. See n. 13 supra. Had petitioner sold his

stock in 1972, and 1973 been required by section 16(b),

Securities Exchange Act, to pay over all or part of his profit

to the corporation, he would have had a gain on the sale

in 1972 and an expense deduction or loss from the payment

in 1973, Cummings v. Commissioner, supra.

Petitioner's final argument is that he was subject to a

prohibited second examination in contravention of section

7605(b)'’ There was no prohibited second examination in

this case. The examination resulting in the deficiency in

petitioners’ minimum tax involved no examination of pe-

titioners’ books and records. Rather, it occurred after an

examination of Tool Research's books and records. It was

made with approval of the auditing employee's supervisors

and involved only a telephone conversation with petitioner.

Also, petitioner was notified of the reopening of his taxable

year 1972. With regard to the purposes underlying the en-

"SEC. 7605. TIME AND PLACE OF EXAMINATION,

(b) Restrictions on Examination of Taxpayer. —- No taxpayer shall

be subjected to unnecessary examination or investigations, and only one

inspection of a taxpayer's books of account shall be made for each

taxable year unless the taxpayer requests otherwise or unless the Sec-

retary or his delegate, after investigation, notifies the taxpayer in writing

that an additional inspection is necessary.

actment of section 7605(b), this Court said in Collins v.

Commissioner, 61 T.C. 693, 698-699 (1974):

It is evident from the legislative history of section

7605(b) that Congress intended that provision to pre-

vent the Internal Revenue Service from undertaking

repetitive investigations as a method of taxpayer har-

rassment. There is no indication that it was enacted to

restrict the scope of the Commissioner's legitimate

power to protect the revenue. * * *

We hold that there was no prohibited second examination

of petitioners’ books and records under section 7605.

As we held in Key Buick Co. v. Commissioner, 68 T.C.

178 (1977), this Court is without jurisdiction to award at-

torney’s fees to petitioners.

Decision will be entered for the respondent.

Reviewed by the Court.

Hall, J.: | concur in the result.

A share of stock awarded as compensation to a person

who is subject to a legal requirement that he must disgorge

any gains on a sale thereof within 6 months obviously pro-

vides significantly less compensation to him than would an

otherwise identical share awarded to a person not so subject.

Such differences in value may be ignored under section 83

for transactions within its scope, but section 83(e)(1) forbids

respondent from applying section 83 to transactions, such

as this, covered under section 421. Hence section 1.57-

1(f)(3), Income Tax Regs., overreaches in defying this pro-

hibition. It cannot be reconciled with the statute and, in my

view, is invalid. Section 57(a)(6) defines as the tax pref-

erence the excess of ‘‘fair market value’’ over the option

price. The statute nowhere authorizes respondent to use, as

he does, a figure clearly in excess of fair market value. On

the other hand, petitioner is clearly wrong in arguing that

pe eae

either his option price, or the price 6 months later, was fair

market value. Since he failed to show the true fair market

value of the restricted shares, and there is no evidence in

the record to show it, we have no choice but to sustain

respondent.

Drennen, J., agrees with this concurring opinion.

APPENDIX C.

United States Constitution — Amendment V.

No person shall be held to answer for a capital, or oth-

erwise infamous crime, unless on a presentment or indict-

ment of a Grand Jury, except in cases arising in the land

or naval forces, or in the Militia, when in actual service in

time of War or public danger; nor shall any person be subject

for the same offence to be twice put in jeopardy of life or

limb; nor shall be compelled in any criminal case to be a

witness against himself, nor be deprived of life, liberty, or

property, without due process of law; nor shall private prop-

erty be taken for public use, without just compensation.

APPENDIX D.

Internal Revenue Code Section 56(a).

(a) General Rule. — In addition to the other taxes im-

posed by this chapter, there is hereby imposed for each

taxable year, with respect to the income of every person,

a tax equal to 15 percent of the amount by which the sum

of the items of tax preference exceeds the greater of —

(1) $10,000, or

(2) the regular tax deduction for the taxable year

(as determined under subsection (c)).

—

APPENDIX E.

Internal Revenue Code Section 57(a)(6).

(a) In General. — For purposes of this part, the items

of tax preference are —

(6) Stock options. — With respect to the transfer of a

share of stock pursuant to the exercise of a qualified stock

option (as defined in section 422(b)) or a restricted stock

option (as defined in section 424(b)), the amount by which

the fair market value of the share at the time of exercise

exceeds the option price.

APPENDIX F.

Internal Revenue Code Section 83(a).

(a) General Rule. — If, in connection with the perform-

ance of services, property is transferred to any person other

than the person for whom such services are performed, the

excess of —

(1) the fair market value of such property (deter-

mined 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. The preceding

sentence shall not apply if such person sells or otherwise

disposes of such property in an arm’s length transaction

before his rights in such property become transferable or

not subject to a substantial risk of forfeiture.

=— =

APPENDIX G.

Internal Revenue Code Section 83(e).

(e) Applicability of Section. — This section shall not

apply to —

(1) a transaction to which section 421 applies,

(2) a transfer to or from a trust described in section

401(a) or a transfer under an annuity plan which meets the

requirements of section 404(a)(2),

(3) the transfer of an option without a readily ascer-

tainable fair market value, or

(4) the transfer of property pursuant to the exercise of

an option with a readily ascertainable fair market value at

the date of grant.

APPENDIX H.

Internal Revenue Code Section 421(a).

(a) Effect of Qualifying Transfer. — If a share is trans-

ferred to an individual in a transfer in respect of which the

requirements of section 422(a), 423(a), or 424(a) are met

(1) except as provided in section 422(c)(1), no in-

come shall result at the time of the transfer of such

share to the individual upon his exercise of the option

with respect to such share;

(2) no deduction under section 162 (relating to

trade or business expenses) shall be allowable at any

time to the employer corporation, a parent or subsidiary

corporatiom of such corporation, or a corporation is-

suing or assuming a stock option in a transaction to

which section 425(a) applies, with respect to the share

so transferred; and

(3) no amount other than the price paid under the

option shall be considered as received by any of such

corporation for the share so transferred.

—

APPENDIX I.

Internal Revenue Code Section 422(a).

(a) In General.—Subject to the provisions of subsection

(c)(1), section 421(a) shall apply with respect to the transfer

of a share of stock to an individual pursuant to his exercise

of a qualified stock option if—

(1) no disposition of such share is made by such

individual within the 3-year period beginning on the

day after the day of the transfer of such share, and

(2) at all times during the period beginning with

the date of the granting of the option and ending on

the day 3 months before the date of such exercise, such

individual was an employee of either the corporation

granting such option, a parent or subsidiary corporation

of such corporation, or a corporation or a parent or

subsidiary corporation of such corporation issuing or

assuming a stock option in a transaction to which sec-

tion 425(a) applies.

APPENDIX J.

Proposed Treasury Regulation Section 1.57(f)(3),

as Proposed December 30, 1970.

(f) Stock options —

(3) Fair market value. The fair market value of a share

of stock received pursuant to the exercise of a qualified or

restricted stock option is to be determined as of the date of

the exercise of the option and consistent with the principles

applicable under section 83(a)(1) and the regulations there-

under,

APPENDIX K.

Treasury Regulations Section 1.57-1(f)(3), as Adopted

in Final Form September 11, 1978.

(f) Stock options —

(3) Fair market value. In accordance with the principles

of section 83(a) (1), the fair market value of a share of stock

received pursuant to the exercise of a qualified or restricted

stock option is to be determined without regard to restric-

tions (other than nonlapse restrictions within the meaning

of §1.83-3(h)). Notwithstanding any valuation date given

in section 83(a)(1), for purposes of this section, fair market

value is determined as of the date the option is exercised.

APPENDIX L.

Treasury Regulations Section 1.83-3(h).

(h) Nonlapse restriction. For purposes of section 83 and

the regulations thereunder, a restriction which by its terms

will never lapse (also referred to as a ‘‘nonlapse restriction’)

is a permanent limitation on the transferability of property

(i) Which will require the transferee of the property to

sell, or offer to sell, such property at a price determined

under a formula, and

(ii) Which will continue to apply to an be enforced

against the transferee or any subsequent holder (other than

the transferor).

A limitation subjecting the property to a permanent right

of first refusal in a particular person at a price determined

under a formula is a permanent nonlapse restriction. Lim-

itations imposed by registration requirements of State or

Federal security laws or similar laws imposed with respect

to sales or other dispositions of stock or securities are not

nonlapse restrictions, An obligation to resell or to offer to

sell property transferred in connection with the performance

of services to a specific person or persons at its fair market

value at the time of such sale is not a nonlapse restriction.

See §1.83-5(c) for examples of nonlapse restrictions.

APPENDIX M.

Section 16(b) of the Securities Exchange Act of 1934,

15 U.S.C. §78pib).

(b) For the purpose of preventing the unfair use of in-

formation 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 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. Suit to

recover such profit may be instituted at law or in equity in

any court of competent jurisdiction by the issuer, or by the

owner of any security of the issuer in the name and in behalf

of the issuer if the issuer shall fail or refuse to bring such

suit within sixty days after request or shall fail diligently

to prosecute the same thereafter; but no such suit shall be

brought more than two years after the date such profit was

realized, This subsection shall not be construed to cover

any transaction where such beneficial owner was not such

both at the time of the purchase and sale, or the sale and

purchase, of the security involved, or any transaction or

transactions which the Commission by rules and regulations

may exempt as not comprehended within the purpose of this

subsection.

APPENDIX N.

Rule 16b-6; 17 C.F.R. 240.16b-6.

(a) To the extent specified in paragraph (b) of this rule,

the Commission hereby exempts as not comprehended

within the purposes of Section 16(b) of the Act any trans-

action or transactions involving the purchase and sale, or

sale and purchase of any equity security where such purchase

is pursuant to the exercise of an option or similar right either

(1) acquired more than six months before its exercise, or

(2) acquired pursuant to the terms of an employment contract

entered into more than six months before its exercise.

(b) In respect of transactions specified in paragraph (a)

the profits inuring to the issuer shall not exceed the differ-

ence between the proceeds of sale and the lowest market

price of any security of the same class within six months

before or after the date of sale. Nothing in this rule shall

be deemed to enlarge the amount of profit which would

inure to the issuer in the absence of this rule.

prehended within the purposes of Section 16(b) of the Act,

the disposition of a security, purchased in a transaction

specified in paragraph (a), pursuant to a plan or agreement

for merger or consolidation, or reclassification of the is-

suers’ securities, or for the exchange of its securities for the

securities of another person which has acquired its assets,

or which is in control as defined in Section 368(c) of the

Internal Revenue Code of 1954, of a person which has

acquired its assets, where the terms of such plan or agree-

ment are binding upon all stockholders of the issuer except

to the extent that dissenting stockholders may be entitled,

under statutory provisions or provisions contained in the

certificate of incorporation, to receive the appraised or fair

value of their holdings. [Added by Release No. 34-5004,

February 25, 1954, 19 F. R. 1174; amended by Release

No. 34-7717 (477,291), October 1, 1965, 30 F. R. 12772.]

(d) The exemptions provided by this rule shall not apply

to any transaction made unlawful by Section 16(c) of the

Act or by any rules and regulations thereunder.

(e) The burden of establishing market price of a security

for the purpose of this rule shall rest upon the person claim-

ing the exemption.

(f) The exemption granted pursuant to this rule shall apply

to any liability under Section 16(b) existing at or after the

effective date of this rule but shall not be deemed to affect

judgments rendered prior to that date.

[Adopted in Release No. 34-4509. November 29, 1950,

15 F. R. 7357; amended by Release No. 34-5004. February

25, 1954, 19 F. R. 1174; and by Release No. 34-7717

(177,291), October 1, 1965, 30 F. R. 12772.)

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.