Kolom v. C. I. R.

Decision Date09 April 1981
Docket NumberNo. 79-7077,79-7077
Citation644 F.2d 1282
Parties81-1 USTC P 9359 Aaron L. KOLOM and Serita Kolom, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
CourtU.S. Court of Appeals — Ninth Circuit

Hilbert P. Zarky, Mitchell, Silberberg & Knupp, Los Angeles, Cal., on brief; S. Zachary Samuels, Los Angeles, Cal., argued, for petitioners-appellants.

Gilbert E. Andrews, M. Carr Ferguson, Washington, D. C., on brief; Donald B. Susswein, Atty., Washington, D. C., argued, for respondent-appellee.

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 1 appeal from a decision of the United States Tax Court determining a deficiency 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.

I

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 requirements of sections 421 and 422 of the Internal Revenue Code of 1954 (the Code). 2 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:

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), 3 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 511/8. Six months later the mean price of the stock on the exchange was 235/8. 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 203/8.

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 purchase 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, the taxpayer could not sell the stock in the year the option was exercised because all of his profit would belong to the corporation. 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 consequences are the same whether the taxpayer sold the stock in the year the option was exercised or the succeeding 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 minimum tax. He 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, 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 administrative omission resulting in criticism, undesirable precedent or inconsistent treatment." The request for reopening 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 deficiency 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 section 16(b) profit restrictions, and (2) the Tax Court improperly concluded that Kolom was not subjected to an impermissible second examination in determining his 1972 tax deficiency.

II

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 his employment, enabling that employee to acquire stock of his employer at prices less than the market value of the stock, without resulting 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 market value and the option price at the time of exercise) receives 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, sections 56 and 57 of the Code were enacted. 4 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)(6) 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 element" of the transaction.

The primary issue in this dispute is the method by which this bargain element subject to minimum taxation is to be determined. The parties disagree about the fair market value of the shares at the time Kolom exercised his option. Kolom contends 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 market 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 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 § 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 inconsistent with section 57(a)(6) as applied in this case because 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....

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