Kolom v. Comm'r of Internal Revenue

Decision Date21 November 1978
Docket NumberDocket No. 5699-76.
Citation71 T.C. 235
PartiesAARON L. KOLOM and SERITA KOLOM, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Held, for purposes of the minimum tax provisions of secs. 56 and 57(a)(6), I.R.C. 1954, the fair market value of relatively small amounts of stock acquired through the exercise of qualified stock options by a taxpayer subject to the insider trading provisions of sec. 16(b), Securities Exchange Act of 1934, is the mean price at which the stock was sold on the New York Stock Exchange on the date of exercise of the stock options. Held, further, the minimum tax provisions of secs. 56 and 57(a)(6) as applied to the facts of this case are not unconstitutional. Held, further, the determination of the deficiency in this case did not result from a second examination of petitioners' books and records within the meaning of sec. 7605. Held, further, this Court lacks jurisdiction to award attorney's fees to petitioners. S. Zachary Samuels, for the petitioners.

Kenneth G. Gordon, 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 deficiency 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 deficiency 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 qualified stock options;

(2) Whether the minimum tax provisions of sections 56 and 57(a)(6), I.R.C. 1954,1 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 (4) Whether respondent should be required to pay petitioners' 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 petitioner) was an officer and director of Tool Research & Engineering Corp. (hereinafter Tool Research), a corporation 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 l.

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 cumulative. 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, 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 options 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:2

+---------------------------------------------------------+
                ¦          ¦           ¦Mean price   ¦Option     ¦Total   ¦
                +----------+-----------+-------------+-----------+--------¦
                ¦Date of   ¦Number     ¦per share    ¦price      ¦option  ¦
                +----------+-----------+-------------+-----------+--------¦
                ¦exercise  ¦of shares  ¦on N.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 have been subject to the provisions of section 16(b), Securities Exchange Act of 1934, 15 U.S.C. sec. 78p(b).3

On September 15, 1972, when petitioner exercised the first of his options, the closing market price of Tool Research stock on the New York Stock Exchange was 51 1/8; upon the expiration of 6 months, the stock closed at 23 5/8. On October 5, 1972, when petitioner exercised his remaining options, Tool Research stock closed at 44;6 months later the stock closed at 20 3/8. 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:

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, 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.

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 meeting 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, Revenue 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 “substantial error” and a “serious administrative omission resulting in criticism, undesirable precedent or inconsistent treatment.” The reopening memorandum was approved by Mr. Beal's group supervisor, the chief of the field audit branch, the acting technical division, and the acting district director. The approval 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 dates 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)4 as applicable to the year 1972 imposed a tax of 10 percent of the...

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