Strom v. U.S.

• Decision Date: 06 April 2011
• Docket Number: 09–35197.,Nos. 09–35175,s. 09–35175
• Citation: 641 F.3d 1051
• Parties: Mark G. STROM and Bernee D. Strom, Plaintiffs–Appellees,v.UNITED STATES of America, Defendant–Appellant.Mark G. Strom and Bernee D. Strom, Plaintiffs–Appellants,v.United States of America, Defendant–Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

641 F.3d 1051

107 A.F.T.R.2d 2011-1704

2011-1 USTC P 50,319

11 Cal. Daily Op. Serv. 4132

2011 Daily Journal D.A.R. 4980

Mark G. STROM and Bernee D. Strom, Plaintiffs–Appellees,

v.UNITED STATES of America, Defendant–Appellant.Mark G. Strom and Bernee D. Strom, Plaintiffs–Appellants,

v.United States of America, Defendant–Appellee.

Nos. 09–35175

09–35197.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Aug. 5, 2010.Filed April 6, 2011.

Darrell D. Hallett, Cori Flanders–Palmer, Chicoine & Hallett, P.S., Seattle, WA, for the plaintiffs-appellees/cross-appellants.Kenneth L. Greene, Ellen Page DelSole, John A. DiCicco, Acting Assistant Attorney General, Tax Division, Department of Justice, Washington, D.C., for the defendant-appellant/cross-appellee.Appeal from the United States District Court for the Western District of Washington, Robert S. Lasnik, Chief District Judge, Presiding. D.C. No. 2:06–cv–00802–RSL.Before: WILLIAM C. CANBY, JR., STEPHEN REINHARDT ^* and MARSHA S. BERZON, Circuit Judges.

OPINION

BERZON, Circuit Judge:

Ordinarily, when an employee is compensated with nonstatutory stock options that do not have a readily ascertainable fair market value at the time of the grant, the employee realizes income for tax purposes upon exercising the options.¹ See 26 U.S.C. §§ 83(a) & (e)(3)- (e)(4); 26 C.F.R. § 1.83–7(a). The taxpayer is taxed on an amount equal to the fair market value of the stock on the date of exercise minus the option price paid for the stock. See 26 C.F.R. § 1.83–1(a)(1); id. § 1.83–7(a). Internal Revenue Code § 83(c)(3), however, allows taxpayers to defer recognition and valuation of income so long as a profitable sale of the stock acquired through the exercise of the options “could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934.” 26 U.S.C. § 83(c)(3). Section 16(b), in turn, forbids a corporate insider from profiting on a purchase made within six months of a sale (or a sale made within six months of a purchase) of the corporation's stock. See 15 U.S.C. § 78p(b). If a taxpayer is permitted to defer tax consequences under IRC § 83(c)(3), the taxpayer will be later taxed on an amount equal to the fair market value of the stock on the date that § 83(c)(3) no longer applies minus the option price paid for the stock. See 26 U.S.C. § 83(a); 26 C.F.R. § 1.83–1(a)(1).

In this opinion, we first interpret the phrase “could subject a person to suit under section 16(b)” and determine what that phrase requires a taxpayer to demonstrate before she can postpone tax consequences under § 83(c)(3). We then hold that the taxpayer here has not demonstrated an entitlement to deferral of tax consequences under § 83(c)(3), and after addressing a distinct legal issue pertinent to the ultimate resolution of this case, reverse and remand for further proceedings.

Factual and Procedural History

In November 1998, Bernee D. Strom was hired as the President and Chief Operating Officer (“COO”) of InfoSpace.com, Inc. (“InfoSpace”).² She was appointed to the company's board of directors around the same time she was hired. According to Strom, about a year after joining InfoSpace she announced that she was planning to leave the company because of ethical concerns with the way the company's founder “practiced business.”

To avoid the market disruptions that might result from an abrupt resignation by the company President and COO, Strom agreed to continue working in a different position at InfoSpace for a few more months. She transitioned into the role of President of InfoSpace Venture Capital Fund (“Ventures”), a new venture capital division of InfoSpace that later became a wholly-owned subsidiary. Strom stayed on the board of directors of InfoSpace until April 2000 and remained President of Ventures until June 30, 2000, at which time she voluntarily resigned from Ventures and severed all connection to InfoSpace.

When Strom was hired as President of InfoSpace, she entered into three stock option agreements granting her a conditional right to purchase a total of 750,000 shares of InfoSpace stock at $15 per share. Most of the stock options were not vested at the time of grant. Instead, the option agreements provided that Strom would acquire a right to purchase a fixed number of shares on specified future dates. Two of the agreements, collectively covering 500,000 shares, provided that Strom's right to buy those shares would vest on certain dates so long as she was not terminated for cause or did not voluntarily leave InfoSpace or an InfoSpace affiliate. The third agreement governed the remaining 250,000 shares and provided that, so long as Strom was not terminated for cause or did not voluntarily leave the company, her options to buy those shares would vest at the latest six years after her start date, but sooner if gross revenue and net income performance criteria were met.

Strom exercised options to acquire shares in September and December 1999, and then almost monthly through July 19, 2000. Because the market price of InfoSpace stock rose substantially during 1999 and early 2000, the value of the stock greatly exceeded Strom's $15 option price during that period. In March 2000, the value of InfoSpace stock began rapidly to decline. By January 2001, the market value fluctuated between $55 and $64 per share, down from prices in excess of $1000 per share in early 2000 (though still in excess of Strom's $15 option price).³ At issue here is whether Strom can postpone tax consequences attributable to her option exercises during this period. Because she must report as gross income the difference between the market value of the stock and her $15 option price, her taxes will be significantly lower if she can defer calculation of income until a period after the stock price dropped. See 26 U.S.C. § 83(a); 26 C.F.R. § 1.83–1(a)(1).

During Strom's employment, InfoSpace was involved in mergers with three different companies. We explain the pertinence of those mergers below, but in brief, Strom maintains that she was subject to an InfoSpace policy that restricted her from selling her stock for a few months before and after each merger. InfoSpace created that policy, Strom represents, to comply with pooling-of-interests accounting rules, a method of accounting for business combinations or mergers permitted during the tax years at issue.

Strom reported as gross income for 1999, the year she began exercising options, the difference between the market value of the InfoSpace stock on the dates she exercised her options and the $15 option price. InfoSpace withheld federal income and Medicare taxes from Strom's wages for 1999 with respect to that income. Strom did not, however, report any income on her 2000 income tax returns related to her exercise of InfoSpace options, even though she exercised options that year. InfoSpace did not withhold income tax with respect to Strom's exercise of stock options in 2000, but it did withhold Medicare tax premised on her realizing income by exercising those options.

Strom filed administrative claims with the IRS seeking a refund of the income and Medicare taxes paid in 1999 and the Medicare taxes paid in 2000. When the IRS failed to act on Strom's claims, she brought the instant refund suit in district court seeking to recover approximately $3.7 million.⁴ See 26 U.S.C. § 7422; 28 U.S.C. § 1346.

The district court granted Strom's motion for summary judgment in the main, holding that she was entitled to defer the calculation and recognition of income attributable to her option exercises until December 23, 2000, almost the entire period at issue. The district court also granted summary judgment in favor of the government on a narrow ground, ruling that Strom could not further defer tax consequences through January 2001.

The parties cross-appealed.

Discussion

I

A

As noted above, the ordinary rule is that an employee realizes income for tax purposes upon exercising a compensatory nonstatutory stock option that does not have a readily ascertainable fair market value at the time it is granted.⁵ 26 U.S.C. § 83(a) & (e)(3)- (e)(4); 26 C.F.R. § 1.83–7(a). This rule does not apply, however, until the employee's rights to the stock obtained “are transferable or are not subject to a substantial risk of forfeiture.” 26 U.S.C. § 83(a). In other words, the employee can defer calculation of the gain realized until her rights to the stock are relatively secure.⁶ Id. The taxpayer is then taxed on an amount equal to the “fair market value of such property ... at the first time the rights ... in such property are transferable or are not subject to a substantial risk of forfeiture, which ever occurs earlier, over ... the amount (if any) paid for such property.” See 26 U.S.C. § 83(a)(1)-(2); see also 26 C.F.R. § 1.83–1(a)(1).

Rights in property can be “subject to a substantial risk of forfeiture” for a variety of reasons. For instance, an employee might receive property subject to a condition that it be forfeited if performance targets are not achieved. See generally 26 C.F.R. § 1.83–3(c)–(d) (providing examples). Ordinarily, this determination “depends upon the facts and circumstances” of the case. Id. at § 1.83–3(c). But the Internal Revenue Code enumerates some specific ways property is deemed subject to a substantial risk of forfeiture and not transferable. The provision pertinent to this case, § 83(c)(3), provides:

So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person's rights in such property are—(A) subject to a substantial risk of forfeiture, and (B) not transferable.

26 U.S.C. § 83(c)(3)(A)-(B) (emphasis added). Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) is a prophylactic rule prohibiting corporate insiders from profiting on “short-swing” securities trades—specifically, on a purchase and a sale of their company's securities made...