Wednesday, June 8, 2011
Corporations couldn't rely on employee-tax professional to avoid the accuracy-related penalty
Seven W. Enterprises, Inc. & Subsidiaries and Highland Supply Corporation & Subsidiaries, (2011) 136 TC No. 26
The Tax Court has concluded that corporations that engaged an independent consultant to prepare their returns could rely on his
advice as a tax professional to avoid the accuracy-related penalty under Code Sec. 6662(a) and Code Sec. 6662(b)(2) . However,
when those corporations employed that individual as their vice president to prepare their returns, they no longer had reasonable
cause to avoid the penalty.
Background. Under Code Sec. 6662(a) and Code Sec. 6662(b)(2) , a 20% penalty applies for any substantial underpayment of income
tax. The accuracy-related penalty under Code Sec. 6662(a) doesn't apply, however, to any portion of an underpayment if a taxpayer
shows that there was reasonable cause for it, and that the taxpayer acted in good faith with respect to that portion. ( Code Sec.
6664(c)(1) , Reg. § 1.6664-4(a) ) In determining reasonable cause, pertinent facts and circumstances include the taxpayer's
efforts to assess his proper tax liability, the taxpayer's knowledge and experience and the reliance on the advice of a
professional in determining whether the taxpayer acted with reasonable cause and in good faith. ( Reg. § 1.6664-4(b)(1) )
Facts. William Mues, a certified public accountant, worked as a consultant from February 2001 until March 2002 for Seven W.
Enterprises, Inc. (7W) and Highland Supply Corporation (HSC)—(collectively, the Corporations), two closely held businesses
controlled by the Weder family. 7W and HSC, were each the parent of a group of corporations which filed a consolidated Federal
income tax returns, 7W Group and HSC Group, respectively. Mues, who had previously been employed by the Corporations beginning in
1990 until resigning in January 2001, provided his consulting services from February 2001 until March 2002 as an independent
contractor under an agreement with the Corporations and was not subject to the Corporations' supervision or direction.
During this period, Mues prepared 7W Group's 2000 tax return and HSC Group's 2001 tax return. In March 2002, the Corporations
hired Mues as their vice president of taxes. In this position, Mues prepared and signed, on the Corporations' behalf, 7W Group's
2001, 2002, and 2003 tax returns and HSC Group's 2002, 2003, and 2004 tax returns. In 2000 through 2004, Mues incorrectly
concluded that the Corporations weren't liable for personal holding company taxes and, as a result, understated their tax
liabilities for those years.
IRS issued 7W Group a notice of deficiency relating to 2000 through 2003 and HSC Group a notice of deficiency relating to 2003 and
2004. IRS determined, and the Corporations agreed, that incorrect reporting of personal holding company tax on their returns for
the years in issue resulted in substantial tax understatements. In addition, IRS contended that the Corporations were liable for
In response, the Corporations argued that the accuracy-related penalty was inapplicable. They maintained that they had reasonable
cause for their underpayments and acted in good faith. Alternatively, they contended that they reasonably relied on the advice of
Mues in 2000 when he served as a consultant and in 2001 through 2004 when he served as vice president of taxes.
Court's conclusion. The Tax Court held that under Reg. § 1.6664-4(b)(1) and Reg. § 1.6664-4(c)(1) , 7W Group wasn't liable for an
accuracy-related penalty relating to 2000 because it reasonably relied on Mues to prepare its tax return. Mues signed 7W Group's
2000 return as a paid preparer and the consulting agreement specifically provided that he wasn't subject to 7W Group's
supervision. 7W Group provided Mues, an experienced and knowledgeable tax professional, with all of the relevant information
necessary to prepare the return and relied in good faith on Mues to accurately and correctly prepare its 2000 return.
However, the Tax Court disagreed with the Corporations' contention that they exercised ordinary business care and prudence on
their 2001 through 2004 returns. Further, the Court found that Mues didn't qualify as “a person, other than the taxpayer,” under
Reg. § 1.6664-4(c)(2) , for the returns which he signed on behalf of the Corporations. The Court reasoned that a corporation can
act only through its officers. The Corporations authorized Mues to act as both the vice president of taxes and the taxpayer.
Unlike the 2000 return, which Mues signed as a paid preparer, the 2001 through 2004 returns were signed by Mues on the
Corporations' behalf. Thus, the Corporations didn't have reasonable cause for the 2001 through 2004 underpayments, and they were
liable for accuracy-related penalties for those years.
6662; 6664; 7491.
SEVEN W. ENTERPRISES, INC. and SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent HIGHLAND SUPPLY
CORPORATION and SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Code Sec(s): 6662; 6664; 7491
Docket: Docket Nos. 13594-08, 13595-08.
Date Issued: 06/7/2011
Judge: Opinion by FOLEY
Reference(s): Code Sec. 6662 ; Code Sec. 6664 ; Code Sec. 7491
Official Tax Court Syllabus
From February 2001 until March 2002, M worked as a consultant for P1 and P2 (collectively, Ps). During this period, M prepared
P1's 2000 tax return and P2's 2001 tax return. In March 2002, Ps hired M as their vice president of taxes. As Ps' vice president
of taxes, M prepared and signed, on behalf of Ps, P1's 2001, 2002, and 2003 tax returns and P2's 2002, 2003, and 2004 tax returns.
In 2000 through 2004, Ps incorrectly concluded that they were not liable for personal holding company taxes and, as a result,
understated their tax liabilities relating to those years.
R issued P1 a notice of deficiency relating to 2000 through 2003 and P2 a notice of deficiency relating to 2003 and 2004. In the
notices, R determined that Ps were liable for accuracy-related penalties. Ps contend that they had reasonable cause for their
underpayments and acted in good faith. Alternatively, Ps contend that they reasonably relied on the advice of M in 2000 when M
served as a consultant and in 2001 through 2004 when he served as vice president of taxes. 1. Held: Pursuant to sec. 1.6664-4
(b)(1) and (c)(1), Income Tax Regs., P1 is not liable for an accuracy-related penalty relating to 2000 because it reasonably
relied on M to prepare its tax return. 2. Held, further, M does not qualify as “a person, other than the taxpayer”, pursuant to
sec. 1.6664-4(c)(2), Income Tax Regs., with respect to the returns which he signed on behalf of Ps, and therefore the
aforementioned regulation is not applicable to Ps' underpayments of taxes relating to 2001 through 2004. 3. Held, further, Ps are
liable for accuracy- related penalties relating to 2001 through 2004.
Patrick B. Mathis, William J. Niehoff, and Philip D.
Speicher, for petitioners.
James M. Cascino, David B. Flassing, and William G. Merkle, for respondent.
Opinion by FOLEY
The issue for decision is whether petitioners are liable for section 6662(a) 1 accuracy-related penalties relating to tax years
ending in 2000, 2001, 2002, 2003, and 2004 (years in issue). 2
FINDINGS OF FACT
The Weder family controlled two closely held businesses: Highland Supply Corporation (HSC) and Seven W. Enterprises, Inc. (7W).
HSC was the parent of a group of corporations (collectively, HSC Group), which filed a consolidated Federal income tax return and
manufactured floral, packaging, and industrial wire products. HSC Group included Highland Southern Wire, Inc., and Weder
Investment, Inc. (WI). 3 7W, a corporation principally engaged in leasing nonresidential buildings, was the parent of a group of
entities (collectively, 7W Group), which filed a consolidated Federal income tax return. 7W owned an 89- percent interest in Weder
Agricultural Limited (WAL), a limited partnership.
In 1990, HSC Group and 7W Group (collectively, petitioners) hired William Mues, a certified public accountant, to serve as their
tax manager. Mues had experience relating to personal holding company tax matters and had previously worked at Deloitte Haskins &
Sells, preparing tax returns for individuals, corporations, partnerships, and trusts, and at Peabody Coal Co., preparing
consolidated returns. In 1991, petitioners promoted Mues to vice president of taxes. While employed by petitioners, Mues drafted
documents, performed general legal work, and prepared returns for petitioners and petitioners' shareholders. Petitioners provided
Mues with full access to all resources necessary to handle petitioners' tax matters (i.e., access to corporate and accounting
personnel, corporate records, research databases, and outside professionals). In addition, petitioners authorized Mues to sign, on
their behalf, Internal Revenue Service (IRS) documents.
On December 12, 1995, Southpac Trust International, Inc., as trustee of the Family Trust (STI), an entity unrelated to
petitioners, executed a $4,062,000 interest-bearing promissory note (the promissory note) for the benefit of HSC. In 1996, HSC
assigned the promissory note to WI.
In 1997, the IRS began auditing HSC Group's 1995 return and eventually expanded the audit to include HSC Group's 1996 and 1997
returns. On April 2, 1999, the IRS and HSC Group reached a settlement with respect to the audit relating to HSC Group's 1995,
1996, and 1997 returns. The agreed adjustments were in excess of $2.2 million and included the disallowance of more than $450,000
of deductions relating to HSC's president's personal expenses. These adjustments were set forth on Form CG-4549, Income Tax
Examination Changes, which required HSC Group's signature. Mues signed his name on the line labeled “Signature of Taxpayer”. The
IRS and petitioners also reached settlements relating to HSC Group's and 7W Group's 1998 and 1999 returns. HSC Group had recurring
adjustments relating to research and development expenses.
While an employee of petitioners and prior to 2001, Mues obtained a master's degree in business administration and began law
school as a part-time student. In January 2001, Mues resigned as vice president of taxes and continued his legal studies as a
full-time student. After resigning, Mues, pursuant to an agreement, provided petitioners with consulting services concerning tax
matters and was not subject to petitioners' supervision or direction. As a consultant, Mues prepared 7W Group's 2000 return and
HSC Group's 2001 return. In March 2002, after Mues completed law school, petitioners hired him to serve as their vice president of
taxes. In accordance with his responsibilities, Mues prepared and signed, on behalf of petitioners, 7W Group's 2001, 2002, and
2003 returns and HSC Group's 2002, 2003, and 2004 returns.
With respect to the years in issue, Mues incorrectly characterized petitioners' income and concluded that petitioners were not
liable for personal holding company taxes. The personal holding company tax is a penalty tax on undistributed income and is
designed to discourage individuals from using closely held corporations to defer taxation on dividends, interest, rents, and other
forms of passive income. See secs. 541, 543; Fulman v. United States, 434 U.S. 528, 530-531 [41 AFTR 2d 78-698] (1978); H.
Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 562-563; S. Rept. 558, 73d Cong., 2d Sess. (1934), 1939-1 C.B
(Part 2) 586, 596-598. On HSC Group's 2003 and 2004 returns, Mues incorrectly concluded that interest income, relating to the
promissory note held by WI, was income from a source within HSC Group and that WI was not liable for the personal holding company
tax. As a result, HSC Group, whose consolidated return included WI, understated its 2003 and 2004 tax liabilities. On 7W Group's
2000, 2001, 2002, and 2003 returns, Mues made a similar mistake with respect to interest income received by WAL. During 2000,
2001, 2002, and 2003, WAL received interest income relating to an installment note issued by an entity outside 7W Group, and each
year 7W, in determining its income, took into account a portion of that interest income equal to 7W's distributive share. For
purposes of calculating the personal holding company tax, however, Mues did not take this income into account. In addition, Mues
misapplied the personal holding company tax rules relating to rental income and, in doing so, incorrectly concluded that 7W's
rental income was not subject to the personal holding company tax. As a result, 7W Group understated its 2000 through 2003 tax
On March 7, 2008, respondent issued 7W Group a notice of deficiency relating to 2000, 2001, 2002, and 2003 and HSC Group a notice
of deficiency relating to 2003 and 2004 (collectively, notices). In the notices, respondent determined that petitioners were
liable for section 6662(a) accuracy-related penalties. On June 4, 2008, petitioners, whose principal place of business was
Highland, Illinois, timely filed petitions with the Court seeking redetermination of the penalties set forth in the notices.
Section 6662(a) and (b)(2) imposes a 20-percent penalty on the portion of an underpayment of tax attributable to any
substantial understatement of income tax. The parties agree that petitioners' incorrect reporting of personal holding company tax
on their returns relating to the years in issue resulted in substantial understatements of income tax as defined in section See
sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 6662(d). 446-447 (2001). Section 6664(c)(1), however, provides that no
penalty shall be imposed if a taxpayer demonstrates that there was reasonable cause for the underpayment and that the taxpayer
acted in good faith. See also sec. 7491(c); Higbee v. Commissioner, supra. The determination of whether a taxpayer acted with
reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess his or her
proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor. Sec.
1.6664-4(b)(1), Income Tax Regs. I. 7W Group's 2000 Return With respect to its 2000 return, 7W Group contends that it is entitled
to relief from the accuracy-related penalty because it relied in good faith on the advice of Mues, an independent, competent tax
advisor. Indeed, when he prepared 7W Group's 2000 return, Mues, having resigned from his position as petitioners' vice president
of taxes, was working for petitioners pursuant to a consulting agreement. Respondent emphasizes that Mues continued to perform the
same activities before and after his resignation; requests, in essence, that we ignore the consulting agreement; and urges us to
hold that Mues was not sufficiently independent for petitioners to avail themselves of relief pursuant to section 6664(c).
We reject respondent's contention. Mues resigned, signed a valid consulting agreement, and served as petitioners' independent
contractor. See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 322-325 (1992); Weber v. Commissioner, 103 T.C. 378, 387-390
(1994) (delineating factors to be considered when determining an employment relationship between parties), affd. 60 F.3d 1104
[76 AFTR 2d 95-5782] (4th Cir. 1995). In addition, Mues signed 7W Group's 2000 return as a paid preparer and the consulting
agreement specifically provided that he was not subject to petitioners' supervision. 7W Group provided Mues, an experienced and
knowledgeable tax professional, with all of the relevant information necessary to prepare the return and relied, in good faith, on
Mues to accurately and correctly prepare 7W Group's 2000 return. Therefore, it was reasonable for 7W Group to rely on Mues to
prepare its 2000 return. See sec. 6664(c); Montgomery v. Commissioner, 127 T.C. 43, 67 (2006) (stating that it is reasonable
to rely on an advisor's professional judgment if the taxpayer “selects a competent tax adviser and supplies him or her with all
relevant information” and that “a taxpayer who seeks the advice of an adviser does not have to challenge the adviser's
conclusions, seek a second opinion, or try to check the advice by reviewing the tax code himself or herself.” (citing United
States v. Boyle, 469 U.S. 241, 250-251 [55 AFTR 2d 85-1535] (1985))); , sec. 1.6664-4(b)(1), (c)(1), Income Tax Regs.
Accordingly, 7W Group is not liable for the section 6662(a) accuracy-related penalty relating to 2000.
II. Petitioners' 2001 Through 2004 Returns Petitioners contend that they exercised ordinary business care and prudence relating to
their 2001 through 2004 returns. We disagree. It is unclear whether petitioners' myriad of mistakes was the result of confusion,
inattention to detail, or pure laziness, but we are convinced that petitioners and Mues failed to exercise the requisite due care.
See United States v. Boyle, supra at 250-251; Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2000), affd. 299
F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002).
Petitioners are sophisticated taxpayers. See Campbell v. Commissioner, 134 T.C. 20, 33 (2010); sec. 1.6664-4(b)(1), Income Tax
Regs. Indeed, Mues was a well-educated and experienced tax professional with full access to petitioners' records and personnel.
Petitioners readily acknowledge that Mues was familiar with the personal holding company tax rules, yet emphasize that these rules
are complex and that Mues' mistakes were reasonable. The personal holding company tax rules certainly are complex, but Mues failed
to apply some of the most basic provisions of those rules. In fact, Mues conceded that in applying the section 543(a)(2) test he
“truncated the test” and “misapplied the second prong”. He simply did not read the entire test. Moreover, he did not understand or
do the requisite work to ascertain the basic facts relating to petitioners' income items. For example, the applicability of the
personal holding company tax rules to HSC Group (or any member of the affiliated group) depended in part on the determination of
whether income items were from inside or outside the affiliated group. See sec. 542(b). Mues failed to recognize that STI (i.e.,
the debtor on the note held by WI) was an entity outside the HSC Group. Mues was petitioners' vice president of taxes both when
the note was executed and when it was assigned. Furthermore, Mues testified that he knew at the time he prepared HSC Group's
returns that the note's debtor was outside the group, yet he inexplicably treated the interest income as if it was derived from
within HSC Group and not subject to the personal holding company tax. When asked by the Court whether this was reasonable, Mues
stated: “it seemed reasonable at the time. It seems less reasonable now in hindsight.” Petitioners' repeated audit adjustments
relating to multiple IRS audits coupled with Mues' experience, expertise, and education further bolster our conclusion that
petitioners failed to exercise ordinary business care and prudence as to the See Cobb v. Commissioner, 77 T.C. 1096, 1101-
disputed items. 1102 (1981), affd. without published opinion 680 F.2d 1388 (5th Cir. 1982).
Petitioners further contend that the accuracy-related penalties should not apply because they relied on the advice of Mues—a
competent tax advisor. Again, we disagree. As previously discussed, good-faith reliance on the advice of an independent, competent
tax advisor may constitute reasonable cause and good faith. , Sec. 1.6664-4(b)(1), (c)(1), Income Tax Regs.; see also
Neonatology Associates, P.A. v. Commissioner, supra at 98. The right to rely on professional tax advice, however, is subject to
certain restrictions. See United States v. Boyle, supra at 250-251; , sec. 1.6664-4(b), (c), Income Tax Regs. Pursuant to
section 1.6664-4(c)(2), Income Tax Regs., “advice” is “any communication *** setting forth the analysis or conclusion of a person,
other than the taxpayer”. (Emphasis added.) Petitioners contend that, pursuant to section 7701(a)(1) and (14), the definition
of a “taxpayer” is limited to petitioners (i.e., the persons subject to the tax) and does not include Mues—petitioners' employee.
A corporation can act (e.g., sign the corporation's return) only through its officers. See sec. 6062; DiLeo v. Commissioner,
96 T.C. 858, 875 (1991), affd. 959 F.2d 16 [69 AFTR 2d 92-998] (2d Cir. 1992). Petitioners authorized Mues to act as both the
vice president of taxes and the taxpayer. Indeed, unlike the 2000 return, which Mues signed as a paid preparer, the 2001 through
2004 returns were signed by Mues on petitioners' behalf. Simply put, Mues does not qualify as “a person, other than the taxpayer”
with respect to the returns which he signed on behalf of the taxpayer (i.e., petitioners). Thus, petitioners did not have
reasonable cause for the 2001 through 2004 underpayments. 4 See sec. 1.6664-4(b) and (c), Income Tax Regs. We need not, and do
not, opine as to whether reliance on an in- house professional tax advisor may establish reasonable cause in other circumstances.
Contentions we have not addressed are irrelevant, moot, or meritless.
To reflect the foregoing,
Appropriate decisions will be entered.
Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the
years in issue.
The years in issue are the tax years ending Dec. 31, 2000, 2001, 2002, and 2003 with respect to 7W Group and the tax years
ending Apr. 30, 2003 and 2004 with respect to HSC Group.
WI is wholly owned by Highland Southern Wire, Inc., which is wholly owned by HSC.
We note that petitioners, citing several regulations, contend that respondent's position is contrary to regulations providing
that reasonable cause includes reliance on the advice of “house counsel”. The cited regulations simply are not applicable. Secs.
53.4941(a)-1(b)(6), 53.4945-1(a)(2)(vi), 53.4955-1(b)(7), and 53.4958-1(d)(4)(iii)(A), Foundation Excise Tax Regs., relate to
prohibited transactions and the application of excise taxes. Sec. 1.856-7(c)(2)(iii), Income Tax Regs., relates to the
determination of whether an entity qualifies, pursuant to sec. 856(c), as a real estate investment trust. These regulations are
distinguishable because they explicitly provide that legal counsel includes “house counsel” and that the advice of counsel must be
in a “reasoned written opinion”. Furthermore, while sec. 1.6664-4, Income Tax Regs., provides a standard for determining whether
a taxpayer has acted in good faith, the cited regulations relate to whether a taxpayer has acted willfully.
Nield Montgomery, et ux. v. Commissioner, 127 TC 43, Code Sec(s) 83.
NIELD AND LINDA MONTGOMERY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: [pg. 43] 127 T.C. No. 3
Code Sec(s): 83
Docket: Dkt. No. 633-05.
Date Issued: 08/28/2006 .
Judge: Opinion by Haines, J.
Tax Year(s): Year 2000.
Disposition: Decision for Taxpayers in part and for Commissioner in part.
1. Transfers of restricted property—incentive stock options—substantial risk of forfeiture—Securities Exchange Act. IRS properly
determined that communications corp. founder/ex-pres.'s rights in ISO shares weren't on exercise subject to substantial risk of
forfeiture within meaning of Code Sec. 83(c) : taxpayer's argument that such risk existed because he was insider subject to
liability and potential disgorgement under 1934 SEA §16(b) was flawed. Regardless of taxpayer's dubious insider sta tus, there was
clearly no risk of §16(b) liability because he didn't sell any shares within operative rules' 6-month period, as measured from
last acquisition/grant date. And his attempt to take his transactions outside those rules, re-characterizing them as
“discretionary transactions,” was erroneous since for SEA purposes, discretionary transactions were defined as those going to
fund-switching transactions effected within contributory employee benefit plans, which didn't happen here.
Reference(s): ¶ 835.02(5) Code Sec. 83
2. Incentive stock options—treatment and qualification—holding periods; disqualifying dispositions; computations. IRS properly
determined that aggregate FMV of stock with respect to which communications corp. founder/ex-pres. held ISOs exceeded Code Sec.
422(d) 's $100,000 limitation: taxpayer's objection to IRS's computation, arguing that computation should have included only those
shares not subject to disqualifying disposition, was belied by statute's plain language and statutory scheme, indicating that all
shares are taken into account.
Reference(s): ¶ 4225.01 Code Sec. 422 ; Code Sec. 421
3. Alternative minimum taxable income—computations—transfers of restricted property—incentive stock options—capital losses—
alternative tax net operating losses—carrybacks. IRS properly determined that Code Sec. 1211 and Code Sec. 1212 regular tax
capital loss limitations applied to AMTI calculation and forbid communications corp. founder/ex- pres.'s claim for ISO-related
excess AMT loss: application of loss rules was consistent with earlier case law and established principles, under which regular
tax rules generally apply in AMT context absent explicit exception; and fact that IRS had not included Code Sec. 1211 in Form 6251
instructions for some years was irrelevant. Also, ATNOL wasn't available since ATNOL was defined by reference to allowable Code
Sec. 172 NOL and computed without/excluding excess AMT capital loss.
Reference(s): ¶ 565.01(5) ; ¶ 12,115.01(10) ; ¶ 565.01(10) Code Sec. 55 ; Code Sec. 56 ; Code Sec. 1211 ; Code Sec. 1212 ; Code
4. Accuracy-related substantial understatement penalties—burden of proof and production—reasonable cause—reliance on professional.
Accuracy-related substantial understatement penalties weren't upheld against communications corp. founder/ex-pres. and wife for
year they improperly reported tax consequences of incentive stock options transactions: although IRS satisfied its burden of
production with proof taxpayers had substantial understatement, they showed reasonable cause therefor by their reliance on
accounting firm to which they gave all relevant information necessary to prepare return reflecting what were complex issues that
had not been previously litigated as of their return date.
Reference(s): ¶ 66,625.01(3) ; ¶ 74,915.03(10) Code Sec. 6662 ; Code Sec. 7491
Official Tax Court Syllabus
P-H, president and CEO of MGC Communications, Inc. (MGC), received incentive stock options (ISOs) from MGC between April 1996 and
March 1999. In November 1999, P-H resigned as president and CEO of MGC and entered into an employment contract with MGC which
included provisions accelerating the vesting dates of his ISOs. In early 2000, P-H exercised many of his ISOs. P-H subsequently
sold shares of MGC stock in 2000 and 2001 at prices above and below the exercise prices that he paid for the shares.
Ps filed a joint Federal income tax return for 2000 reporting total tax of $2,831,360, including alternative minimum tax (AMT). Ps
subsequently submitted to R an amended return for 2000 in which they claimed (1) they were not subject to AMT, and (2) [pg. 44]
they overpaid their taxes. R rejected Ps' claimed overpayment and issued to Ps a notice of deficiency for 2000. R determined Ps
failed to report wages, capital gains, and additional alternative minimum taxable income (AMTI) arising from the exercise of P-H's
Held: P-H's rights to the MGC shares he acquired upon the exercise of his ISOs were not subject to a substantial risk of
forfeiture within the meaning of sec. 83, I.R.C., and sec. 16(b) of the Securities Exchange Act of 1934. Held, further: R's
determinations Ps failed to report wages, capital gains, and AMTI arising from the exercise of P-H's ISOs are sustained in that
(1) R properly applied the $100,000 annual limit imposed on ISOs under sec. 422(d), I.R.C., (2) Ps are not entitled to carry
back capital losses to 2000, and (3) Ps are not entitled to carry back alternative tax net operating losses to 2000. Held,
further: Ps are not liable for an accuracy-related penalty for 2000 under sec. 6662(b)(2), I.R.C.
Duncan C. Turner and Brian G. Isaacson, for petitioners.
Kirk M. Paxson, Julie L. Payne, and William C. Schmidt, for respondent.
Respondent determined a deficiency of $417,601 in petitioners' Federal income tax for 2000 and an accuracy-related penalty of
$83,520 under section 6662(b). 1 All references to petitioner in the singular are to petitioner Nield Montgomery.
After concessions, 2 the issues remaining for decision are:
1. Whether petitioner's rights in shares of stock acquired upon the exercise of incentive stock options (ISOs) in 2000 were
subject to a substantial risk of forfeiture within the meaning of section 83(c)(3) and section 16(b) of the Securities
Exchange Act of 1934) 3 (the Exchange Act). We hold petitioner's rights were not subject to a substantial risk of forfeiture.
2. Whether respondent properly determined that petitioner's options exceeded the $100,000 annual limit imposed on ISOs under
section 422(d). We hold respondent correctly applied section 422(d) in this case. [pg. 45]
3. Whether petitioners may carry back capital losses to reduce the amount of their alternative minimum taxable income for 2000. We
hold they may not.
4. Whether petitioners may carry back alternative tax net operating losses to reduce the amount of their alternative minimum
taxable income for 2000. We hold they may not.
5. Whether petitioners are liable for an accuracy-related penalty under section 6662(b)(2) for 2000. We hold petitioners are not
liable for the accuracy-related penalty under section 6662(b).
FINDINGS OF FACT
Some facts have been stipulated and are so found. The parties' stipulations of facts, with attached exhibits, are incorporated
herein by this reference. At the time the petition was filed, petitioners (husband and wife) resided in Las Vegas, Nevada.
A. MGC Communications, Inc.
In 1995, petitioner cofounded NevTEL, Inc., subsequently renamed MGC Communications Inc. (MGC), 4 to engage in the business of
providing local telephone service in Nevada. Petitioner served as MGC's president and chief executive officer from 1995 to
November 1999. During the period in question, MGC's common stock was publicly traded on the NASDAQ market system, and MGC was
subject to the reporting requirements of the Exchange Act.
MGC shares were subject to a 6-for-10 reverse stock split in May 1998 and a 3-for-2 stock split in August 2000. Unless otherwise
indicated, all data (including tables) set forth below reflect these stock splits.
1. MGC Communications, Inc. Stock Option Plan
In 1996, MGC adopted the MGC Communications, Inc. Stock Option Plan (the MGC stock option plan) which provided in pertinent part:
(1) The plan would be administered by a committee of no fewer than two “disinterested persons” (the committee), who would be
appointed by MGC's board of directors (MGC board) from its membership or, in the absence of [pg. 46] such appointments, by the
entire MGC board; (2) the committee would have the sole discretion to (a) select the persons to be granted options, (b) determine
the number of shares subject to each option, (c) determine the duration of the exercise period for any option, (d) determine that
options may only be exercised in installments, and (e) impose other terms and conditions on each option as the committee in its
sole discretion deemed advisable. The MGC stock option plan expressly contemplated that the committee would grant to MGC employees
ISOs within the meaning of sections 421 and 422.
2. Petitioner's Incentive Stock Options
On April 1, 1996, September 4, 1998, and March 1, 1999, petitioner executed a series of share option agreements under which he was
granted ISOs from MGC. Each of the share option agreements stated that if petitioner were considered an “insider” subject to
section 16(b) of the Exchange Act, petitioner “shall be restricted from selling any Option Shares acquired by him through exercise
of the Options or any portion thereof during the six (6) month period following the date of grant of the Option.” Table 1 sets
forth the dates on which petitioner's ISOs were granted and the number of MGC shares petitioner was entitled to purchase under
Grant Grant date Shares
----- ---------- ------
1 4/1/96 540,000
2 9/4/98 22,500
3 9/4/98 45,000
4 3/1/99 15,000
5 3/1/99 22,500
Petitioner's ISOs provided for exercise prices, i.e., the price petitioner would pay for each MGC share, ranging from $0.55 to
$5.33. Petitioner's ISOs originally were scheduled to vest on various dates between 1997 and 2003.
Petitioner was not granted any additional MGC stock options after March 1, 1999. During the period in question, petitioners owned
less than 10 percent of the total combined voting power of all classes of MGC's stock. [pg. 47]
Petitioner unilaterally determined the specific terms and conditions of the ISOs that he received under the share option
agreements. The MGC board did not appoint a committee to administer the MGC stock option plan, and the MGC board did not play any
role in consummating the share option agreements described above.
B. Petitioner's 1999 Employment Agreement With MGC
On November 1, 1999, petitioner entered into a comprehensive agreement with MGC governing his employment status with MGC and his
ISOs (the 1999 employment agreement). Pursuant to the 1999 employment agreement: (1) Petitioner resigned as president, chief
executive officer, and director of MGC, and he resigned as an officer and director of MGC's subsidiaries; (2) petitioner agreed to
assist MGC's new chief executive officer “in order to provide for a smooth transition for the Company”; (3) MGC agreed to make a
lump-sum payment of $360,000 to petitioner; (4) MGC and petitioner agreed to accelerate the vesting dates of petitioner's ISOs;
and (5) petitioner and MGC agreed that petitioner would continue to be employed by MGC through April 1, 2001, for the purpose of
providing advice regarding regulatory developments, testimony at legal, regulatory, and administrative proceedings as necessary,
and other mutually agreed duties.
After November 1, 1999, MGC never requested petitioner to prepare any formal reports for the company, and petitioner did not
prepare any formal reports for MGC.
Table 2 sets forth (1) the fair market value of MGC shares as of the dates petitioner's ISOs were granted, and (2) the total fair
market value of all shares as to which petitioner's ISOs were exercisable for the first time during each of the years 1997 to 2001
(taking into account the ac celerated vesting schedule that MGC and petitioner agreed to on November 1, 1999):
exercisable FMV of MGC shares as of ISO grant date
----------- ------------------------------------------------ Total
Grant 1 Grant 2 Grant 3 Grant 4 Grant 5 FMV
------- ------- ------- ------- ------- --------
1997 $60,000 -- -- -- -- $ 60,000
1998 60,000 -- -- -- -- 60,000
1999 60,000 $96,000 $240,000 $20,298 -- 416,298
2000 60,000 24,000 -- 20,298 $91,350 195,648
2001 60,000 -- -- 20,304 -- 80,304
C. Petitioner's SEC Filings
In February 2000, petitioner filed with the Securities and Exchange Commission (SEC) a Form 5, Annual Statement Of Changes In
Beneficial Ownership of Securities, in which he reported owning 736,500 shares of MGC common stock and options to purchase 430,000
additional shares of MGC common stock. 5 A cover letter accompanying petitioner's Form 5 stated that the report would be
petitioner's last because he was no longer subject to the reporting requirements of section 16(a) of the Exchange Act.
Petitioner did not file any further Forms 5 with the SEC.
During 2000 and 2001, petitioner remained in contact with certain MGC executive officers and was privy to material, non-public
information regarding MGC's operations and financial matters.
D. Petitioner's Acquisitions and Dispositions of MGC Shares
Table 3 sets forth the ISOs that petitioner exercised, identified by grant, exercise date, numbers of MGC shares acquired, total
exercise price, and total fair market value (FMV) of the MGC shares acquired as of each exercise date:
Grant Exercise date Shares acquired Exercise price FMV
----- ------------- --------------- -------------- ---
1 1/11/00 324,000 $179,982 $10,773,000
2 1/11/00 18,000 96,000 598,500
3 1/11/00 45,000 240,000 1,496,250
4 1/11/00 5,000 20,300 166,250
4 3/9/00 5,000 20,300 237,050
5 3/9/00 22,500 91,350 1,066,725
1 3/29/00 108,000 59,994 4,733,640
Petitioner subsequently disposed of a number of the MGC shares he had acquired upon the exercise of his ISOs (as described in
Table 3 above). In particular, on May 4, 2000, petitioner transferred 2,250 shares of MGC stock by way of a gift. In addition,
petitioner sold a number of MGC shares during 2000 and 2001, as set forth in the following table: [pg. 49]
Gain or loss
exercise price and
Grant Sale date Shares sold Sale proceeds sales proceeds)
----- --------- ----------- ------------- ---------------
1 9/29/00 175,000 $1,480,729 $1,383,517
1 12/8/00 50,000 209,991 182,216
1 12/20/00 42,000 140,121 116,790
1 12/20/00 13,000 43,371 36,149
1 12/21/00 41,750 151,486 128,294
2 12/21/00 9,750 35,377 (16,623)
2 12/21/00 8,250 29,934 (14,066)
3 12/21/00 10,250 37,191 (17,475)
3 12/28/00 6,000 28,947 (3,053)
3 12/29/00 19,000 82,196 (93,037)
3 3/13/01 5,000 19,122 (7,544)
3 3/14/01 4,740 18,297 (7,036)
4 3/14/01 250 963 (52)
4 3/15/01 4,750 18,215 (1,070)
4 3/15/01 998 3,827 (225)
4 3/15/01 4,002 15,346 (902)
5 3/14/01 250 963 (52)
5 3/16/01 10,000 39,496 (1,104)
5 3/19/01 5,000 19,278 (1,022)
5 3/20/01 7,500 27,275 (2,160)
Petitioners have never been in the trade or business of trading stocks. Petitioners held their MGC shares for investment purposes
and not as traders or dealers.
MGC never requested that petitioner disgorge any profits from his sales of MGC shares, petitioner was never sued by MGC or one of
its shareholders pursuant to section 16(b) of the Exchange Act, and petitioner never paid over to MGC any part of the proceeds
from his sales of MGC common stock.
E. Petitioners' Tax Return and Amended Return
On or about October 18, 2001, petitioners filed a joint Federal income tax return for the taxable year 2000 reporting total tax of
$2,831,360 (including AMT described below). Petitioners reported total payments of $2,636,723, leaving a balance due of $196,006
(including an estimated tax penalty of $1,369). Petitioners submitted Form 6251, Alternative Minimum Tax—Individuals, with their
tax return for 2000. On Form 6251, line 10, petitioners reported $3,988,180 of alternative minimum tax income (arising from the
exercise of petitioner's ISOs) in excess of regular taxable income, a total of $10,665,935 of alternative minimum taxable income
(AMTI), and AMT of $526,679. Petitioners' tax return was pre-[pg. 50] pared and signed by a tax return preparer employed at
Deloitte & Touche LLP.
Petitioners failed to remit the full amount of tax due with their tax return. Respondent accepted petitioners' tax return as filed
and assessed the tax reported therein, as well as statutory interest and a late-payment penalty.
Respondent issued to petitioners a Final Notice of Intent to Levy and Notice of Your Right to a Hearing with regard to their
unpaid taxes for 2000. Petitioners submitted to respondent an amended return for 2000 and a request for an administrative hearing
under section 6330. In their amended return, petitioners claimed that they overstated the amount of tax due on their original
return, and they claimed they were due a refund of $519,087. Contrary to their original return, petitioners submitted a Form 6251
with their amended return in which they reported $850,534 of alternative minimum taxable income in excess of regular taxable
income, a total of $7,148,666 of AMTI, and zero AMT.
Respondent declined to consider petitioners' refund claim and issued to petitioners a Notice of Determination Concerning
Collections Actions for 2000. Petitioners filed a petition for lien or levy action with the Court at docket No. 16864-02L. Upon
review of the matter, the Court remanded the collection case to respondent's Office of Appeals for consideration of petitioners'
amended return. During the remand, respondent audited petitioners' original and amended returns and issued to petitioners a
Supplemental Notice of Determination under section 6330 and a notice of deficiency under section 6213(a). 6
In the notice of deficiency, respondent determined (1) petitioners failed to report the correct amount of wages and capital gains
arising from the exercise of petitioner's ISOs, (2) petitioners were not entitled to certain itemized deductions, (3) petitioners
were liable for AMT in excess of that reported on their original return, and (4) petitioners were liable for an accuracy- related
penalty. Specifically, respondent determined that petitioners' correct tax liability for 2000 totaled $3,248,961—a sum comprising
regular tax of $2,511,949 and [pg. 51] AMT of $737,012. Petitioners filed a petition for redetermination in this case challenging
the notice of deficiency.
At the conclusion of the trial in this case, the Court directed the parties to file seriatim briefs. After petitioners filed their
opening brief, respondent filed an answering brief and a motion for leave to file amended answer seeking an increased deficiency
and an increased accuracy-related penalty to conform the pleadings to testimony offered by petitioner at trial. Respondent
asserted that petitioner's trial testimony demonstrated that petitioner's options were not ISOs as defined in section 422(b).
Respondent's motion was denied by Order dated May 10, 2006. Under the following analysis, petitioner's options are treated as ISOs
(consistent with respondent's position in the notice of deficiency).
I. Taxation of Stock Options
A. Incentive Stock Options
Generally, under section 421(a), a taxpayer is not required to recognize income upon the grant or exercise of an ISO. 7
Section 422(a) provides that section 421(a) shall apply with respect to the transfer of a share of stock to a taxpayer pursuant
to the exercise of an ISO if (1) no disposition of such share is made by the individual within 2 years from the date of the
granting of the option nor within 1 year after the transfer of the share to the individual, and (2) the taxpayer remains an
employee of the corporation granting the option (or of a parent or subsidiary corporation of such corporation) during the period
beginning on the date the option was granted and ending on the day 3 months before the date the option was exercised. Any gain or
loss on a sale of shares [pg. 52] acquired pursuant to the exercise of an ISO that are held for the periods prescribed in
section 422(a)(1) generally will qualify as a capital gain or loss. Secs. 1001, 1221, 1222.
Section 421(b) provides that if a taxpayer disposes of any shares of stock acquired pursuant to the exercise of an ISO before
the expiration of the holding periods prescribed in section 422(a)(1), the taxpayer shall recognize an increase in income in the
taxable year in which such disqualifying disposition occurs. 8 Section 422(c)(2) provides in pertinent part that if a taxpayer
disposes of any shares of stock acquired pursuant to the exercise of an ISO before the expiration of the holding periods required
in section 422(a)(1), and such disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized
to such individual, the amount includable in the taxpayer's gross income shall not exceed the excess (if any) of the amount
realized on such sale or exchange over the adjusted basis of such shares.
Section 422(d) imposes an annual limit on options that qualify as ISOs. Section 422(d) provides:
SEC. 422(d). $100,000 Per Year Limitation.—
(1) In general.—To the extent that the aggregate fair market value of stock with respect to which incentive stock options
(determined without regard to this subsection) are exercisable for the 1st time by any individual during any calendar year (under
all plans of the individual's employer corporation and its parent and subsidiary corporations) exceeds $100,000, such options
shall be treated as options which are not incentive stock options.
(2) Ordering rule.—Paragraph (1) shall be applied by taking options into account in the order in which they were granted.
(3) Determination of fair market value.—For purposes of paragraph (1), the fair market value of any stock shall be determined as
of the time the option with respect to such stock is granted.
In sum, when the aggregate fair market value of stock that a taxpayer may acquire pursuant to ISOs that are exercisable for the
first time during any taxable year exceeds $100,000, such options shall be treated as nonqualified stock options (NSOs) under
section 83 (as discussed in detail below). [pg. 53]
B. Alternative Minimum Tax
1. In General
The Internal Revenue Code imposes upon taxpayers an AMT in addition to all other taxes imposed by subtitle A. Sec. 55(a).
Although a taxpayer exercising an ISO may defer recognition of income for regular tax purposes, the taxpayer nevertheless may
incur AMT liability. See sec. 56(b)(3). The AMT is imposed upon the taxpayer's AMTI, which is an income base broader than that
applicable for regular tax purposes. Allen v. Commissioner, 118 T.C. 1, 5 (2002); see also H. Conf. Rept. 99-841 (Vol. II), at
II-249, II-264 (1986), 1986-3 C.B. (Vol. 4) 1, 249, 264. AMTI is defined as the taxable income of a taxpayer for the taxable year,
determined with adjustments provided in sections 56 and 58, and increased by the amount of items of tax preference described
in section 57. Sec. 55(b)(2).
For purposes of computing a taxpayer's AMTI, section 56(b)(3) provides that section 421 shall not apply to the transfer of
stock acquired pursuant to the exercise of an ISO as defined by section 422. Therefore, under the AMT, the spread between the
exercise price and the fair market value of the shares of stock on the date an ISO is exercised is treated as an item of
adjustment and is included in the computation of AMTI. See sec. 56(b)(3); sec. 1.83-7(a), Income Tax Regs.; see also Speltz v.
Commissioner, 124 T.C. 165, 178-179 (2005), affd. 454 F.3d 782 [98 AFTR 2d 2006-5364] (8th Cir. 2006). Insofar as section
56(b)(3) provides that section 421 shall not apply to the exercise of an ISO, section 83 is applicable to the exercise of an
ISO inasmuch as the exclusion for ISOs set forth in section 83(e)(1) is negated. 9
2. Section 83
Section 83(a) provides in pertinent part that if property is transferred to a taxpayer in connection with the performance of
services (i.e., stock transferred to a taxpayer upon the exercise of a stock option), the excess of the fair market value of the
stock (measured as of the first time the taxpayer's [pg. 54] rights in the stock are not subject to a substantial risk of
forfeiture) over the amount, if any, paid for the stock (the exercise price) shall be included in the taxpayer's gross income in
the first taxable year in which the taxpayer's rights in the stock are not subject to a substantial risk of forfeiture. See Tanner
v. Commissioner, 117 T.C. 237, 242 (2001), affd. 65 Fed. Appx. 508 [91 AFTR 2d 2003-1842] (5th Cir. 2003); sec. 1.83-7(a),
Income Tax Regs. As mentioned above, the combined application of various provisions of sections 55, 56, and 83, requires
that, upon the exercise of an ISO, such income be included in the computation of AMTI.
Section 83(c) contains special rules related to recognition of income under section 83(a). Section 83(c)(3) provides that a
taxpayer's rights in property (stock) are subject to a substantial risk of forfeiture and are not transferable so long as the sale
of the stock at a profit could subject the taxpayer to suit under section 16(b) of the Exchange Act.
3. AMT Impact on Basis
As a result of the unique treatment of the exercise of ISOs under the AMT regime, a taxpayer normally will have two different
bases in the same shares of stock. The taxpayer's regular tax basis is the exercise price or cost basis. See sec. 1012. However,
for AMT purposes, section 56(b)(3) provides that the adjusted basis of any stock acquired by the exercise of an ISO “shall be
determined on the basis of the treatment prescribed by this paragraph.” In other words, a taxpayer's adjusted AMT basis equals the
exercise or cost basis in the shares increased by the amount of income included in AMTI. See secs. 55(b)(2), 56(b)(3), 83(a).
The following example illustrates the general operation of the ISO basis rules. Assume a taxpayer is granted an ISO giving him the
right to purchase 100 shares of ABC, Inc., common stock at $1 per share. The taxpayer exercises the ISO at a time when ABC, Inc.
common stock is trading at $10 per share and the taxpayer's rights in such shares are freely transferrable. Under this example,
the taxpayer's basis for regular tax purposes is $100—the total exercise price or cost incurred by the taxpayer to purchase the
100 shares of stock. On the other hand, the taxpayer's adjusted basis solely for AMT purposes is $1,000—an amount that comprises
the tax-[pg. 55] payer's $100 cost basis plus the $900 bargain purchase element of the transaction that is included in the
computation of the taxpayer's AMT liability.
The anomaly in the ISO basis rules may create inequitable results when a taxpayer has incurred AMT liability upon the exercise of
an ISO in one taxable year, only to have the shares of stock decrease in value the following year. In this situation, the AMT
imposed on the bargain purchase element of the ISO results in a payment of tax on income the taxpayer may never actually receive.
II. The Parties' Positions
A. Respondent's Determinations
Respondent determined that the aggregate fair market value of the stock with respect to which petitioner held ISOs that were first
exercisable in 1999 and 2000 exceeded the $100,000 limitation imposed under section 422(d). In connection with this
determination, respondent asserts that the aggregate value of stock that a taxpayer may acquire pursuant to ISOs during a taxable
year is computed for purposes of the $100,000 limitation of section 422(d) without taking into account any disqualifying
dispositions; i.e., transfers or sales of stock prior to the expiration of the holding periods required under section 422(a)(1).
Taking into account the effects of section 422(d) and petitioner's disqualifying dispositions of MGC shares, respondent
determined that petitioners failed to report gross income (wages and capital gains) subject to regular tax, and they failed to
compute properly their AMT for 2000.
B. Petitioners' Contentions
Petitioners first contend they were not obliged to recognize any income related to the shares of stock petitioner acquired upon
the exercise of his ISOs during the taxable year 2000 because petitioner's rights in the MGC shares in question were subject to a
substantial risk of forfeiture during 2000. Specifically, petitioner maintains he was a statutory insider of MGC throughout 2000,
and he could have been sued by MGC or another MGC shareholder under section 16(b) of the Exchange Act and forced to disgorge the
profits he realized when he sold his MGC shares. See sec. 83(c)(3). [pg. 56]
In the alternative, petitioners assert they incurred capital losses or alternative tax net operating losses (ATNOLs) in years
subsequent to the taxable year 2000, and such losses may be carried back to reduce their AMTI for 2000. Petitioners contend that
for AMT purposes (1) capital losses are not subject to the $3,000 limitation imposed under section 1211, and (2) imposing a
$3,000 limitation on the amount of capital losses petitioners may report would defeat Congress's intent to tax only the economic
gain received by a taxpayer.
III. Whether Petitioner's Rights in his MGC Shares Were Subject to a Substantial Risk of Forfeiture Within the Meaning of
Section 16(a) of the Exchange Act requires the principal stock holders of any class of equity security registered under
section 12 of the Exchange Act, and the directors and officers of the issuer of such securities (hereinafter insiders), to file
periodic statements with the SEC disclosing the amount of equity securities such insider owns, and purchases and sales made by
such insider, during the reporting period. Section 16(b) of the Exchange Act provides in pertinent part:
(b) For the purpose of preventing the unfair use of information 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) or a security- based swap agreement (as defined
in section 206B of the Gramm-Leach- Bliley Act) involving any such equity security within any period of less than six months,
unless such security or security- based swap agreement 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 or security-based swap agreement purchased or of not
repurchasing the security or security-based swap agreement sold for a period exceeding six months.
The remainder of section 16(b) provides that an issuer or any shareholder of the issuer may bring suit against an insider to
recover any profit realized by the insider on any purchase and sale, or any sale and purchase, of any equity security of such
issuer within any period of less than 6 months.
Section 16(b), the so-called short-swing profit recovery provision, is a prophylactic and strict liability measure [pg. 57]
“under which an insider's short-swing profits can be recovered regardless of whether the insider actually was in possession of
material, non-public information.” Ownership Reports and Trading By Officers, Directors and Principal Security Holders (Ownership
Reports), Exchange Act Release No. 34-28869, 56 Fed. Reg. 7242, 7243 (Feb. 21, 1991); see Levy v. Sterling Holding Co., LLC, 314
F.3d 106, 109-111 (3d Cir. 2002); Magma Power Co. v. Dow Chem. Co., 136 F.3d 316, 320 (2d Cir. 1998). Section 16(b) applies to
transactions involving derivative securities such as stock options. At Home Corp. v. Cox Commcns. Inc., 446 F.3d 403 (2d Cir.
2006); Magma Power Co. v. Dow Chem. Co., supra at 321; SEC rule 16a-1(c) and (d), 17 C.F.R. sec. 240.16a-1(c) and (d) (2006).
The elements of a claim under section 16(b) of the Exchange Act are “(1) a purchase and (2) a sale of securities (3) by an
officer or director of the issuer or by a shareholder who owns more than ten percent of any one class of the issuer's securities
(4) within a six-month period.” Gwozdzinsky v. Zell/Chilmark Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998).
The parties disagree whether petitioner was an insider subject to liability under section 16(b) of the Exchange Act during 2000.
Respondent points out that, after petitioner's resignation as an officer and director of MGC in 1999, petitioner no longer filed
Form 4, Statement of Changes in Beneficial Ownership, or Form 5, Statement of Changes in Beneficial Ownership of Securities, with
the SEC, he was not a 10-percent shareholder, and he apparently no longer considered himself an insider subject to the reporting
requirements of section 16(a) of the Exchange Act. Re spondent also points out that no lawsuit was ever filed against petitioner
seeking disgorgement of the profits he realized when he sold MGC shares during 2000 and 2001. Petitioner counters that he remained
an insider at MGC during 2000 and 2001 as an adviser to MGC's executives. Although we are doubtful petitioner was an insider
subject to liability under section 16(b) of the Exchange Act during 2000, we need not decide the point. Assuming arguendo that
petitioner was an insider within the meaning of section 16(b) of the Exchange Act, we conclude that petitioner was not subject
to a substantial risk of forfeiture during the taxable year 2000 because he exercised his ISOs and acquired shares of MGC stock at
a point in [pg. 58] time outside of the 6-month period which would give rise to a lawsuit under section 16(b) of the Exchange
It is well settled that it is the acquisition (grant) of a stock option (as opposed to the exercise of a stock option) that is
deemed to be a purchase of a security for purposes of the 6-month short-swing profit recovery provision under section 16(b) of
the Exchange Act. 10 See Magma Power Co. v. Dow Chem. Co., supra at 321-322. The SEC made this point indelibly clear when it
adopted the regulatory framework governing insider transactions involving derivative securities in 1991. The SEC stated in
The functional equivalence of derivative securities and their underlying equity securities for section 16 purposes requires that
the acquisition of the derivative security be deemed the significant event, not the exercise. *** The Rules correspondingly
recognize that, for purposes of the abuses addressed by section 16, the exercise of a derivative security, much like the
conversion of a convertible security, essentially changes the form of beneficial ownership from indirect to direct. Since the
exercise represents neither the acquisition nor the disposition of a right affording the opportunity to profit, it should not be
an event that is matched against another transaction in the equity securities for purposes of section 16(b) short-swing profit
recovery. [Emphases added; fn. ref. omitted.]
Ownership Reports, supra, 56 Fed. Reg. at 7248-7249. The SEC went on to state that “to avoid short-swing profit recovery, a grant
of an employee stock option by an issuer, absent an exemption, must occur at least six months before or after a sale of the equity
security or any derivative security relating to the equity security.” Id., 56 Fed. Reg. at 7251 n.120; see sec. 16(b) of the
Exchange Act (last sentence authorizes the SEC to adopt rules and regulations exempting transactions as not comprehended within
the purpose of the provision).
In Tanner v. Commissioner, 117 T.C. 237, 239 (2001), affd. 65 Fed. Appx. 508 (5th Cir. 2003), this Court held that the 6-month
period under which an insider is subject to liability [pg. 59] under section 16(b) of the Exchange Act begins on the date that a
stock option is granted. In Tanner v. Commissioner, supra, the taxpayer, an officer, director, and owner of approximately 65
percent of an issuer's stock, was granted an NSO in July 1993 to purchase up to 182,000 of the issuer's shares at an exercise
price of 75 cents per share. The taxpayer exercised the NSO in September 1994, and the Commissioner determined the taxpayer was
obliged to report compensation income on his return for 1994 pursuant to section 83. The taxpayer challenged the Commissioner's
determination and asserted he was not obliged to report compensation income in 1994 because he had signed a lockup agreement which
purportedly extended for 2 years the period under which he would he would remain liable under section 16(b) of the Exchange Act.
We rejected the taxpayer's arguments and held (1) the 6-month period under section 16(b) of the Exchange Act began to run in
July 1993 when the taxpayer was granted the NSO in question, (2) the 6- month period was not extended by the 2-year lockup
agreement, and (3) the 6-month period expired long before the taxpayer exercised the NSO in September 1994. Id. at 244-246.
Petitioner contends the Court's holding in Tanner v. Commissioner, supra, is not controlling in this case. Petitioner testified at
trial that the MGC stock option plan was not administered by the MGC Board nor by a committee as contemplated under the plan, and
he unilaterally granted the ISOs in question to himself. Consistent with these points, petitioner maintains (1) he obtained his
ISOs pursuant to a “discretionary transaction” within the meaning of SEC rule 16b-3(b)(1), 17 C.F.R. sec. 240.16b-3(b)(1)
(2006); (2) his ISOs were not exempt from the application of section 16(b) of the Exchange Act; and (3) because he failed to
report to the SEC that he exercised the ISOs, and subsequently sold some of the shares so acquired, he remained liable under
section 16(b) of the Exchange Act until approximately June 2003.
Petitioner's reliance on the discretionary transaction provisions contained in SEC rule 16b-3 is misplaced. A discretionary
transaction is defined in SEC rule 16b-3(b)(1) as a transaction pursuant to an employee benefit plan that (1) is at the volition
of a plan participant; (2) is not made in connection with the participant's death, disability, retirement, or termination of
employment; (3) is not required to be [pg. 60] made available to a plan participant pursuant to the Internal Revenue Code; and (4)
results in either an intraplan transfer involving an issuer equity securities fund, or a cash distribution funded by a volitional
disposition of an issuer equity security. SEC rule 16b-3(f) provides that a discretionary transaction shall be exempt from
section 16(b) of the Exchange Act only if an election effecting an acquisition (or disposition) is made at least 6 months
following the date of the most recent disposition (or acquisition), as the case may be.
A review of the SEC's release adopting SEC rule 16b-3 reveals the exemption for discretionary transactions was targeted at
opportunities for abuse arising from so- called fund-switching transactions effected within contributory employee benefit plans.
In particular, the SEC stated in pertinent part:
Many contributory employee benefit plans permit a participant to choose one of several funds in which to invest (e.g., an issuer
stock fund, a bond fund, or a money market fund). Plan participants typically are given the opportunity to engage in 'fund-
switching' transactions, permitting the transfer of assets from one fund to another, at periodic intervals. Plan participants also
commonly have the right to withdraw their investments in cash from a fund containing equity securities of the issuer. Fund-
switching transactions involving an issuer equity securities fund and cash distributions from these funds may present
opportunities for abuse because the investment decision is similar to that involved in a market transaction. Moreover, the plan
may buy and sell issuer equity securities in the market in order to effect these transactions, so that the real party on the other
side of the transaction is not the issuer but instead a market participant. [Fn. ref. omitted.]
Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 34-37260, 61 Fed.
Reg. 30376, 30379 (June 14, 1996).
Although petitioner exercised discretion in granting ISOs to himself, in exercising the ISOs, and in disposing of the underlying
shares, petitioner's activities were not undertaken under the auspices of an employee benefit plan as contemplated under SEC rule
16b-3, nor did his activities result in an intrafund transfer or a cash distribution from a plan. Accordingly, we conclude the
discretionary transaction provisions are not relevant to the question whether petitioner was subject to a suit under section 16
(b) of the Exchange Act during 2000. [pg. 61]
The period during which petitioner was subject to liability under section 16(b) of the Exchange Act is directly addressed in SEC
rule 16b-3(d)(3) and SEC rule 16(b)-6(a) and (b), 17 C.F.R. sec. 240.16b-6(a) and (b) (2006), which apply specifically to
derivative securities. Read together, these regulations provide that (1) the establishment of a call equivalent posi tion (grant
of a stock option) shall be deemed a purchase of the underlying security for purposes of section 16(b) of the Exchange Act, (2)
the acquisition of underlying securities at a fixed price upon the exercise of a call equivalent position shall be exempt from the
operation of section 16(b) of the Exchange Act, and (3) if 6 months elapse between the acquisition of a derivative security and
the disposition of the derivative security or its underlying equity security, the transaction is exempt from the operation of
section 16(b) of the Exchange Act. Inasmuch as petitioner did not sell any MGC shares within 6 months of March 1999—the last date
MGC granted petitioner an ISO—we conclude petitioner qualified for the exemption set forth in SEC rule 16b-3(d)(3). Consequently,
we hold petitioner was not subject to a suit under section 16(b) of the Exchange Act during 2000.
We would reach the same conclusion even if some technical impediment precluded petitioner's ISOs from qualifying for exemption
under SEC rule 16b. That rule merely provides exemptions or a “safe-harbor” from the applicability of section 16(b) of the
Exchange Act—it does not impose affirmative liability. As previously discussed, because petitioner's ISOs were granted between
April 1996 and March 1999, the 6-month period during which petitioner would have been subject to suit under section 16(b) of the
Exchange Act expired in September 1999, several months before petitioner exercised his ISOs in 2000. Petitioner simply has not
persuaded us that his liability under section 16(b) of the Exchange Act extended beyond September 1999. Because petitioner was
not subject to a suit under section 16(b) of the Exchange Act during 2000, we conclude petitioner's rights in his MGC shares
were not subject to a substantial risk of forfeiture within the meaning of section 83(c). 11[pg. 62]
IV. Whether Respondent Correctly Applied the $100,000 Annual Limit on ISOs Imposed Under Section 422(d)
Section 422(d) provides stock options will be subject to taxation as NSOs under section 83 if the aggregate fair market value
of stock a taxpayer may acquire pursuant to ISOs that are exercisable for the first time during any taxable year exceeds $100,000.
Section 421(b) provides that if the transfer of a share of stock to a taxpayer pursuant to the exercise of an option would
otherwise meet the requirements of section 422(a), except there is a failure to meet a holding period requirement, any increase
in the income of the taxpayer or deduction from income of his employer corporation shall be recognized in the taxable year in
which such disposition occurs.
The fair market value of the MGC shares petitioner was entitled to purchase under his ISOs, measured as of the dates petitioner's
ISOs were granted and which were first exercisable in 1999 and 2000, exceeded $100,000. The parties also agree that during 2000
and 2001, petitioner engaged in disqualifying dispositions of MGC shares that he acquired upon exercising his ISOs.
Respondent determined that the value of the MGC shares petitioner could acquire pursuant to his ISOs exceeded the $100,000 limit
imposed under section 422(d) by $316,298 and $95,648 for 1999 and 2000, respectively. 12 Petitioners contend, without citation to
any authority or any meaningful discussion, that respondent erroneously applied section 422(d). As we understand petitioners'
position, they assert the $100,000 limitation is only applied to shares that are not subject to a subsequent disqualifying
disposition during the same taxable year in which the shares were acquired. We disagree.
Section 422(b), summarized supra note 7, sets forth the definition of the term “in centive stock option”. Section 422(b) [pg.
63] does not impose a holding period requirement on shares of stock acquired pursuant to the exercise of an ISO, nor does it
cross-reference section 422(a)(1) or otherwise exclude shares which are later subject to disqualifying dispositions. Equally
important, although section 422(a) provides the general rule that section 421(a) shall apply with respect to the transfer of a
share of stock to an individual pursuant to an exercise of an ISO if, among other requirements, certain holding periods are
satisfied under section 422(a)(1), section 422(a) does not state that a violation of the holding period requirement will cause
the option to fail to qualify as an ISO. Along the same lines, although section 421(b) describes the tax effects if a taxpayer
receives shares of stock pursuant to the exercise of an option which would meet the requirements of section 422(a), except for a
failure to meet any of the holding period requirements of section 422(a)(1), section 421(b) does not state that the option is
not to be considered an ISO. In contrast, section 422(d) unambiguously states that options exceeding the $100,000 limitation
“shall be treated as options which are not incentive stock options.”
In the absence of any language in the controlling statutory provisions suggesting a disqualifying disposition of stock will cause
the related option to be treated as something other than an ISO, we reject petitioners' argument on this point. We sustain
respondent's interpretation and application of the $100,000 limit imposed under section 422(d) in this case.
V. Whether Petitioners May Reduce Their AMTI in 2000 by AMT Capital Losses Realized in 2001
Capital Losses Under Regular Tax and Alternative Minimum Tax
Sales of securities generally are subject to the capital gain and loss provisions. Section 165(f) provides that capital losses
are permitted only to the extent allowed in sections 1211 and 1212.
Under section 1212(b), a noncorporate taxpayer is required to offset capital losses against capital gains for a particular
taxable year. If aggregate capital losses exceed aggregate capital gains for a taxable year, up to $3,000 of the excess may be
deducted against ordinary income. 13 Sec. 1212(b). A noncorporate taxpayer may carry forward unrecognized cap-[pg. 64] ital
losses to subsequent taxable years, but it does not allow such unrecognized capital losses to be carried back to prior taxable
years. Sec. 1212(b). The Internal Revenue Code does not explicitly address the treatment of capital losses for AMT purposes. See
secs. 55-59 (and accompanying regulations).
Petitioners are not securities dealers, and they held their MGC shares strictly as investors. There is no dispute the MGC shares
in question are capital assets under section 1221. The record also shows petitioner sold MGC shares in 2001 and that he realized
capital losses as a result. 14 However, the capital loss limitations of sections 1211(b) and 1212(b) restricted petitioners'
ability to deduct these regular capital losses. 15
Petitioners also realized AMT capital losses in 2001 taking into account petitioner's adjusted AMT basis in his MGC shares.
Petitioners contend that they may carry back these AMT capital losses to reduce their AMTI in 2000. Petitioners argue the capital
loss limitations of sections 1211 and 1212 do not apply to bar the carryback of AMT capital losses for purposes of calculating
AMTI. We disagree.
In Merlo v. Commissioner, 126 T.C. 205, 211-212 (2006), on appeal to the U.S. Court of Appeals for the Fifth Circuit, the Court
recently rejected the argument that the capital loss limitations of sections 1211 and 1212 do not apply for purposes of
calculating a taxpayer's AMTI. In so holding, we cited section 1.55-1(a), Income Tax Regs., which states in pertinent part that,
except as otherwise provided: “[A]ll Internal Revenue Code provisions that apply in determining the regular taxable income of a
taxpayer also apply in determining the alternative minimum taxable income of the taxpayer.” In the absence of any statute,
regulation, or other published guidance which purports to change the treatment of capital losses for AMT purposes, we held the
capital loss limitations of sections 1211 and 1212 apply in calculating a taxpayer's AMTI. Id. at 212.
Like the taxpayer in Merlo v. Commissioner, supra, petitioners argue the instructions to lines 9 and 10 of Form 6251 for 2000 do
not mention section 1211, and, therefore, [pg. 65] section 1211 does not apply for purposes of calculating petitioners' AMTI.
Petitioners' reliance on these instructions is misplaced. It is settled law that taxpayers cannot rely on Internal Revenue Service
instructions to justify a reporting position otherwise inconsistent with controlling statutory provisions. Johnson v.
Commissioner, 620 F.2d 153, 155 [45 AFTR 2d 80-1149] (7th Cir. 1980), affg. T.C. Memo. [sic, 1978] 978-426; Graham v.
Commissioner, T.C. Memo. 1995-114 [1995 RIA TC Memo ¶95,114]; Jones v. Commissioner, T.C. Memo. 1993-358 [1993 RIA TC Memo
Consistent with Merlo v. Commissioner, supra, we conclude petitioners may not carry back their AMT capital losses to reduce their
AMTI in 2000. See Spitz v. Commissioner, T.C. Memo. 2006-168 [TC Memo 2006-168].
VI. Whether Petitioners May Carry Back Net Operating Losses and Alternative Tax Net Operating Losses To Reduce Their AMTI for 2000
In a further attempt to carry back their AMT capital losses, petitioners assert their AMT capital losses entitle them to an ATNOL
deduction under section 56. This, too, is an argument the Court rejected in Merlo v. Commissioner, supra.
A taxpayer normally may carry back a net operating loss (NOL) to the 2 taxable years preceding the loss, then forward to each of
the 20 taxable years following the loss. 16 Sec. 172(b)(1)(A). Section 172(c) defines an NOL as “the excess of the deductions
allowed by this chapter over the gross income”, as modified under section 172(d). In the case of a noncorporate taxpayer, the
amount deductible on account of capital losses shall not exceed the amount includable on account of capital gains. Sec. 172(d)
(2)(A); sec. 1.172-3(a)(2), Income Tax Regs. Consequently, the effect of section 172(d)(2)(A) is that net capital losses are
excluded from the NOL computation. See, e.g., Parekh v. Commissioner, T.C. Memo. 1998-151 [1998 RIA TC Memo ¶98,151]. In Merlo
v. Commissioner, supra, we stated in pertinent part:
For AMT purposes, section 56(a)(4) provides that an ATNOL deduction shall be allowed in lieu of an NOL deduction under section
172. An ATNOL deduction is defined as the NOL deduction allowable under section 172 and is computed by taking into consideration
all the adjustments to [pg. 66] taxable income under sections 56 and 58 and all the preference items under section 57 (but
only to the extent that the preference items increased the NOL for the year for regular tax purposes). Sec. 56(d)(1).
Petitioner's net regular capital loss is excluded from computing his NOL deduction. See sec. 172(c), (d)(2)(A); sec. 1.172-3
(a)(2), Income Tax Regs. For AMT purposes, petitioner's ATNOL is the same as his NOL, taking into consideration all the
adjustments to his taxable income under sections 56, 57, and 58. See , sec. 56(a)(4), (d)(1). No adjustments under those
sections modify the exclusion of net capital losses from the NOL computation under section 172(d)(2)(A). Therefore, petitioner's
AMT capital loss is excluded for purposes of calculating his ATNOL deduction. As a result, petitioner's AMT capital loss realized
in 2001 does not create an ATNOL that can be carried back to 2000 under sections 56 and 172(b).
Merlo v. Commissioner, supra at 212-213 (fn. ref. omitted).
Consistent with Merlo v. Commissioner, supra, we hold petitioners may not claim an ATNOL carryback to reduce their AMTI for 2000.
See Spitz v. Commissioner, supra.
VII. Whether Petitioners Are Liable for a Substantial Understatement Penalty Under Section 6662(b)(2)
Respondent determined petitioners are liable for a substantial understatement penalty under section 6662(b)(2). 17 Petitioners
assert (1) respondent's determination is invalid because respondent did not consider “standardized exception criteria” before
imposing the penalty, and (2) the penalty is inapplicable because petitioners acted in good faith and reasonably relied upon tax
professionals to prepare their tax return for 2000.
While the Commissioner bears the initial burden of production as to the accuracy-related penalty and must come forward with
sufficient evidence showing it is appropriate to impose the penalty, the taxpayer bears the burden of proof as to any exception to
the accuracy-related penalty. See sec. 7491(c); Rule 142(a); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). One such
exception to the accuracy-related penalty applies to any portion of an underpayment if the taxpayer can prove there was reasonable
cause for the taxpayer's position and the taxpayer acted in good faith with respect to that portion. Sec. 6664(c)(1); sec.
1.6664-4(b), Income Tax Regs. The determination of whether a taxpayer [pg. 67] acted with reasonable cause and in good faith
depends on the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability, the
knowledge and experience of the taxpayer, and the reliance on the advice of a professional. Sec. 1.6664-4(b)(1), Income Tax
Regs. When a taxpayer selects a competent tax adviser and supplies him or her with all relevant information, it is consistent with
ordinary business care and prudence to rely upon the adviser's professional judgment as to the taxpayer's tax obligations. United
States v. Boyle, 469 U.S. 241, 250-251 [55 AFTR 2d 85-1535] (1985). Moreover, a taxpayer who seeks the advice of an adviser does
not have to challenge the adviser's conclusions, seek a second opinion, or try to check the advice by reviewing the tax code
himself or herself. Id.
Petitioners received professional assistance in preparing their 2000 tax return. The return was prepared and signed by a
representative of Deloitte & Touche, and we are satisfied from a review of the return petitioners supplied the return preparer
with all relevant information. We likewise conclude petitioners relied on their return preparer to accurately and properly prepare
their return for 2000. We find nothing in the record to indicate it was unreasonable for petitioners to accept the advice of their
return preparer. Our holding sustaining respondent's determinations on the substantive issues in dispute does not, in and of
itself, require holding for respondent on the penalty. See Hitchins v. Commissioner, 103 T.C. 711, 719-720 (1994) (“Indeed, we
have specifically refused to impose *** [a penalty] where it appeared that the issue was one not previously considered by the
Court and the statutory language was not entirely clear.”). Considering that the complex issues underlying the deficiency in this
case had yet to be litigated at the time petitioners filed their return for 2000, we are persuaded petitioners had reasonable
cause and acted in good faith in reporting their stock option transactions. See, e.g., Williams v. Commissioner, 123 T.C. 144
(2004) (declining to impose a penalty involving an issue of first impression and the interrelationship between complex tax and
bankruptcy laws). Consequently, we hold petitioners are not liable for an accuracy- related penalty under section 6662(b)(2) for
2000. [pg. 68]
To reflect the foregoing,
Decision will be entered pursuant to Rule 155.
Unless otherwise indicated, section references are to the Internal Revenue Code, as amended, and Rule references are to the Tax
Court Rules of Practice and Procedure.
The parties filed a stipulation of settled issues in which they agreed to the amounts of deductions petitioners are entitled to
claim for charitable contributions made during 2000.
The Securities Exchange Act of 1934, ch. 404, sec. 16(b), 48 Stat. 896, codified at 15 U.S.C. sec. 78p(b) (2000). For
convenience, all citations are to sections of the Securities Exchange Act of 1934.
Although MGC Communications, Inc., was subsequently renamed Mpower Communications, Inc., we shall refer to the corporation as
Adjusted for MGC's August 2000 stock split, petitioner held options to purchase 645,000 shares of MGC common stock. See supra
Petitioners' collection review case at docket No. 16864-02L was stayed pending the disposition of the instant case.
Sec. 422(b) defines an incentive stock option (ISO) in pertinent part as an option granted to a taxpayer by an employer
corporation (or a parent or subsidiary corporation) to purchase stock of any such corporation but only if (1) the option is
granted pursuant to a plan which is approved by the stockholders of the granting corporation, (2) such option is granted within
the earlier of 10 years from the date such plan is adopted or approved by the stockholders, (3) such option is not exercisable
after 10 years from the date such option is granted, (4) the option price is not less than the fair market value of the stock at
the time such option is granted, (5) such option is not transferrable by the taxpayer other than by will or the laws of descent
and distribution and is exercisable during the taxpayer's lifetime only by the taxpayer, and (6) such taxpayer, at the time the
option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock
of the employer corporation or of its parent or subsidiary corporation.
Sec. 424(c) provides that the term “disposition” as related to shares of stock acquired pursuant to the exercise of an ISO
generally means “a sale, exchange, gift, or a transfer of legal title”.
Sec. 56(b)(3) further provides, however, that sec. 422(c)(2) shall apply “in any case where the disposition and the
inclusion for *** this part are within the same taxable year and such section shall not apply in any other case.”
For the sake of completeness, we observe the exercise of a stock option is treated as a purchase of the underlying security for
purposes of the insider reporting provisions under section 16(a) of the Exchange Act. SEC rule 16a-1(b), 17 C.F.R. sec.
240.16a-1(b) (2006) defines a “call equivalent position” as “a derivative security position that increases in value as the value
of the underlying equity increases, including, but not limited to, a long convertible security, a long call option, and a short
put option position.” SEC rule 16a-4(b), 17 C.F.R. sec. 240.16a-4(b) (2006), provides that the exercise of a call equivalent
position shall be reported on Form 4 and treated for reporting purposes as (1) a purchase of the underlying security and (2) a
closing of the derivative security position.
Petitioner contends sec. 1.83-3(j)(1), Income Tax Regs., is invalid insofar as the regulation fails to acknowledge that the
period during which an insider may remain subject to suit under sec. 16(b) of the Exchange Act may extend beyond the normal 6-
month period specified in that provision. Because we have rejected petitioner's argument that the period he was subject to a suit
under sec. 16(b) of the Exchange Act extended beyond the 6-month period beginning with the dates his ISOs were granted, we need
not address petitioner's challenge to the validity of sec. 1.83-3(j)(1), Income Tax Regs.
Respondent determined the following shares were not eligible to be treated as having been transferred to petitioner pursuant to
ISOs: (1) 10,499 of the 22,500 shares that were the subject of option grant No. 2 dated Sept. 4, 1998; (2) all of the 45,000
shares that were the subject of option grant No. 3 dated Sept. 4, 1998; (3) 6,057 of the 15,000 shares that were the subject of
option grant No. 4 dated Mar. 1, 1999; and (4) all of the 22,500 shares that were the subject of option grant No. 5 dated Mar. 1,
For married individuals filing separately, $3,000 is reduced to $1,500. Sec. 1211(b)(1). If the excess of capital losses over
capital gains is less than $3,000 (or $1,500), then only that excess may be deducted. Sec. 1211(b)(2).
To avoid confusion between petitioner's capital losses, we shall refer to his capital losses for regular tax purposes as his
“regular capital losses”, and we shall refer to his capital loss for AMT purposes as his “AMT capital loss”.
The effect of the capital loss limitations of secs. 1211(b) and 1212(b) for regular tax purposes is not in issue and thus,
is not discussed in detail.
In the case of NOLs incurred in 2001 or 2002, sec. 172(b)(1)(H) creates a 5-year carryback. Petitioners argue they are
entitled to relief from the 5-year carryback. However, because we conclude infra that petitioners are not entitled to an ATNOL,
petitioners' argument is moot.
There is a substantial understatement of tax if the amount of the understatement exceeds the greater of either 10 percent of the
tax required to be shown on the return, or $5,000. , Sec. 6662(a), (b)(1) and (2), (d)(1)(A); sec. 1.6662-4(a) and (b)(1),
Income Tax Regs. This threshold is satisfied in the instant case.