Justice Department Argues Denial of Costs was Proper

In 1982 the stockholders and option holders of IMED Corp., including Albert Henry, sold their stock and options to Warner- Lambert Co. On his 1982 return, Albert reported the option proceeds as long-term capital gain. The IRS determined that the option proceeds were not entitled to treatment as long-term capital gain and issued a deficiency determination, indicating that Henry owed over $2 million in taxes. In 1991, Henry filed a Tax Court petition, challenging the deficiency as well as the assessment of negligence and substantial understatement penalties. After the petition was filed, the case was suspended while the issue of the correct classification of the option proceeds was litigated in a separate action involving three other former option holders of IMED. Following the court's decision in that case, the parties stipulated that Henry's liability on the underlying tax would be governed by that decision. As a result, the trial in this case involved only the two penalties.

Trial on the penalty issues was held in February 1996, with the Tax Court finding that Henry was not liable for the substantial understatement penalty but that he was liable for the negligence penalty. The Ninth Circuit subsequently reversed the Tax Court's finding on the negligence penalty in 1999. After the appeals court remanded to the Tax Court, Henry moved for litigation costs, including attorney's fees. On March 28, 2000, the Tax Court issued an order awarding costs on the substantial understatement penalty but denying costs on the negligence penalty.

The Justice Department argues that the Tax Court correctly determined that the position of the government with respect to the penalty asserted against Henry under section 6653(a) was substantially justified and thus properly denied Henry litigation costs under section 7430.

[1] On his 1982 federal income tax return, taxpayer Albert Henry took the erroneous position that proceeds received from his sale of options to purchase stock in his former employer (IMED Corporation) constituted long-term capital gain (rather than ordinary income). In a prior appeal, this Court held that taxpayer was not liable for an addition to tax that was asserted against him by the Commissioner of Internal Revenue under former Section 6653(a) of the Internal Revenue Code (I.R.C.) for taking that erroneous position. The issue in this case is whether the Tax Court properly exercised its discretion in concluding that taxpayer is not entitled to litigation costs under Section 7430 of the Code for his successful defense of the addition to tax.

STATEMENT OF JURISDICTION

[2] On November 22, 1991, taxpayer filed a petition in the United States Tax Court contesting the Commissioner of Internal Revenue's determination of a deficiency of $2,099,534 in federal income tax for the 1982 taxable year. (CR 1.) ¹ The petition also contested the Commissioner's determination that taxpayer was liable for additions to tax of $104,976.70 under former I.R.C. section 6653(a) and $524,883.50 under former I.R.C. section 6661. (Ibid.) The Tax Court had jurisdiction over the petitions pursuant to I.R.C. sections 6213(a), 6214 and 7442.

[3] On January 16, 1997, the Tax Court (Hon. Joel Gerber) entered a decision determining that taxpayer was liable for the asserted deficiency and the addition to tax under Section 6653(a). (CR 31.) The Tax Court, however, determined that taxpayer was not liable for the addition to tax under Section 6661. (Ibid.)

[4] Taxpayer appealed the Tax Court's decision on the Section 6653(a) addition to tax to this Court, which concluded that he was not liable for that addition to tax. Henry v. Commissioner, 170 F.3d 1217 (9th Cir. 1999). After this Court issued its opinion, taxpayer filed a motion in the Tax Court seeking an award of litigation costs under I.R.C. section 7430(a) for his successful defense of the additions to tax that had been asserted against him under Sections 6653(a) and 6661. (CR 44.) The Tax Court determined that taxpayer was entitled to an award of litigation costs with respect to the addition to tax asserted under Section 6661, but was not entitled to such costs with respect to the addition to tax asserted under Section 6653(a). (CR 52.) After the Tax Court entered an order and decision reflecting this determination (CR 56), taxpayer filed a timely notice of appeal to this Court (CR 57). See I.R.C. section 7483. This Court has jurisdiction over the appeal under I.R.C. section 7482.

STATEMENT OF THE CASE

[5] Taxpayer filed a motion in the Tax Court seeking an award of litigation costs under I.R.C. section 7430(a) for the expenses he incurred in successfully defending himself against the imposition of an addition to tax under former I.R.C. section 6653(a). (CR 43.) After the Tax Court entered an order and decision that did not allow taxpayer the costs he sought (CR 56), taxpayer filed a notice of appeal to this Court (CR57).

STATEMENT OF FACTS

[6] Taxpayer is the former vice-president of finance and chief financial officer of IMED Corporation (IMED). (CR 35 at 5.) Between 1972 and 1982, IMED was a company engaged in the design, manufacture and sale of electronic medical instruments. (Id. at 4.) In August 1982, Warner-Lambert Corporation (Warner-Lambert) acquired IMED. (Id. at 13.) As part of the transaction, Warner-Lambert also purchased stock options owned by certain individuals associated with IMED. (CR 25 at 7.)

[7] IMED instituted the stock option plan during the 1970s to enable its employees to participate in the company's growth and prosperity. (CR 35 at 6.) The plan was managed by Richard Cramer, Kevin Monaghan, and Dan Hendrickson. (Ibid.) Cramer (who founded IMED in 1972) was the company's president, chief executive officer and chairman of the board of directors. (CR 35 at 4.) See Cramer v. Commissioner, 64 F.3d 1406, 1408 (9th Cir. 1995). Monaghan was assistant secretary of the board of directors and served as IMED's outside general counsel. (CR 35 at 4.) Hendrickson (who was responsible for the accounting department and had overall corporate tax responsibility) became treasurer of IMED in February 1978 after previously serving as the company's controller. (Id. at 4-5; Tr. 222.) Cramer, Monaghan and Hendrickson all participated in the IMED option program. (Cramer v. Commissioner, 64 F.3d at 1408; Tr. 233.)

[8] Taxpayer joined IMED in March 1978. (CR 35 at 5.) Initially, taxpayer raised equity for the company and instituted financial controls. (Ibid.) Subsequently, taxpayer assumed responsibility for determining IMED's capital needs, preparing cash- flow forecasts, and raising cash as necessary. (Ibid.) As IMED's chief financial officer, taxpayer was Hendrickson's direct supervisor. (Tr. 110.)

[9] Taxpayer received his first stock options in August 1979. (Jt. Ex. 7-K.) The stock option plan provided taxpayer with the right to purchase 29,250 shares of IMED stock at the price of $13.00 per share in 20% increments over a five-year period. (Jt. Ex. 7-K at 1.) The right to purchase the stock, however, was contingent upon taxpayer's continued employment by IMED on the date the option was exercised. (Ibid.) The stock option plan also precluded taxpayer from assigning the option to any person not approved as a "qualified offeree" by IMED's Board of Directors. (Jt. Ex. 7-K at 2.) The 1979 options were not traded on any registered exchange. (CR 25 at 5.)

[10] Pursuant to the stock option plan, taxpayer acquired 4,000 shares of IMED stock in March 1980 at a price of $13 per share (or $52,000) total). (CR 27 at 9.) Taxpayer sold these shares in October 1980, receiving a total of $190,000. (Ibid.)

[11] On June 1, 1981, IMED (and its affiliated corporation, IMED International Corporation) issued an option to purchase 325,000 paired shares of their stock to a Swiss trust for the benefit of taxpayer and other individuals associated with IMED. (Jt. Ex. 13-Q.) The agreement authorized the trust to purchase 50,000 shares of stock for the benefit of taxpayer at a strike price of $100 per paired share. (Id. at 3.) The option would vest and be exercisable in 3 annual increments, beginning July 31, 1983, and annually thereafter for 2 years, subject to a special provision accelerating the vesting schedule. (Jt. Ex. 14-R at 1-2.) The vesting provisions were intended to ensure that taxpayer (and the other beneficiaries) would remain officers, directors or consultants of IMED or IMED International for a specified period. (Jt. Ex. 15-S at 2.) The options could only be transferred to a beneficiary of the trust. (Jt. Ex. 14-R at 2.) Like the 1979 options, these options were not traded on any registered exchange. (CR 25 at 6.)

[12] In the latter part of 1981, the officers and directors of IMED entered into negotiations with the management of Warner-Lambert that culminated in Warner-Lambert's acquisition of IMED in August 1982. (Id. at 7.) In that transaction, Warner-Lambert purchased all of IMED's outstanding stock, and acquired all outstanding stock options (whether vested or nonvested). (Id.) Taxpayer sold the remaining shares covered by the 1979 option (25,250 shares) for a total consideration of $3,807,953, and the shares covered by the 1981 option for a total consideration of $3,190,500. (Id.)

[13] The tax treatment to be accorded the IMED stock options was a matter of considerable interest to the option holders. In general, the tax treatment of a transfer of property in connection with the performance of services is governed by Section 83 of the Internal Revenue Code. Section 83 requires the person who performs the services to include in his or her gross income the excess of the fair market value of the property over the amount, if any, paid therefor in the first taxable year in which the property is either transferable or not subject to a substantial risk of forfeiture. I.R.C. section 83(a)(1). For the purpose of calculating the amount to be included in the recipient's income, the fair market value of the transferred property is to be determined as of the time the property becomes transferable or is no longer subject to a substantial risk of forfeiture. I.R.C. section 83(a)(1). Thus, any appreciation in the value of the property that occurs between the time of the transfer and the time the value of the property becomes includable in income under I.R.C. section 83(a) will be treated as compensation income. For the purpose of calculating the amount to be included in income, the fair market value of the property is to be "determined without regard to any restriction other than a restriction which by its terms will never lapse." I.R.C. section 83(a)(1).

[14] Rather than waiting to be taxed until the property becomes transferable or no longer subject to a substantial risk of forfeiture, the recipient of the restricted property may elect to include in his or her gross income for the year in which the property is transferred the excess of the fair market value of the property at that time (again determined without regard to any restriction other than a restriction which by its terms will never lapse) over the amount, if any, paid for the property. I.R.C. section 83(b). If such an election, is made, I.R.C. section 83(a) will not apply with respect to the transfer. Ibid. A Section 83(b) election thus has the effect of preventing any appreciation in the value of the property that occurs between the year of the transfer and the time the property otherwise would become includable in income under I.R.C. section 83(a) from being treated as compensation income. ² Instead, that appreciation is taxable as capital gain. See Cramer v. Commissioner, 64 F.3d at 1411.

[15] The foregoing rules do not necessarily apply where, as in this case, the property that is transferred in connection with the performance of services consists of an option. Section 83(e)(3) provides that the statute does not apply to "the transfer of an option without a readily ascertainable fair market value." In the event the option lacks a readily ascertainable fair market value, the owner of the option recognizes compensation income when the option is exercised or otherwise disposed of in an arm's length transaction. Treas. Reg. section 1.83-7(a). ³ Under Treas. Reg. section 1.83- 7(b)(2), an option (like the IMED options) that is not actively traded on an established market does not have a readily ascertainable fair market value unless the taxpayer can demonstrate that several conditions exist. In Cramer v. Commissioner, 64 F.3d at 1412, this Court held that the IMED options did not satisfy those conditions.

[16] Dan Hendrickson became aware by 1978 that characterizing proceeds from the sale of IMED options as long-term capital gain contravened Treas. Reg. section 1.83-7 (Tr. 243-244), and he communicated that fact to several other owners of IMED options long before the Warner-Lambert transaction (Tr. 247). Cramer and Monaghan, however, elected to take that position on their 1982 returns in the belief that the definition of "readily ascertainable fair market value" in Treas Reg. section 1.83-7(b)(2) was invalid. (Ibid.) In an effort to buttress their tax position, the IMED officials who negotiated the sale of the company -- a group that included taxpayer -- persuaded Warner-Lambert not to claim a deduction for the purchase price of the options. (Tr. 320.)

[17] Taxpayer, like Cramer and Monaghan, reported the proceeds received from the sale of his options to Warner-Lambert as long-term capital gain on his 1982 federal income tax return. During the course of an ensuing IRS audit of the return, the IRS revenue agent assigned to the case contacted taxpayer's accountant (Robert Douglas) and requested (CR 49 at 3 paragraph 12; Ex. Rec. at 139 paragraph 13):

various documents, including correspondence from IMED notifying

[18] The Commissioner of Internal Revenue eventually determined that the amount received by taxpayer from the sale of his IMED options was properly characterized as ordinary income and not long- term capital gain, and, accordingly, asserted a deficiency in tax of $2,099,534 against him. (Jt. Ex. 2-E.) The Commissioner also determined that taxpayer was liable for an addition to tax of $104,976 under former I.R.C. section 6653(a) for intentional disregard of rules and regulations, and an addition to tax of $524,883.50 under former I.R.C. section 6661 for substantial understatement of tax. (Ibid.)

[19] The IRS agent assigned to taxpayer's case explained his position on the Section 6653(a) addition to tax as follows (CR 49, Ex. B at 6-7; Ex. Rec. at 162-163):

In a letter of October 28, 1981 from Arthur Young & Company to

[20] While taxpayer's case was pending in the Tax Court, the Tax Court issued an opinion in a case involving several of taxpayer's colleagues at IMED who had also claimed long-term capital gain treatment from the sale of options to Warner-Lambert. Cramer v. Commissioner, 101 T.C. 225 (1993). In that opinion, the court concluded that Treas. Reg. section 1.83-7(b)(2) provided a reasonable interpretation of the statute. 101 T.C. at 237-250. The court also upheld additions to tax imposed against Cramer, Monaghan, and another individual associated with IMED, Warren Boynton, under former I.R.C. section 6653(a) for their intentional disregard of Treas. Reg. section 1.83-7. 101 T.C. at 250-254. This Court subsequently affirmed the Tax Court's decision in all respects. Cramer v. Commissioner, 64 F.3d 1406 (9th Cir. 1995).

[21] During the course of the Tax Court proceedings in taxpayer's case, taxpayer's attorney sent a letter to the IRS asserting that taxpayer should not be subject to the addition to tax under Section 6653(a). The letter stated that taxpayer, unlike the petitioners in the Cramer case (CR 49, Ex. G at 2, Ex. Rec. at 236):

was not part of and, in fact, was intentionally excluded from,

Absent further documentary or testimonial evidence

[23] The Tax Court, after conducting a trial on the issue, issued a memorandum opinion upholding imposition of the Section 6653(a) addition to tax against taxpayer. (CR 35.) The court noted that taxpayer had "failed to ask pertinent questions or even make a cursory investigation beyond the information provided to [him] concerning the IMED stock options" (id. at 23), and had not provided Douglas "with sufficient information to render a fully informed opinion concerning the relevant facts and law" (id. at 22). The court also rejected taxpayer's argument that he should be treated differently from the taxpayers in Cramer v. Commissioner (id. at 26- 27):

There were numerous opportunities for [taxpayer] to

[24] On appeal, this Court reversed the Tax Court's decision, concluding that "the Tax Court's determination is based on pure speculation and conjecture that is not supported by the record." Henry v. Commissioner, 170 F.3d 1217, 1221 (9th Cir. 1999). The Court found that "[t]here is absolutely no evidence in the record that Hendrickson or Douglas told Henry of any risk or of the regulation that was contrary to their position." Id. at 1222. The Court concluded that "[t]he Tax Court's opinion fails to provide more than speculative inferences that [taxpayer] was aware of Treas. Reg. section 1.83-7 and negligently disregarded it." Id. at 1223.

[25] After this Court issued its opinion, taxpayer filed a motion in the Tax Court seeking an award of litigation costs under I.R.C. section 7430 for the expenses he incurred in successfully defending against the additions to tax asserted by the Commissioner under Sections 6653(a) and 6661. (CR 44.) Section 7430 provides for an award of litigation costs to a "prevailing party" against the Government in tax litigation in certain circumstances. In order to be a "prevailing party," a litigant must establish, inter alia, that the position of the United States in the proceeding was not "substantially justified." I.R.C. section 7430(c)(4)(A).

[26] The Tax Court issued an order concluding that taxpayer was not entitled to an award of litigation costs with respect to the Section 6653(a) addition to tax, but was entitled to such costs with respect to the addition to tax asserted under Section 6661. (CR 52.) The court held that the position of the United States with respect to the Section 6653(a) addition to tax was "substantially justified" (id. at 4):

First, we must decide whether respondent was reasonable in

SUMMARY OF ARGUMENT

[27] On his 1982 federal income tax return, taxpayer contravened Treas. Reg. section 1.83-7 by taking the erroneous position that proceeds he had received from the sale of stock options in IMED constituted long-term capital gain rather than ordinary income. The IRS issued a notice of deficiency to taxpayer determining a deficiency in his federal income tax for 1982. The IRS also determined that taxpayer was liable for an addition to tax under former I.R.C. section 6653(a), which provides for an addition to tax in cases involving negligence or intentional disregard of rules and regulations.

[28] Taxpayer filed a Tax Court petition contesting both the deficiency determination and the addition to tax, but eventually conceded the deficiency. The Tax Court determined that taxpayer was liable for the addition to tax, but this Court reversed that determination on appeal. Taxpayer then filed a motion seeking an award of litigation costs under I.R.C. section 7430 for the expenses he incurred in successfully defending against the addition to tax. The Tax Court concluded that the IRS's position on the Section 6653(a) issue was "substantially justified," and, accordingly, denied the motion. The Tax Court's decision is correct and should be affirmed.

[29] The Government's position is "substantially justified" for purposes of Section 7430 if it is "justified to a degree that could satisfy a reasonable person" or has a "reasonable basis both in law and fact." Norgaard v. Commissioner, 939 F.2d 874, 881 (9th Cir. 1991). In the instant case, the IRS acted reasonably by requiring taxpayer to prove to a court that he was not liable for the addition to tax asserted under Section 6653(a). The underlying issue involved taxpayer's credibility. But his unsubstantiated claim that he did not know of, or have reason to know of, the existence of Treas. Reg. section 1.83-7 at the time he filed his 1982 tax return, and relied entirely on his accountant in reporting the proceeds from the sale of his IMED options as long-term capital gain, was suspect on its face. Taxpayer was the chief financial officer of a closely held corporation where the few other officers knew of the regulation and made deliberate decisions to disregard the regulation on their 1982 tax returns. Taxpayer also was involved in all of the important business decisions affecting IMED, and directly supervised the corporation's treasurer (Dan Hendrickson) who knew by 1978 that characterizing proceeds from the sale of IMED options as long-term capital gain contravened the regulation.

[30] Moreover, taxpayer's claim to have relied on his accountant was undermined by his failure to produce any evidence in support of that claim, even though the IRS specifically asked him for any such information. It was not unreasonable for the IRS to conclude that in a case where the underlying tax issue was open to question, and involved several millions of dollars in taxes, taxpayer would have received some sort of written opinion from his accountant if he had truly been relying on the accountant to formulate his reporting position. The fact that taxpayer never received such an opinion, combined with the fact that the other officials in IMED made deliberate decisions to disregard Treas. Reg. section 1.83-7 on their 1982 returns, suggests that taxpayer did not rely on his accountant in taking a position contrary to the regulation, but rather was acting in concert with his colleagues. In these circumstances, the Tax Court properly exercised its discretion in concluding that the IRS was not obligated to take taxpayer's unsubstantiated claim at face value.

[31] The decision of the Tax Court should be affirmed.

ARGUMENT

THE TAX COURT CORRECTLY HELD THAT TAXPAYER IS NOT ENTITLED TO

A. INTRODUCTION

[33] Section 7430 of the Internal Revenue Code (26 U.S.C.), Addendum, infra, authorizes a court to award reasonable litigation costs (including attorneys' fees) against the United States in certain circumstances. In order to qualify for an award of fees under Section 7430, a party must establish, inter alia, that he or she was a "prevailing party." section 7430(a). A "prevailing party" is a party which, inter alia, establishes that the position of the United States in the proceeding was not "substantially justified." section 7430(c)(4)(A). ⁶ The "position of the United States" is (i) the position taken by the United States in a judicial proceeding, and (ii) the position taken in an administrative proceeding as of the earlier of the date the taxpayer receives a notice of the decision of the Internal Revenue Service Office of Appeals, or the date of the notice of deficiency. section 7430(c)(7). The Government's position is "substantially justified" if it is "justified to a degree that could satisfy a reasonable person" or has a "reasonable basis both in law and fact." Norgaard v. Commissioner, 939 F.2d 874, 881 (9th Cir. 1991); see Pierce v. Underwood, 487 U.S. 552, 565 (1988).

[34] The issue in this case is whether the Commissioner was "substantially justified" in asserting an addition to tax against taxpayer under former I.R.C. section 6653(a). Section 6653(a) provides for imposition of an addition to tax if any part of an underpayment of tax is due to negligence or intentional disregard of rules and regulations. The Commissioner asserted the addition to tax because taxpayer's 1982 federal income tax return took the (erroneous) position that proceeds received from the sale of options to purchase stock in IMED constituted long-term capital gain, rather than ordinary income, and that position contravened Treas. Reg. section 1.83-7.

[35] In Cramer v. Commissioner, 101 T.C. 225, 250-254 (1993), the Tax Court determined that three principals of IMED, Richard Cramer, Warren Boynton, and Kevin Monaghan, were liable for the addition to tax imposed by Section 6653(a) because they intentionally disregarded the regulation in treating proceeds received from the sale of options in the corporation as long-term capital gain. The Tax Court found that Cramer and Monaghan were unequivocally put on notice that their reporting position was subject to challenge by the IRS prior to filing their 1982 tax returns, and rejected Boynton's claim that he was unaware of the risk associated with his reporting position. This Court affirmed the Tax Court's decision. Cramer v. Commissioner, 64 F.3d 1406 (9th Cir. 1995).

[36] In Henry v. Commissioner, 73 T.C.M. (CCH) 1769 (1997) (CR 35), the Tax Court upheld imposition of an addition to tax against taxpayer under Section 6653(a), after concluding that his "plea of ignorance does not ring true" (CR 35 at 26). On appeal, this Court concluded that the Tax Court's decision was not supported by the record. Henry v. Commissioner, 170 F.3d 1217 (9th Cir. 1999). After the Court issued its opinion, taxpayer filed a motion in the Tax Court seeking an award of litigation costs for his successful defense of the addition to tax. The Tax Court denied the motion on the ground that the position of the United States with respect to the Section 6653(a) addition to tax was "substantially justified."

B. THE TAX COURT CORRECTLY HELD THAT THE POSITION OF THE UNITED

[38] Moreover, taxpayer's claim to have relied on his accountant was undermined by his failure to produce any evidence in support of that claim, even though the IRS specifically asked him for any such information. It was not unreasonable for the IRS to conclude that in a case where the underlying tax issue was open to question, and involved several millions of dollars in taxes, taxpayer would have received some sort of written opinion from his accountant if he had truly been relying on the accountant to formulate his reporting position. The fact that taxpayer never received such an opinion, combined with the fact that the other officials in IMED made deliberate decisions to disregard Treas. Reg. section 1.83-7 on their 1982 returns, suggests that taxpayer did not rely on his accountant in taking a position contrary to the regulation, but rather was acting in concert with his colleagues. In these circumstances, the Tax Court properly exercised its discretion in concluding that the IRS was not obligated to take taxpayer's unsubstantiated claim at face value.

[39] 2. Taxpayer unjustifiably accuses the IRS of failing to conduct an adequate investigation of his individual culpability. (Br. 14.) Taxpayer ignores the fact that the IRS, on at least two occasions, requested that he provide any information that would tend to support his claim, and that taxpayer failed to provide any such evidence. During the course of the IRS's audit of taxpayer's return, the revenue agent requested (CR 49 at 3 paragraph 12; Ex. Rec. at 139 paragraph 13):

various documents, including correspondence from IMED notifying

Absent further documentary or testimonial evidence

[42] 3. Taxpayer's reliance (Br. 12) on Heasley v. Commissioner, 967 F.2d 116 (5th Cir. 1992), is misplaced. In Heasley, the taxpayers conceded an underlying deficiency determination resulting from an investment in a tax shelter, but successfully contested the imposition of additions to tax (including an addition to tax asserted under former I.R.C. section 6653(a)). The taxpayers then sought litigation costs under Section 7430 for the expenses they incurred in defending against the additions to tax. The court of appeals held that the taxpayers were entitled to litigation costs with respect to the Section 6653(a) addition to tax (967 F.2d at 121):

The Heasleys demonstrated that they are moderate income

[44] 4. Taxpayer's reliance (Br. 17) on United States v. Sam Ellis Stores, Inc., 768 F. Supp. 286 (S.D. Cal. 1991), aff'd, 981 F.2d 1260 (9th Cir. 1992), is similarly misplaced. In that case, the court concluded that an award of litigation costs under Section 7430 of the Code was appropriate because the IRS had conducted an "abbreviated audit" of the taxpayer's 1993 tax return, and had voluntarily dismissed its case prior to trial. Id. at 289. By contrast, the IRS here audited taxpayer's return for several years before issuing a notice of deficiency, requested all relevant information from him before asserting an addition to tax, and prevailed on the addition to tax after a trial in the Tax Court.

[45] 5. Taxpayer contends (Br. 18) that if the IRS "had adequately investigated the matter before imposing penalties, it would have discovered that Mr. Douglas alone made the decision as to how to classify the option proceeds on Mr. Henry's 1982 tax return." But the fact that taxpayer's accountant may have made the ultimate decision as to the tax classification of the option proceeds says nothing about whether taxpayer knew of, or had reason to know of, the existence of Treas. Reg. section 1.83-7 before filing his 1982 return. Douglas could not have provided any information on that point. Indeed, Douglas's testimony at the Tax Court trial could be read as indicating that he believed that taxpayer knew that there was a problem with his position (Tr. 283):

Q And was it your testimony that Petitioners' position was

First, we must decide whether respondent was reasonable in

[47] 7. Taxpayer's brief repeatedly refers to this Court's characterization of the Tax Court's findings with respect to the Section 6653(a) addition to tax as "guilt by association." But that characterization did not obligate the Tax Court to award taxpayer the litigation costs he seeks in this case. The Court's "guilt by association" characterization reflected its determination that the record did not support imposition of an addition to tax against taxpayer. The issue in this case is different -- to wit, whether taxpayer's status within IMED, combined with the absence of any evidence supporting his claim, provided the IRS with a sufficient basis for asserting the addition to tax under Section 6653(a). The fact that this Court ultimately disagreed with the Tax Court and concluded that taxpayer should not be liable for that amount does not mean that the IRS acted unreasonably by requiring taxpayer to prove his uncorroborated claim in court. See Norgaard v. Commissioner, 939 F.2d at 881-882 (reversing Tax Court's imposition of an addition to tax for negligence but denying the taxpayers' request for litigation costs on the ground that the Commissioner's position was substantially justified).

CONCLUSION

[48] For the reasons stated above, the decision of the Tax Court should be affirmed.

Respectfully submitted,

[49] This case was previously before this Court, which ruled that taxpayer was not liable for the addition to tax asserted against him under Section 6653(a) of the Code. Henry v. Commissioner, 170 F.3d 1217 (9th Cir. 1999). Counsel for the appellee are not aware of any other related cases that are pending in the Court or any other court.

CERTIFICATE OF SERVICE

[50] It is hereby certified that service of this brief has been made on counsel for the appellant on this 30th day of July, 2001, by mailing two copies thereof to each of them, in an envelope, properly addressed as follows:

Charles F. Gibbs, Esquire

² Taxpayer filed a Section 83(b) election for the option acquired in 1979. (Jt. Ex. 8-L.) The election reported the fair market value of the option as "zero." Taxpayer did not file a Section 83(b) election for the option acquired in 1981. Although taxpayer did not file such a election for the 1981 option, he apparently took the position that the value of the option was includable in ordinary income in that year under Section 83(a) because it was not subject to a substantial risk of forfeiture. See Cramer v. Commissioner, 64 F.3d at 1414.

³ In other words, the grant of an option without a readily ascertainable fair market value (which is the usual case) is treated as a nontaxable event, and the compensatory income aspect of the transaction (which is governed by Section 83(a)) is suspended until the option is exercised or disposed of. By contrast, the grant of an option with a readily ascertainable fair market value is treated as a taxable event to which Section 83(a) applies.

⁴ The Tax Court held that taxpayer was not liable for the addition to tax imposed under former I.R.C. section 6661 because he had adequately disclosed his position on his 1982 tax return. (CR 35 at 29-32.) The Commissioner did not cross-appeal from the Tax Court's decision on the Section 6661 issue.

⁵ The Government filed a cross-appeal from the Tax Court's decision, but has since decided not to pursue the cross-appeal.

⁶ In order to be a "prevailing party," a party must also establish that he has substantially prevailed with respect to the amount in controversy or the most significant issue or set of issues presented, and that he meets certain net worth requirements. section 7430(c)(4)(A)(ii) & (iii). In order to qualify for an award of litigation costs, a "prevailing party" must also establish (i) that he exhausted all administrative remedies available to him (section 7430(b)(1)), and (ii) that he did not unreasonably protract the proceedings (section 7430(c)(4)).

For purposes of this appeal, the Commissioner does not dispute that taxpayer satisfies all other requirements for receiving litigation costs under Section 7430.

⁷ At the Tax Court trial in Cramer v. Commissioner, Richard Cramer testified that he had a "very healthy respect for [taxpayer's] abilities as a chief financial officer./ (Cramer Tr. (Resp. Ex. AD) at 97-98.)