Part III. Administrative, Procedural, and Miscellaneous

Public Comment Invited on Recommendations for 2004–2005 Guidance Priority List

Notice 2004–26

The Department of Treasury and Internal Revenue Service invite public comment on recommendations for items that should be included on the 2004–2005 Guidance Priority List.

Treasury’s Office of Tax Policy and the Service use the Guidance Priority List each year to identify and prioritize the tax issues that should be addressed through regulations, revenue rulings, revenue procedures, notices, and other published administrative guidance. The 2004–2005 Guidance Priority List establishes the guidance that the Treasury Department and the Service intend to issue from July 1, 2004, through June 30, 2005. The Treasury Department and the Service recognize the importance of public input to formulate a Guidance Priority List that focuses resources on guidance items that are most important to taxpayers and tax administration.

In reviewing recommendations and selecting projects for inclusion on the 2004–2005 Guidance Priority List, the Treasury Department and the Service will consider the following:

1. Whether the recommended guidance is consistent with the Internal Revenue Code and Congressional intent;

2. Whether the recommended guidance promotes sound tax administration;

3. Whether taxpayers can easily understand and apply the recommended guidance;

4. Whether the Service can administer the recommended guidance on a uniform basis; and

5. Whether the recommended guidance reduces controversy and lessens the burden on taxpayers or the Service.

Taxpayers may submit recommendations for guidance at any time during the

year. Please submit recommendations by April 30, 2004, for possible inclusion on the original 2004–2005 Guidance Priority List. The Service will update the 2004–2005 Guidance Priority List quarterly to reflect additional guidance that the Treasury Department and the Service intend to publish during the plan year. The quarterly updates allow the Treasury Department and the Service to respond to the need for additional guidance that may arise during the plan year. Generally, recommendations for guidance received after April 30, 2004, will be reviewed for inclusion in the next quarterly update if received by August 31, 2004; November 30, 2004; or February 28, 2005, respectively. Taxpayers are not required to submit recommendations for guidance in a particular format. Taxpayers should, however, briefly describe the recommended guidance and explain the need for the guidance. In addition, taxpayers may include an analysis of how the issue should be resolved.

Taxpayers should send written comments to:

Internal Revenue Service Attn: CC:PA:LPD:PR (Notice 2004–26) Room 5226 P.O. Box 7604 Ben Franklin Station Washington, D.C. 20044

or hand deliver comments between the hours of 8 a.m. and 5 p.m. to:

Courier’s Desk Internal Revenue Service Attn: CC:PA:LPD:PR (Notice 2004–26) 1111 Constitution Avenue, N.W. Washington, D.C. 20224

Alternatively, taxpayers may submit comments electronically via e-mail to the following address: Notice.Com- ments@irscounsel.treas.gov . Taxpayers should include “Notice 2004–26” in the subject line. All comments will be available for public inspection and copying in their entirety.

For further information regarding this notice, contact Crystal Foster of the Office of Associate Chief Counsel (Procedure

and Administration) at (202) 622–7326 (not a toll-free call).

Loss Deductions for Diminution in Value of Stock Attributable to Corporate Misconduct

Notice 2004–27

The Internal Revenue Service and Treasury Department are aware that some taxpayers who acquired stock on the open market for investment have been advised that they may be able to deduct as a theft loss the decline in market value of their stock caused by disclosure of accounting fraud or other illegal misconduct of the officers or directors of the corporation that issued the stock. The purpose of this notice is to advise taxpayers that the Service intends to disallow such deductions and may impose penalties under § 6662.

Section 165(a) of the Internal Revenue Code allows a deduction for any loss sustained during the taxable year not compensated for by insurance or otherwise. Under § 165(c) losses for individuals are limited to (1) losses incurred in a trade or business, (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business, and (3) losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. Section 1.165–1(b) of the Income Tax Regulations generally provides that, to be allowable as a deduction under section 165(a), a loss must be evidenced by a closed and completed transaction, fixed by an identifiable event or events, and actually sustained during the taxable year.

Section 1.165–4(a) provides that no deduction shall be allowed under § 165(a) solely on account of a decline in the value of stock owned by the taxpayer when the decline is due to a fluctuation in the market price of the stock or to another similar cause. However, a deduction is allowed under § 165(a) if the stock is worthless and has no recognizable value. A decline in the value of stock owned by the taxpayer is not allowed as a deduction under § 165(a) until

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Frivolous Arguments to Avoid Concerning Statutory and Nonstatutory Stock Options

Notice 2004–28

The Internal Revenue Service is aware that certain promoters are advising taxpayers to take highly questionable, and in most cases meritless, positions, described below, on current and amended returns regarding income or alternative minimum tax (“AMT”) due upon the exercise of nonstatutory or statutory stock options. This notice alerts taxpayers that the Service intends to challenge such positions and will treat them as frivolous in appropriate cases. However, the Service will consider each position and will not reject or contest it solely because it is submitted along with a frivolous position. See Treas. Reg. § 1.6694–2(c)(2) (“a ‘frivolous’ position with respect to an item is one that is patently improper”). The Service also may apply civil or criminal penalties to taxpayers and to promoters of these positions.

Income Tax Treatment of Stock Options Generally

The federal income tax treatment of stock options granted in exchange for services is well established. In general, the income tax consequences associated with an option arise when the option is exercised. When an employee exercises a compensatory stock option (commonly known as a “nonstatutory option”), both § 83 of the Internal Revenue Code (Code) and long-standing judicial authority require that the difference between the fair market value of the stock and the option exercise price be included in the employee’s gross income as compensation. See, e.g., Commissioner v. LoBue, 351 U.S. 243 (1956). In the case of stock purchased under an incentive stock option (or a “statutory option”) taxed under §§ 421 and 422, § 56 provides that the difference between the fair market value of the stock and the option exercise price must be included in the employee’s gross income for purposes of computing AMT.

Statutory stock options are not subject to tax on the date of grant. Nonstatutory stock options rarely are subject to tax on the date of grant, and taxation at grant

the taxable year in which the loss is actually sustained as a result of the sale or exchange of the stock or the stock becoming wholly worthless.

Section 165(f) provides that losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212. Stock held for investment is a capital asset under section 1221. Sections 1211 and 1212 limit the amount that individual taxpayers may deduct for losses from sales or exchanges of capital assets and provide rules for carrying forward to subsequent years the amount of any excess capital loss.

Under § 165(g)(1), if any stock that is a capital asset in the hands of a taxpayer, such as stock purchased as an investment, becomes worthless during a taxable year, the resulting loss is treated as a loss from the sale or exchange of a capital asset ( i.e., a capital loss). Section 1.165–5(c) explains that if the stock becomes wholly worthless during a taxable year, the resulting loss may be deducted under § 165(a) subject to the limitations imposed on capital losses under §§ 1211 and 1212 and the regulations thereunder.

Therefore, under § 165(a), subject to the limitations of §§ 1211 and 1212, a taxpayer who owns stock that was acquired on the open market for investment and that has declined in value is allowed a deduction for a capital loss in the taxable year in which the stock is sold or exchanged or becomes wholly worthless.

Sections 165(e) and 1.165–8(a)(2) provide that, in general, a loss arising from a theft shall be treated under § 165(a) as sustained during the taxable year in which the taxpayer discovers the loss. Section 1.165–1(d)(3) provides that if in the year of discovery there exists a claim for reimbursement with respect to which the taxpayer has a reasonable prospect of recovery, the portion of the loss that may be reimbursed is not treated as sustained until the tax year in which it can be ascertained with reasonable certainty that reimbursement will not be received.

Whether a loss constitutes a theft loss is determined by examining the law of the state where the alleged theft occurred. Edwards v. Bromberg, 232 F.2d 107, 111 (5 ^th Cir. 1956); Viehweg v. Commissioner, 90 T.C. 1248, 1253 (1988). Thus, to claim a theft loss, the taxpayer must prove that the “loss resulted from a taking of prop

erty that is illegal under the law of the state where it occurred and that the taking was done with criminal intent.” Rev. Rul. 72–112, 1972–1 C.B. 60. In cases involving stock purchased on the open market, the courts have consistently disallowed theft loss deductions relating to a decline in the value of the stock that was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations. In Paine v. Commis- sioner, 63 T.C. 736, aff’d without pub- lished opinion, 523 F.2d 1053 (5 ^th Cir. 1975), the taxpayers claimed a theft loss deduction for a decline in value of stock stemming from misrepresentations of the financial status of the corporation by corporate officials. The court noted that the taxpayers did not purchase the stock from the corporate officers who made the misrepresentations, but on the open market. In MTS International Inc. v. Commissioner, 169 F.3d 1018 (6 ^th Cir. 1999), an individual taxpayer sold at a loss stock that was acquired on a public stock exchange and argued that the substantial decline in value was due to criminal conduct by the corporation’s officers. The Sixth Circuit concluded that the loss was not a theft loss. See also Crowell v. Commissioner, T.C. Memo. 1986–314; DeFusco v. Commis- sioner, T.C. Memo. 1979–230; Barry v. Commissioner, T.C. Memo. 1978–215; and Rev. Rul. 77–17, 1977–1 C.B. 44.

Accordingly, the Service will disallow a deduction for a theft loss under § 165(a) relating to a decline in the value of stock that was acquired on the open market for investment. If the stock is sold or exchanged or becomes wholly worthless, any resulting loss is a capital loss.

DRAFTING INFORMATION

The principal author of this notice is Norma Rotunno of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this notice, please contact Ms. Rotunno at (202) 622–7900 (not a toll-free call).

2004-16 I.R.B. 783 April 19, 2004

as the economic equivalent of the underlying stock and thus were not subject to any taxation of the spread on exercise.” Promoters of this argument typically claim that because an option and the underlying stock are functional equivalents, there is no gain when the employee exercises the option. As discussed above, generally, when an employee is granted a nonstatutory option, § 83 requires the inclusion of income equal to the difference between the stock’s fair market value and the exercise price when the option is exercised. Section 56(b)(3) requires the employee to include that difference in AMT income when an employee exercises a statutory stock option.

These positions and other similar claims that disregard the long-standing judicial and statutory authorities concerning the taxation of statutory and nonstatutory options will be treated as frivolous in appropriate circumstances.

In evaluating positions of this kind, the Service will determine the additional tax due from the taxpayer according to the principles outlined above. In addition to liability for tax due plus statutory interest, individuals who claim tax benefits on their returns based on these and other frivolous arguments face substantial civil and criminal penalties. Potentially applicable civil penalties include: (1) the § 6662 accuracy-related penalty, which is equal to 20 percent of the amount of taxes the taxpayer should have paid; (2) the § 6663 penalty for civil fraud, which is equal to 75 percent of the amount of taxes the taxpayer should have paid; (3) a $500 penalty under § 6702 for filing a frivolous return; and (4) a penalty of up to $25,000 under § 6673 if the taxpayer makes frivolous arguments in the United States Tax Court.

Taxpayers filing returns based on these or similar positions also may face criminal prosecution for: (1) attempting to evade or defeat tax under § 7201 for which the penalty is a fine of up to $100,000 and imprisonment for up to 5 years; or (2) making false statements on a return under § 7206 for which the penalty is a fine of up to $100,000 and imprisonment for up to 3 years.

typically occurs only if an option is actively traded on an established securities market on that date or, if not so traded, it has a readily ascertainable fair market value. See § 83(a) and (e), and § 1.83–7(a) and (b) of the Income Tax Regulations. A non-publicly traded nonstatutory stock option is considered to have a readily ascertainable fair market value on the grant date only if, on that date, it satisfies four conditions: (1) the option is transferable; (2) the option is exercisable immediately in full by the optionee; (3) the option or the property subject to the option is not subject to any restriction or condition which has a significant effect upon the fair market value of the option; and (4) the fair market value of the option privilege is readily ascertainable. § 1.83–7(b).

For more information regarding the federal tax treatment of stock options granted in exchange for services, please consult Publication 525, “Taxable and Nontaxable Income,” pages 9–11.

Positions Promoted

The positions being promoted include, but are not limited to, the following:

at their grant date rather than their exercise date.” Promoters of this argument typically claim that the proper time for an employee to measure taxable income from a stock option is when the option is granted (before the stock has appreciated) rather than when it is exercised (after the stock has appreciated). This claim will rarely be supported by the facts. For a nonstatutory option, unless the requirements for taxation at grant as described above are satisfied, the proper time for measurement and inclusion of income is on the date of exercise. A statutory option will never be subject to tax on grant. See §§ 421 and 422.

chased under an option is reduced by any restriction placed on the stock by the employer that prohibits the employee from selling the stock for a specified period of time.” Promoters of this argument typically claim that if an employee cannot sell stock purchased under an option for a period of time because of an agreement

with an employer, then the value of the stock cannot be as high as the value of the same stock that does not have that restriction. This claim is without merit because § 83(a) clearly requires that the value of property transferred in connection with the performance of services must be determined without regard to restrictions that will lapse, such as a requirement to hold shares for a period of time. See also § 1.83–1(a)(1) and Sakol v. Commis- sioner, 67 T.C. 986 (1977), aff’d, 574 F.2d 694 (2 ^nd Cir. 1978), cert denied, 439 U.S. 859 (1978).

ker sells a taxpayer’s stock that was purchased under a nonstatutory op- tion, the stock having been pledged as security for a loan to pay the ex- ercise price, that sale is a forfeiture of the stock that causes an ordi- nary loss rather than a capital loss.” Promoters of this argument generally claim that a sale of stock required by a broker’s margin call should be treated as an ordinary loss. This claim is baseless because, when an employee is the beneficial owner of shares held by the employee’s broker pursuant to a stock option exercise, the stock is then a capital asset to the employee. See § 1221. Capital gains or losses occur upon the subsequent sale of the stock, such as pursuant to a margin call. The same analysis applies for purposes of AMT, and gain or loss on disposition due to a margin call would be capital gain or loss for AMT purposes. See §§ 56, 421 and 422.

borrowed funds was not in sub- stance a purchase because the em- ployee did not have the ability to repay the loan.” Promoters of this argument typically assert that an employee’s purchase of shares pursuant to a stock option in exchange for a note to pay the purchase price should not be respected where the employee is subsequently unable to pay the debt. This claim will fail where, in fact, beneficial ownership of the stock was transferred to the employee, irrespective of the employee’s subsequent ability to repay the debt. See § 1.83–3(a).

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sent of the Commissioner to change to a method of accounting provided in the final regulations, provided the taxpayer follows the administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s automatic consent to a change in accounting method (for further guidance, for example, see Rev. Proc. 2002–9, 2002–1 C.B. 327, as modified and clarified by Announcement 2002–17, 2002–1 C.B. 561, modified and amplified by Rev. Proc. 2002–19, 2002–1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002–54, 2002–2 C.B. 432). The final regulations further provide that any applicable § 481(a) adjustment for a change to a method of accounting provided in the final regulations for a taxpayer’s first taxable year ending on or after December 31, 2003, is determined by taking into account only amounts paid or incurred in taxable years ending on or after January 24, 2002. The preamble to the final regulations states that the Service may issue additional guidance for utilizing the automatic consent procedures to change to a method of accounting provided in the regulations. This revenue procedure constitutes the exclusive guidance for utilizing the automatic consent procedures to change to a method of accounting provided in the final regulations for a taxpayer’s first taxable year ending on or after December 31, 2003. For changes in methods of accounting to which this revenue procedure applies, a taxpayer may not file an application for a change in method of accounting under Rev. Proc. 97–27, 1997–1 C.B. 680 (as modified and amplified by Rev. Proc. 2002–19, 2002–1 C.B. 696, as amplified and clarified by Rev. Proc. 2002–54, 2002–2 C.B. 432). See section 4.02(1) of Rev. Proc. 97–27.

.03 Section 1.446–1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to change a method of accounting.

.04 Rev. Proc. 2002–9 provides procedures by which a taxpayer may obtain automatic consent to change to a method of accounting described in the Appendix of Rev. Proc. 2002–9.

.05 Rev. Rul. 90–38, 1990–1 C.B. 57, provides that, if a taxpayer uses an erroneous method of accounting for two or more consecutive taxable years, the tax

Persons who promote these or similar positions and those who assist taxpayers in claiming tax benefits based on them also face penalties. Potential penalties include: (1) a $250 penalty for each return prepared by an income tax return preparer who knew or should have known that the taxpayer’s argument was frivolous (or $1,000 for each return where the return preparer’s actions were willful, intentional or reckless); (2) a $1,000 penalty under § 6701 for aiding and abetting the understatement of tax; and (3) criminal prosecution under § 7206 for which the penalty is a fine of up to $100,000 and imprisonment for up to 3 years for assisting or advising about the preparation of a false return or other document under the internal revenue laws. Promoters and others who assist taxpayers in engaging in these schemes also may be enjoined from doing so under § 7408.

Taxpayers who have submitted returns relying on these or similar claims should amend them as soon as possible to avoid accruing additional penalties. Taxpayers should consult with a tax advisor to take appropriate corrective action.

For more information regarding the taxability of stock options, taxpayers can contact the Office of Division Counsel/Associate Chief Counsel (Tax Exempt/Government Entities) at (202) 622–6030 (not a toll-free call). For information regarding AMT, contact the Office of Associate Chief Counsel (Income Tax & Accounting) at (202) 622–4920 (not a toll-free call). For information regarding penalties, contact the Office of Associate Chief Counsel (Procedure and Administration) at (202) 622–4940 (not a toll-free call).

26 CFR 601.204: Changes in accounting periods and in methods of accounting. (Also, Part 1, §§ 162, 263, 446, 461, 481; 1.167(a)–3(b), 1.263(a)–4, 1.263(a)–5, 1.446–1, 1.461–4, 1.461–5, 1.481–1.)

Rev. Proc. 2004–23