399 F.

2d 744
68-2 USTC P 9579

Hugh N. MILLS and Jane W. Mills, Petitioners,

v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
No. 11825.

United States Court of Appeals Fourth Circuit.

Argued March 7, 1968.
Decided Sept. 3, 1968.

Arthur T. Ciccarello, Charleston, W. Va., for petitioners.

Karl Schmeidler, Atty., Dept. of Justice (Mitchell Rogovin, Asst. Atty.
Gen., Lee A. Jackson and David O. Walter, Attys., Dept. of Justice, on
brief), for respondent.
Before BOREMAN and BUTZNER, Circuit Judges, and RUSSELL,
District judge.
BUTZNER, Circuit Judge:

Hugh N. Mills and Jane W. Mills 1 seek review of a decision of the tax court
which found a deficiency in their 1961 income tax.2 Two issues are involved.
The first is whether the tax court correctly held that the taxpayer realized
ordinary income, and not long-term capital gain, on the sale of stock options
and stock. The second issue is whether $1,450 of unexplained bank deposits
should be included in the taxpayer's income. On both issues we affirm the tax
court's decision for the commissioner.
I.

The taxpayer organized Mountaineer Fire & Casualty Insurance Company in

1957, but he was unable to raise the necessary capital and surplus to obtain a
license. The taxpayer controlled the corporation. He was its president but
received no salary. Early in 1959 the board of directors increased the authorized

capital of the company, fixed the issuing price of stock at $2.50 per share, and
granted the taxpayer an option to buy 60,000 shares at $1.00 per share. The
agreement granting the option recited that it was in consideration of the benefits
the company would realize from the services of the taxpayer and also in
consideration of his present employment and probable continued employment
as president. The taxpayer agreed to assign some of his options, at no profit to
himself, to associates who undertook to promote the sale of the company's
stock. However, the promotion failed. The taxpayer made no assignments and
cancelled the agreement.
3

In 1961 the taxpayer exercised options for 550 shares of stock, which he
simultaneously sold for $1,250 at a profit of $700. He assigned an additional
1,000 options for $1,000. On January 21, 1961, the taxpayer, having been
appointed Insurance Commissioner of West Virginia and disiring to divest
himself of all connections with Mountaineer, sold his interest in the corporation
for $8,750. He testified that the sale included his options.3 The taxpayer
reported the total sales price of all these transactions as $10,450, which he
treated as a long-term capital gain without deduction for any cost.

In June 1961 the taxpayer, no longer the West Virginia Insurance

Commissioner, agreed to operate the company if sufficient capital could be
raised to obtain a license. Certificates of stock aggregating 30,400 shares were
issued to him, which he immediately endorsed in blank and delivered to Alex
Dandy.4 The taxpayer gave his check for $34,000 payable to Mountaineer.
Dandy later gave the taxpayer a cashier's check for $31,000, which the taxpayer
deposited with $3,000 in currency to cover the $34,000 check he had given the
company.

In September 1961 the taxpayer paid Dandy $8,000 for 8,000 shares of
Mountaineer stock valued at $20,000. At that time the stock was selling at
$2.50 a share.5 In explanation of his transaction with Dandy, the taxpayer
testified that in June 1961 when the stock was issued in his name and assigned
to Dandy, he acted as a fiduciary and that Dandy was the true owner of the
stock. He explained that Dandy sold him 8,000 shares in September because
Dandy previously had promised to do so. He admitted that the transaction had
involved his stock options, but he denied that he had exercised any options
except as an agent or conduit. The taxpayer did not report either his assignment
of the stock to Dandy or his subsequent acquisition of the 8,000 shares.

The tax court held that the taxpayer realized $12,000 profit from the exercise or
sale of options which enabled him to acquire stock worth $20,000 at a cost of
only $8,000. The tax court reasoned that Dandy was able to purchase stock

from the company at $1.00 per share only because the taxpayer either exercised
or assigned his options to Dandy. This transaction, the court found, was
coupled with the understanding that Dandy would turn 8,000 shares over to the
taxpayer when he was able to pay the cost of the stock.
7

The tax court also held that the options granted to the taxpayer were
compensation and that the profit he realized from all transactions connected
with the options was taxable as ordinary income under 61 of the Internal
Revenue Code of 1954 (26 U.S.C. 61). The tax court's decision embraced both
the transactions totaling $10,450 and the transfers involving Dandy resulting in
the $12,000 profit. The taxpayer challenges the tax court's conclusion. He
denies that the options were compensation and contends that Mountaineer
granted the options to enable him and other promoters to have a proprietary
interest in the company. He argues that they were capital assets in his hands
and are taxable only as long-term capital gains.6

The tax court properly rejected the taxpayer's theory. The agreement between
the taxpayer and the corporation expressly recites that the options were granted
in consideration of past and future services. Furthermore, in Commissioner of
Internal Revenue v. LoBue, 351 U.S. 243, 247, 76 S.Ct. 800, 803, 100 L.Ed.
1142 (1956), the Court found no statutory basis for applying the proprietary
interest doctrine to employees' options and held, 'When assets are transferred by
an employer to secure better services they are plainly compensation. It makes
no difference that the compensation is paid in stock rather than in money.' See
2 Mertens, Law of Federal Income Taxation 11.11 (1967 When the options
were granted in 1959 they had no ascertainable market value. For this reason
the taxpayer received the taxable income in 1961 when he exercised or
transferred the options. Commissioner of Internal Revenue v. LoBue, 351 U.S.
243, 248, 76 S.Ct. 800, 100 L.Ed. 1142 (1956); Commissioner of Internal
Revenue v. Smith, 324 U.S. 177, 181, 65 S.Ct. 591, 89 L.Ed. 830 (1945); Rank
v. United States, 345 F.2d 337, 343 (5th Cir. 1965); Treas.Reg. 1.421-6 (26
C.F.R. 1.421-6); see 2 Mertens, Law of Federal Income Taxation 11.11 (1967
ed.)

In view of the fact that the options were compensatory, the taxpayer can find no
support in section 1234 of the Internal Revenue Code of 1954 (26 U.S.C. 1234).
This section allows capital gains treatment of certain options, but it does not
apply to gains attributable to nonrestrictive compensatory stock options.

10

The taxpayer also contends that he is not liable for any deficiency with respect
to the transaction with Dandy because of a variance between the
commissioner's statutory notice and the theory upon which the case was tried

before the tax court. We find no merit in this contention. The statutory notice
referred to 'profit from sale of options and stock.' The agent's work sheet
furnished the taxpayer, at his counsel's request, dealt with the Dandy
transaction in terms of the taxpayer's assignment of the stock to Dandy in June
1961. Before the tax court hearing, however, the taxpayer's counsel was fully
apprised that the commissioner alternatively claimed the taxpayer realized a
profit, not on the original assignment to Dandy, but as a result of the
reassignment from Dandy to the taxpayer. At the hearing the taxpayer moved
that the burden of proof of this part of the assessment should be shifted to the
commissioner because of the variance from the statutory notice. The court
made no specific ruling on this motion, but its decision on this phase of the case
was not based on the taxpayer's failure to sustain the burden of proof. Even if
the burden of proof had been placed upon the commissioner, we would be
compelled to affirm. The historical facts were not in dispute, and the court
accepted as the market value of Mountaineer stock the price at which the
taxpayer sold other shares of the same stock the same month. Cf. Spangler v.
Commissioner of Internal Revenue, 278 F.2d 665, 669 (4th Cir.), cert. denied,
364 U.S. 825, 81 S.Ct. 63, 5 L.Ed.2d 54 (1960).
11

In this court the taxpayer argued that not only should the burden of proof have
shifted, but that the variance was fatal. The taxpayer urges that he is being
taxed for the purchase of stock instead of the sale of stock as set forth in the
statutory notice. This argument is based on an oversimplification of the
problem. What the taxpayer considers a purchase was not an arm's length deal
between vendor and vendee. The tax court carefully pointed out that the tax
was imposed on this transaction because the taxpayer exercised or assigned
8,000 options to permit Dandy to buy the stock with the understanding that
Dandy would turn this stock over to the taxpayer. The taxpayer was able to
realize his gain on this transaction through the exercise or sale of his options.
The statutory notice was sufficiently broad to encompass this theory. Cf.
Helvering v. Gowran, 302 U.S. 238, 245, 58 S.Ct. 154, 82 L.Ed. 224 (1938);
Bryan v. , commissioner of Internal Revenue, 281 F.2d 238, 243 (4th Cir.
1960), cert. denied, 364 U.S. 931, 81 S.Ct. 378, 5 L.Ed.2d 364 (1961); Coastal
Oil Storage Co. v. Commissioner of Internal Revenue, 242 F.2d 396, 400 (4th
Cir. 1957).

12

A contrary conclusion is not required by Helvering v. Tex-Penn Co., 300 U.S.

481, 497, 57 S.Ct. 569, 81 L.Ed. 755 (1937), upon which the taxpayer relies. In
that case the commissioner advanced a new theory in the Supreme Court. Not
only did the notice of deficiency fail to suggest the commissioner's new
position, but as the Court pointed out, it was not presented to the courts below
or in the petition for certiorari. Here, however, the commissioner's alternative

theory, ultimately accepted by the tax court, was made known to the petitioner
before trial and was fully developed in the tax court.
II.
13

Initially the commissioner increased the taxpayer's income by $2,612.15 found

in unexplained bank deposits. By stipulation before trial the commissioner
conceded the sum of $962.15 of the deposits posits was not income, and the
taxpayer conceded that $100 was income. The taxpayer testified that the
remaining $1,550 consisted of cash loans. The tax court held that $100 could
be traced to a loan, but that the taxpayer failed to carry his burden of proof with
respect to the remaining $1,450.

14

A witness, Brown, testified that he had lent the taxpayer between $3,000 and
$4,000 during the year, usually by check, but in one or two instances in cash.
He also stated that the taxpayer had lent him $1,000 early in the year, which he
repaid in cash. The tax court found that Brown apparently lent the taxpayer
money during the year, but the loans did not find their way into the taxpayer's
bank account because they were made for specific purposes. Another witness
testified that he had lent the taxpayer $300 or $400 during the year, mostly in
small amounts of cash. With the exception of the $100 allowed the taxpayer as
a loan, neither the witnesses nor the taxpayer could correlate any loan with the
deposits. The taxpayer produced no records pertaining to the loans that he
claimed.

15

The determination of whether the unexplained bank deposits constituted

income presents a narrow factual issue. The commissioner's determination of a
deficiency is presumed to be correct, and the taxpayer has the burden in the tax
court of proving it wrong. O'Dwyer v. Commissioner of Internal Revenue, 266
F.2d 575, 588 (4th Cir.), cert. denied, 361 U.S. 862, 80 S.Ct. 119, 4 L.Ed.2d
102 (1959). While an arbitrary assessment may destroy this presumption, e.g.,
Helvering v. Taylor, 293 U.S. 507, 514, 55 S.Ct. 287, 79 L.Ed. 623 (1935), we
cannot accept the taxpayer's contention that the determination of the deficiency
in this case was arbitrarily made. In the absence of records kept by the taxpayer
showing the source of his cash receipts the Commissioner may look to other
sources of information to establish income, and may take into account, as prima
facie evidence of income, bank deposits made by the taxpayer during the years
in question.' Boyett v. Commissioner of Internal Revenue, 204 F.2d 205, 208
(5th Cir. 1953). Under the circumstances, the tax court was not bound to find
that the presumption accorded the commissioner's determination was overcome
by the vague and indefinite testimony of the taxpayer. Factor v. Commissioner
of Internal Revenue, 281 F.2d 100, 111 (9th Cir. 1960), cert. denied, 364 U.S.

933, 81 S.Ct. 380, 5 L.Ed.2d 365 (1961).

16

The commissioner conceded that some of the disputed deposits were not
income. The tax court accepted the taxpayer's corroborated testimony with
regard to another deposit. These circumstances, however, do not destroy the
presumption supporting the commissioner's determination of the deficiency
with respect to other items or demonstrate that his assessment was arbitrary.
Marcello v. Commissioner of Internal Revenue, 380 F.2d 494, 497 (5th Cir.
1967); Banks v. Commissioner of Internal Revenue, 322 F.2d 530, 548 (8th
Cir. 1963).

17

The judgment is affirmed.

Mrs. Mills had no income. She is a party only because she and her husband
filed a joint return. Hugh N. Mills will be referred to as the taxpayer

Hugh N. Mills P67,067 P-H Memo TC. The case is not officially reported

For some reason that does not clearly appear in the record, the taxpayer was
able to exercise options when he again became connected with the company
later in 1961

4,000 shares were a reissue. The rest were new

During September 1961 the taxpayer himself sold 1,100 shares at $2.50 per
share. Seven hundred of these were sold to Dandy

The taxpayer does not contend that the options should be treated as restricted
stock options under 421 of the Internal Revenue Code of 1954, which was in
effect at the time. In 1964, 421 was replaced by new 421-425 (26 U.S.C. 421425) providing for special treatment of qualified and restricted stock options

Dicta found in pre-LoBue cases cited by the taxpayer are no longer applicable
E.g., Connolly's Estate v. Commissioner, 135 F.2d 64, 67, 146 A.L.R. 1387
(6th Cir. 1943); Hawke v. Commissioner of Internal Revenue, 109 F.2d 946,
950 (9th Cir.), cert. denied, Hawke v. Helvering, 311 U.S. 657, 61 S.Ct. 11, 85
L.Ed. 421 (1940)