                          In the
 United States Court of Appeals
              For the Seventh Circuit
                       ____________

No. 06-4103
ROBERT C. RACINE and GAIL K. RACINE,
                                     Petitioners-Appellants,
                             v.


COMMISSIONER OF INTERNAL REVENUE,
                                       Respondent-Appellee.
                       ____________
           Appeal from the United States Tax Court.
           No. 17633-04—Joseph R. Goeke, Judge.
                       ____________
      ARGUED MAY 23, 2007—DECIDED JULY 3, 2007
                   ____________


 Before EASTERBROOK, Chief Judge, and BAUER and
MANION, Circuit Judges.
   EASTERBROOK, Chief Judge. Non-cash compensation,
such as shares of stock, is taxable when the “transfer”
to the recipient occurs. 26 U.S.C. §83. According to a
Treasury Regulation, 26 C.F.R. §1.83-3(a)(2), the grant of
an option to purchase stock (or other property) is not it-
self a transfer, which does not occur until the option is
exercised. This case presents the question whether the
“transfer” may be postponed even after the option’s
exercise, on the theory that borrowing to finance the
transaction amounts to a second option that replaces the
first.
2                                             No. 06-4103

  Gail Racine held options to purchase stock of Allegiance
Telecom, Inc., her employer. (Allegiance has since been
acquired by XO Communications, Inc.; we use names
from the time of the events.) Racine’s options were not
qualified for tax deferral under 26 U.S.C. §§ 421-22; as a
result, any gain on exercise (the difference between the
exercise price and the market price) was taxable at
ordinary-income rates as soon as a “transfer” occurred.
Because the full gain is subject to tax, the owner’s basis
in the stock is equal to the market price at the time of
transfer. Usually a high basis at the outset means
lower taxes later; things did not work out that way for
Racine, however. (Gail Racine filed a joint return with her
husband Robert; for simplicity we refer to Gail Racine
as the taxpayer.)
  From March through July 2000 Racine exercised options
to purchase 25,257 shares of Allegiance Telecom’s stock.
The exercise price was $58,810.79, and the market value
of the shares at the time of exercise was $1,972,705.63 (an
average of $78.10 per share). Allegiance Telecom remitted
about $625,000 in income tax on Racine’s gain of about
$1.9 million and demanded reimbursement for the with-
holding tax before it would give Racine clear title to
the shares. To finance the exercise price and the tax,
she borrowed about $684,000 on margin from CIBC
Oppenheimer, a market-maker in Allegiance Telecom.
Unfortunately for Racine, the market price of Allegiance
Telecom’s stock began to decline soon after she exer-
cised the options, and CIBC Oppenheimer issued margin
calls in order to ensure that the stock was worth at least
1.35 times the outstanding debt. (That minimum ratio
is required by the Federal Reserve Board’s Regulation T.)
In November 2000 Racine sold 18,921 shares at an aver-
age price of $15.61 per share, and in May 2001 she sold
1,836 shares at $20.41 per share. That left her with 4,500
shares of stock and a burning desire to reduce her tax
No. 06-4103                                                   3

liability—because by May 2001 her gains had shrunk to
about $366,000,† on which roughly $625,000 in income
tax had been withheld. No one likes to pay a 170% tax.
  Racine had suffered a capital loss, but (with insignificant
exceptions) capital losses may be offset only against
capital gains, of which Racine had none, because the gain
from the options’ exercise was ordinary income, and her
basis in these shares was $1.97 million. If the options had
been tax-qualified, then the basis would have been lower
and the sale of the shares would have produced, not a huge
capital loss, but a modest capital gain or loss.
  Racine’s solution to her problem was to claim a $368,000
refund (plus interest) on her 2000 tax return. The idea was
that the shares had not been “transferred” to Racine
during the first half of 2000, when they traded for more
than $78 apiece. Instead, the return asserted, the transfer
occurred in November 2000 when they were sold—and the
shares held into 2001 were not transferred, and thus
were not subject to tax, until they too were sold. The
refund request was honored, but after an audit the Inter-
nal Revenue Service demanded the money back. The Tax
Court held that the refund had been erroneous and that
Racine must pay $514,000 in back taxes and interest;
the Commissioner’s request for a penalty, however, was
rejected. T.C. Memo 2006-162, 2006 Tax Ct. Memo LEXIS
164 (Aug. 14, 2006). The Tax Court held that a transfer
occurred when the options were exercised because
Racine acquired full legal and beneficial ownership of the
shares: she could sell them outright (ditching all firm-
specific risk in the volatile telecommunications industry),

†
  Racine paid $58,811 for the shares. The sales in November
2000 and May 2001 realized a total of $332,881, and the 4,500
shares she still held had a market price of roughly $92,000. Her
net profit (disregarding any interest paid on the margin loan)
thus was roughly $366,000.
4                                              No. 06-4103

vote them, hypothecate them, and so on. This satisfies the
regulation’s definition of a “transfer.” 26 C.F.R. §1.83-
3(a)(1) (“a transfer of property occurs when a person
acquires a beneficial ownership interest in such property”).
  Racine’s theory is that a “transfer” occurs only when a
taxpayer puts “her own” money into a transaction. This
argument is based on two subsections and one example
from Treas. Reg. §1.83-3(a), which for easy reference
we reproduce below:
    (2) Option. The grant of an option to purchase
    certain property does not constitute a transfer of
    such property. . . . In addition, if the amount paid
    for the transfer of property is an indebtedness
    secured by the transferred property, on which
    there is no personal liability to pay all or a sub-
    stantial part of such indebtedness, such transac-
    tion may be in substance the same as the grant of
    an option. The determination of the substance of
    the transaction shall be based upon all the facts
    and circumstances. The factors to be taken into
    account include the type of property involved, the
    extent to which the risk that the property will
    decline in value has been transferred, and the
    likelihood that the purchase price will, in fact, be
    paid. . . .
    ...
    (6) Risk of loss. An indication that no transfer has
    occurred is the extent to which the transferee does
    not incur the risk of a beneficial owner that the
    value of the property at the time of transfer will
    decline substantially. Therefore, for purposes of
    this (6), risk of decline in property value is not
    limited to the risk that any amount paid for the
    property may be lost.
    ...
No. 06-4103                                               5

    Example (2). On November 17, 1972, W sells to E
    100 shares of stock in W corporation with a fair
    market value of $10,000 in exchange for a $10,000
    note without personal liability. The note requires
    E to make yearly payments of $2,000 commencing
    in 1973. E collects the dividends, votes the stock
    and pays the interest on the note. However, he
    makes no payments toward the face amount of the
    note. Because E has no personal liability on the
    note, and since E is making no payments towards
    the face amount of the note, the likelihood of E
    paying the full purchase price is in substantial
    doubt. As a result E has not incurred the risks of
    a beneficial owner that the value of the stock will
    decline. Therefore, no transfer of the stock has
    occurred on November 17, 1972, but an option to
    purchase the stock has been granted to E.
Buying stock with borrowed money, the theory goes, is
like replacing one option with another: as long as a
broker (or any third party) supplies the capital, the
taxpayer has nothing at risk and can walk away freely,
allowing the broker to sell the collateral in the market
to cover the loan. The non-recourse nature of the debt
(subsection 2), combined with the fact that none of the
taxpayer’s capital is at risk (subsection 6), makes Racine’s
transaction look like example (2), in which a non-recourse
loan works like an option by allowing E to capture any
gain in the stock’s value without taking a risk of loss.
  This line of argument has been made to the Tax Court,
which has consistently rejected it (the decision in
Racine’s case is one of many) and to three other circuits,
all of which have held against the taxpayer. See Palahnuk
v. United States, 475 F.3d 1380 (Fed. Cir. 2007); Cidale v.
United States, 475 F.3d 685 (5th Cir. 2007); United States
v. Tuff, 469 F.3d 1249 (9th Cir. 2006). No court at any
6                                              No. 06-4103

level has ruled against the Commissioner on this sub-
ject. We agree with Palahnuk, Cidale, and Tuff, making
the score 4-0 among appellate tribunals.
  The keystone of Racine’s position is the contention that
she had nothing at risk, because if the price declined
the broker would liquidate the stock and recover the
balance on the loan. This fundamentally misunderstands
financial risk. Racine proceeds as if “risk” means only
risk to one’s other assets, such as her home or retirement
account. That’s not the sort of risk to which Example (2)
refers, however: the Example asks whether the investor
bears a risk that this asset’s price will decline. Racine
bore that risk. In the first half of 2000 she owned stock
trading for about $2 million. She could have sold it and
bought artworks, a new house, or an index fund that held
the Standard & Poor’s 500 portfolio and would track the
stock market as a whole. Instead she chose to remain
undiversified, keeping a risky asset in the hope that
its price would rise. She ventured $2 million and lost
most of it. (The rule limiting business-expense deductions
to amounts at risk, see 26 U.S.C. §465, which Racine
discusses at length, has nothing to do with her situation.
Section 465 does not define a “transfer” for the purpose of
§83.)
  The holder of a call option can gain but not lose, for if
the price declines the holder simply walks away from the
option. That’s the position person E (from Example 2) was
in, which is why it made sense to call E’s status that of
an option-holder even though E was the legal owner of
the shares. But Racine did not have the luxury of walk-
ing away from a decline in the stock’s price and being no
worse off. (A call option’s owner could lose if the option
is traded, for the option’s price declines with the value of
the underlying asset, but this qualification does not mat-
ter to the definition of a “transfer,” which deals with non-
traded options. An option’s owner also faces a loss in
No. 06-4103                                               7

opportunity-cost terms, but the Internal Revenue Code
does not tax opportunity costs and foregone gains. This
is why we treat an “option” as a device insulating the
owner from loss.)
  Racine also is mistaken to call her margin loan “non-
recourse debt.” Her contract with CIBC Oppenheimer
was explicit: Racine was personally liable for the full
amount. “Non-recourse debt” describes an arrangement
in which (as in Example 2) the lender agrees to look
exclusively to the collateral, and never to dun the borrower
for a deficiency if a sale of the collateral fetches less
than the balance. CIBC Oppenheimer did not agree to
collect its loan exclusively by selling shares; such a
promise would have been illegal under Regulation T.
Suppose the market in Allegiance Telecom stock had
become illiquid so that CIBC Oppenheimer could not
sell Racine’s stock, or had plunged so fast that in a single
day the market value of Racine’s stock fell below the
balance on the loan; in either situation Racine would have
had to make up any shortfall. There is a big legal differ-
ence between secured debt and non-recourse debt. A bank
that lends $100,000 against a house appraised for $1
million is well secured, but unless the bank had agreed
not to collect from the house’s owner the loan is with
recourse. If the house burns down, and its value falls to
$50,000, the owner must chip in the difference. Just so
with Racine’s margin loan. She had personal liability on
the indebtedness, so subsection (2) does not help her, and
she took a risk of loss (which came to pass), so sub-
section (6) does not help her either.
  At oral argument, Racine’s lawyer asked us to treat
CIBC Oppenheimer as if it were the issuer, on the
ground that a broker-dealer that finances employees’
exercise of stock options helps the corporation get the
tax deduction (which depends on the option being exer-
cised and the gain treated as deductable wage compensa-
8                                               No. 06-4103

tion). The “as if ” condition may have been possible in 2000,
though after the Sarbanes-Oxley Act the issuer itself can’t
make loans to its executives. Still, nothing in §1.83-3 turns
on who makes a loan; the regulation directs attention to
the financial risk that the taxpayer bears. At all events,
the as-if argument would be a poor legal fiction; CIBC
Oppenheimer was an independent broker-dealer, not an
affiliate of Allegiance Telecom. The risk that Racine took,
and her legal obligation to repay, was no different be-
cause CIBC Oppenheimer was a market maker than it
would have been if she had borrowed from any other
broker-dealer.
  A transfer occurs when a taxpayer exercises an option
and acquires full legal and beneficial ownership of stock—
for the owner is subject to market risk from that time
on. If Racine wanted to reduce her exposure, she could
have hedged with put options, or sold the stock and
invested in a diversified portfolio, or withdrawn the money
from the stock market altogether. That she decided to keep
the money in Allegiance Telecom does not alter the fact
that she owned the stock itself, rather than a call option
on stock.
                                                 AFFIRMED

A true Copy:
      Teste:

                        ________________________________
                        Clerk of the United States Court of
                          Appeals for the Seventh Circuit




                   USCA-02-C-0072—7-3-07
