* Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not

be published and is not precedent except under the limited circumstances set forth in 5TH CIR.

R. 47.5.4.

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 06-20896

In The Matter Of: JAMES PAVLOSKY; DEBORAH THUMANN-PAVLOSKY

Debtors

JAMES PAVLOSKY; DEBORAH THUMANN-PAVLOSKY

Appellants

v.

UNITED STATES OF AMERICA, INTERNAL REVENUE SERVICE

Appellee

Appeal from the United States District Court

for the Southern District of Texas, Houston

USDC No. 4:06-CV-2061

Before KING, BARKSDALE, and DENNIS, Circuit Judges.

PER CURIAM:*

Plaintiffs-appellants James Pavlosky and Deborah Thumann-Pavlosky

filed a core adversary proceeding in their Chapter 13 bankruptcy seeking a tax

abatement of $147,538 for taxable year 2000 and a refund of $26,030 for taxable

United States Court of Appeals

Fifth Circuit

F I L E D

December 4, 2007

Charles R. Fulbruge III

Clerk
No. 06-20896

2

year 2001 from defendant-appellee,the United States Internal Revenue Service.

The bankruptcy court granted the Internal Revenue Service’s motion for

summary judgment and dismissed with prejudice thePavloskys’ complaint. The

bankruptcy court determined thatthe Pavloskys’ 2001 capital loss from the sale

of certain stock obtained through the exercise of an incentive stock option did not

give rise to a net operating loss for purposes of the regular income tax or the

alternative minimum tax net operating loss deduction. Consequently, the

Pavloskys could not carry that capital loss back to taxable year 2000 to offset the

income realized in that year on the exercise of the stock option or use the capital

loss to offset their ordinary income for taxable year 2001. The Pavloskys appeal

the district court’s judgment affirming the bankruptcy court. We AFFIRM.

I. FACTUAL AND PROCEDURAL BACKGROUND

The case arises from an adversary complaint filed by Chapter 13 debtors

James Pavlosky and Deborah Thumann-Pavlosky (“Taxpayers”) against the

Internal Revenue Service (the “IRS”). Taxpayers asked the bankruptcy court to

determine federal income tax liability relative to their alternative minimum tax

(“AMT”), resulting from the exercise of an incentive stock option (“ISO”).

Taxpayers and the IRS stipulated to the relevant facts of this case.

James Pavlosky (“Pavlosky”) was employed by Network Appliance, Inc.,

during tax years 1999, 2000, and 2001. Network Appliance granted Pavlosky

ISOs that allowed him to acquire shares of Network Appliance stock as part of

his compensation package.

On December 20, 2000, Pavlosky exercised an ISO that allowed him to

acquire 30,000 shares of Network Appliance stock. Pavlosky paid $3.2040 per

share, and each share had a fair market value (“FMV”) of $53.75 on the date of

exercise. Thus, Pavlosky paid $96,120 for stock with a FMV of $1,612,500.

Taxpayers chose not to sell the shares in 2000. Throughout 2001, but within

twelve months of the exercise date of December 20, 2000, Taxpayers sold 28,944
No. 06-20896

3

of the 30,000 shares they had acquired for total sales proceeds of $200,345.95.

The per share sales price in each of these sales ranged from $6.2806 to $9.8217,

representing a loss from the AMT basis, as represented by the FMV ofthe shares

at the time of exercise. 

Taxpayers originally filed a joint tax return for taxable year 2000 that

included, for AMT purposes, income stemming from the exercise of the ISO in

that year. As discussed above, though, the incentive stock was sold at a

substantial loss relative to its AMT basis throughout 2001. Consequently, in

2004, Taxpayers filed an amended 2001 tax return treating the loss realized on

the sale of the stock as a net operating loss (“NOL”) deduction, which eliminated

their tax liability for that year. Taxpayers also filed an amended 2000 return,

in which they attempted to carry back to that year the remainder of their loss

to reduce their AMT liability for 2000. The IRS disallowed the claims for refund

contained in the amended returns.

On January 24, 2005, Taxpayers filed a voluntary petition for Chapter 13

bankruptcy relief in the United States Bankruptcy Court for the Southern

District of Texas. On May 11, 2005, the Taxpayers filed an adversary proceeding

in the bankruptcy court, wherein they requested a determination oftheir income

taxes for the years 2000 and 2001. After entering a joint stipulation, the parties

filed cross-motions for summary judgment on the issue whether the Internal

Revenue Code (the “Code”) permitted taxpayers to treat their 2001 losses on the

sale of stock as a NOL for purposes of the AMT. 

On June 1, 2006, the bankruptcy court ruled for the IRS. The bankruptcy

court rejected Taxpayers’ contention that Congress intended in all situations

that gains and losses from the exercise of an ISO and subsequent sale of the

acquired stock offset each other, concluding thatthe Code reserved this relief for

transactions occurring within the same taxable year, not any consecutive 12

month period, thus rendering taxpayers ineligible for such relief.
No. 06-20896

4

Taxpayers appealed to the United States District Court for the Southern

District of Texas. The IRS again relied on the Code’s provisions dealing with

capital loss limitations and the AMT, and Taxpayers focused on the alleged

intent of Congress, as well as a number of policy and equitable considerations.

On October 5, 2006, the district court issued its Memorandum and Order ruling

for the IRS. It concluded that 26 U.S.C. (“I.R.C.”) §§ 56 and 1211 governed the

matter, and, consequently, that the capital loss limitations applied for purposes

of the AMT, as well as the regular tax. The district court also rejected the tax

relief intent that taxpayers attempted to ascribe to Congress, determining that

Taxpayers’ conjectures in this regard were unsupported by either the actual

language of the Code or specific legislative history.

Taxpayers filed a timely notice of appeal to our court.

II. DISCUSSION

Taxpayers’ argumentthattheir loss in 2001 constitutes a regular tax NOL

that may be used to offset their ordinary income in the year 2001 and an

alternative tax net operating loss (“ATNOL”) that may be carried back to offset

the income realized in 2000 on Pavlosky’s exercise of the ISO is foreclosed by our

recent opinion in Merlo v. Commissioner of Internal Revenue, 492 F.3d 618 (5th

Cir. 2007). In rejecting the claim of the taxpayer in Merlo that he was entitled

to carry back the loss he incurred when his incentive stock subsequently became

worthless, we explained that once the taxpayer exercised his ISO, he began

holding the stock he acquired as a capital asset. 492 F.3d at 623. As such, the

loss he incurred in the following year was a capital loss. Id. We consequently

held that, under the applicable Code provisions, the capital loss incurred by the

taxpayer in Merlo did not give rise to a NOL or ATNOL that could be carried

back to offset the AMT he realized upon the initial exercise of his ISO. Id. at

623–24. Our holding in Merlo is dispositive of Taxpayers’ similar attempt in the
No. 06-20896

1 Sections 56(b) and 56(b)(3) provide: 

(b) Adjustments applicable to individuals.—In determining the

amount of the alternative minimum taxable income of any

taxpayer (other thana corporation),the following treatment shall

apply (in lieu of the treatment applicable for purposes of

computing the regular tax):

. . . .

(3) Treatment of incentive stock options.—Section 421

shall not apply to the transfer of stock acquired pursuant

to the exercise of an incentive stock option (as defined in

section 422). Section 422(c)(2) shall apply in any case

where the disposition and the inclusion for purposes of this

part are within the same taxable year and such section

shall not apply in any other case. The adjusted basis of

any stock so acquired shall be determined on the basis of

the treatment prescribed by this paragraph.

I.R.C. §§ 56(b), (b)(3) (emphasis added). 

5

instant case to carry back the capital loss they incurred on the sale of their

incentive stock in 2001.

Additionally, Taxpayers’ assertion that their case is distinguishable from

Merlo because, unlike the taxpayer there,they made a disqualifying disposition,

within the meaning of I.R.C. §§ 421 and 422, of the stock they acquired upon

Pavlosky’s exercise of the ISO is meritless. The exercise of an ISO is not a

taxable eventfor regular tax purposes. Id. § 421. Section 421, however, does not

apply for purposes of the AMT, and, thus, the exercise of an ISO is a taxable

event for AMT purposes.1I.R.C. § 56(b)(3); Merlo, 492 F.3d at 621. If a taxpayer

makes a disqualifying disposition under I.R.C. § 422 of his incentive stock

because he fails to meetthe holding period requirements, he will realize ordinary

income, as opposed to a capital gain, for regular tax purposes, in the year the

disposition occurs. I.R.C. § 421(b). As indicated above, however, section 421

does not apply for purposes of the AMT, and the special rule of I.R.C. § 422(c)(2),

allowing for losses sustained from a disqualifying disposition of incentive stock
No. 06-20896

6

to offset the gross income includible from the exercise of the ISO, applies in the

AMTcontext only where the exercise of the ISO and the disqualifying disposition

occur in the same taxable year “and such section shall not apply in any other

case.” Id. § 56(b)(3); see supra n.1.

In the instant case, Pavlosky exercised his ISO in 2000, and Taxpayers

made their claimed disqualifying disposition of the incentive stock in 2001. It

therefore follows that neither I.R.C. § 421 nor I.R.C. § 422 has any application

in this case for purposes of computing Taxpayers’ AMT. Accordingly, Taxpayers’

reference to these provisions provides no basis to distinguish our decision in

Merlo that a capital loss realized with respect to stock acquired pursuant to the

exercise of an ISO does not give rise to a NOL or ATNOL that can be carried

back to offset the AMT realized on the exercise of the option. 492 F.3d at

623–24.

III. CONCLUSION

For the foregoing reasons, we AFFIRM the district court’s judgment.