Earnout Restriction Causes Substantial Risk of Forfeiture 

    TAX TRENDS 
    by James A. Beavers, J.D., LL.M., CPA, CGMA 
    Published March 01, 2014

    Gross Income

    The Tax Court held that sections of a restricted stock agreement and an employment agreement read together constituted an earnout restriction that might create a substantial risk of forfeiture for stock transferred to an employee.

    Background

    Larry Austin and Arthur Kechijian (the taxpayers) worked together for more than 15 years in the “distressed debt loan portfolio business.” Before 1998, they were the original shareholders and members of a group of related companies called the UMLIC Entities. In December 1998, they formed, and elected subchapter S status for, UMLIC Consolidated Inc., a North Carolina corporation (UMLIC S Corp.). In a Sec. 351 transaction, each transferred his unrestricted ownership interest in the UMLIC Entities to UMLIC S Corp. in exchange for 47,500 shares of its common stock. Concurrently, UMLIC S Corp. issued 5,000 shares of its common stock, in exchange for a note, to an employee stock ownership plan (ESOP) for its employees, including the taxpayers. Thus, as of Dec. 7, 1998, the taxpayers each owned 47.5% of UMLIC S Corp., and the ESOP owned 5%.

    At the same time, as part of the Sec. 351 exchange, each taxpayer executed with UMLIC S Corp. a restricted stock agreement (RSA) and an employment agreement. The stated purpose of the agreements was to induce the taxpayers to exchange their UMLIC interests for UMLIC S Corp. stock and to require them to work for the company for a certain amount of time to obtain full rights to the stock. Under the initial term of the employment agreement, which lasted until Jan. 1, 2004, each taxpayer was required to devote all his efforts to his duties and responsibilities as an officer of the company. The agreement provided that UMLIC S Corp. could terminate the taxpayers’ employment at any time for cause. In Section 7 of the employment agreement, cause was defined to include:

    A: Dishonesty, fraud, embezzlement, alcohol or substance abuse, gross negligence or other similar conduct. . . .
    B: Failure or refusal by Employee, after 15 days written notice to Employee, to cure by faithfully and diligently performing the usual and customary duties of his employment and adhere to the provisions of this Agreement.
    C: Failure or refusal by Employee, after 15 days written notice to Employee, to cure by complying with the reasonable policies, standards and regulations applicable to employees [of the company].

    Section 4 of the RSA governed the consequences of the voluntary or involuntary termination of the taxpayers’ employment with UMLIC S Corp., addressing two types of termination: “termination without cause” and “termination with cause.” If one taxpayer were terminated “without cause, as defined in Section 7 of the Employment Agreement,” he would be deemed by the RSA to have offered to sell all of his stock to the company pursuant to the RSA, and he would receive the full value of his stock.

    If one taxpayer were terminated “with cause, as defined in Section 7 of the Employment Agreement,” he would likewise be deemed to have offered to sell all of his stock to the company. However, the purchase price would then depend on the date of the termination. If he were terminated for cause after Dec. 31, 2003, he would receive 100% of the fair market value (FMV) of his stock. If he were terminated for cause before Jan. 1, 2004, the purchase price he would receive would be at most 50% of the FMV of his stock, with the possibility of receiving nothing, as determined by a formula.

    On their income tax returns for 2000–2003, each taxpayer took the position that his UMLIC S Corp. stock was subject to a “substantial risk of forfeiture” and was thus “substantially nonvested” within the meaning of Regs. Sec. 1.83-3(b) and that, under Regs. Sec. 1.1361-1(b)(3), the stock was owned by the ESOP during those years. Accordingly, they did not report any income or other flowthrough items from UMLIC S Corp. on their individual income tax returns for 2000–2003.

    The IRS issued the taxpayers deficiency notices, in which the IRS claimed that the taxpayers were required to include the passthrough income from UMLIC S Corp. in income on their returns on a number of grounds, including that their UMLIC S Corp. stock was not subject to a substantial risk of forfeiture and thus they owned the stock (and their share of the income from UMLIC S Corp.) for the years in question. The taxpayers challenged the IRS’s determination in Tax Court.

    Sec. 83 and the Regulations

    Under Sec. 83, when property is transferred to a taxpayer in connection with services, the FMV of the property over the amount paid by the taxpayer is included in his or her income in the first year in which his or her rights in the property are not subject to a substantial risk of forfeiture (i.e., substantially vested). Under Sec. 83(c)(1), a substantial risk of forfeiture exists if the taxpayer’s rights in the property are conditioned upon the future performance of services. However, if the employer is required to pay the taxpayer the FMV of the stock upon its return, a substantial risk of forfeiture does not exist. A requirement to continue in employment with the employer for a certain period of time to receive full rights in property transferred (an earnout restriction) is a condition based on the performance of future services and creates a substantial risk of forfeiture.

    Frequently a property-transfer agreement will provide that the recipient taxpayer will give up his or her rights in the property if the employer terminates the taxpayer during the period covered by the agreement. However, Regs. Sec. 1.83-3(c)(2) states that this will not create a substantial risk of forfeiture if the taxpayer must return the property only if he or she is “discharged for cause or for committing a crime.” The idea behind this exception is that such a condition is highly unlikely to occur, so the risk of forfeiture—though real—cannot be considered substantial.

    The Parties’ Arguments

    The IRS moved for summary judgment in the case, claiming that the taxpayers owned the stock during the years in question because the agreements did not cause a substantial risk of forfeiture for the stock. The IRS pointed out that under the express language of the employment agreements and the RSAs, the only time the taxpayers could receive less than the full value for their UMLIC S Corp. stock was if the company discharged them for cause. Because Regs. Sec. 1.83-3(c)(2) states that a substantial risk of forfeiture does not exist if the property must be returned only if the recipient is discharged for cause, under the agreements, a substantial risk of forfeiture did not exist.

    In response, the taxpayers argued that the scope of the phrase “for cause” in Regs. Sec. 1.83-3(c)(2) and in their agreements with UMLIC S Corp. was not the same. They maintained that under the relevant provision of the employment agreements being terminated for cause could include being terminated for merely not performing their duties or not performing them adequately, which was outside of the meaning of “for cause” in Regs. Sec. 1.83-3(c)(2). Thus, the RSAs and employment agreements taken together included a requirement that to retain the stock the taxpayers were required to work for UMLIC S Corp. for the four-year period of the employment agreement, which was a restriction that constituted a substantial risk of forfeiture under Sec. 83(c) and Regs. Sec. 1.83-3(c)(1).

    The Tax Court’s Decision

    The Tax Court held that the agreements between the taxpayers and UMLIC S Corp. read together included an earnout restriction that could create a substantial risk of forfeiture for the taxpayers’ UMLIC S Corp. stock. Therefore, it denied the IRS’s motion for summary judgment and allowed the case to proceed. The Tax Court concluded that the meaning of “discharge for cause” in Regs. Sec. 1.83-3(c)(2) could be different from its meaning in the RSAs and employment agreements between the taxpayers and UMLIC S Corp.

    The Tax Court found that “discharge for cause” in Regs. Sec. 1.83-3(c)(2) most likely referred to a termination for serious employee misconduct that is unlikely to occur, based on the history of the regulation and the canons of statutory construction. The court explained that in the original proposed version of Regs. Sec. 1.83-3(c)(2), the exception to the substantial forfeiture rule applied only if the employee committed a crime. After the proposed regulation was issued, but before the adoption of the final regulation, the Tax Court held that an exception to the substantial-risk-of-forfeiture rule would apply in cases of intentional dishonesty that injured the employer (Ludden, 68 T.C. 826 (1977)) or theft of employer property or embezzlement (Burnetta, 68 T.C. 387 (1977)), the possibility of which the court characterized in those cases as being so remote that it did not constitute a substantial risk of forfeiture. The year after the Tax Court decided these cases, the IRS issued the final regulations that include the “discharge for cause” element, but the IRS did not specifically explain why it included this additional element in the final version of the regulation. The court found that it was a fair inference that the IRS made the revision to the regulation to codify the results in Ludden and Burnetta.

    With respect to statutory construction, the court cited the canon of construction “noscitur a sociis” (Latin for “it is known by its associates”), which holds that the meaning of an unclear word or phrase should be determined by the words immediately surrounding it. The court concluded that it could be surmised that by associating “for cause” with “for committing a crime” in Regs. Sec. 1.83-3(c)(2), the IRS intended “for cause” to denote termination for serious misconduct that is roughly comparable to criminal misconduct.

    After reviewing the employment agreements and the RSAs as a whole, the court determined that under the RSA and the employment agreement, read in conjunction, the taxpayers could be found to have a substantial risk of forfeiture with respect to their UMLIC S Corp. stock. Under Section 5(a) of the RSA, each taxpayer was required to return his stock in return for less than full FMV if he were terminated “for cause.” The conditions under which the taxpayers could be terminated “for cause” are set out in Section 7 of the employment agreements. The court found that termination for the activities specified in Section 7(A) of the employment agreements could be reasonably characterized as a discharge for cause within the meaning of Regs. Sec. 1.83-3(c)(2). However, the court also found that termination for the reasons listed in Section 7(B) would not fall under the scope of discharge for cause under Regs. Sec. 1.83-3(c)(2), even though Section 7(B) was included in a part of the employment agreements addressing termination for cause. According to the court, “section 7(B) appears to constitute, in conjunction with RSA section 5(a), a classic ‘earnout restriction.’” Therefore, the agreements could be found to create a substantial risk of forfeiture under Sec. 83(c)(1).

    Reflections

    Looked at from a different perspective, it could be said that the taxpayers clearly were not subject to a substantial risk of forfeiture for their stock despite the earnout restriction in the agreements. Together, the taxpayers owned all the shares of UMLIC S Corp. other than those owned by the ESOP and had worked together in the predecessor entities of the company for 15 years. Since there was no one else involved in the companies with the power to terminate either taxpayer, it seems likely that in fact there was very little or no chance that either man would be discharged for any reason during the stock restriction periods, making the RSAs look more like a way to avoid taxes than a way to protect the company.

    Austin, 141 T.C. No. 18 (2013)




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