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By Jonathan R. Talansky, Esq.
Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., New York,
On December 16, 2013, the Tax Court decided a case that sheds
important light on the meaning of the term "substantial risk of
forfeiture" under §83.1 The case,
Austin v. Commissioner,2 also serves as a
warning to taxpayers that borrowing terms from Treasury regulations
does not ensure that the contractual provisions will be construed
in a manner identical to the applicable regulations.
The petitioners in Austin were business partners
engaged in distressed debt investing. In 1998, the petitioners
contributed various equity interests to a newly formed S
corporation (the "Company") in exchange for 95% of the stock of the
Company.3 Both taxpayers assumed
active and significant roles in the operation of the Company's
business. As part of the incorporation of the Company, both
petitioners entered into a "Restricted Stock Agreement" ("RSA") and
an "Employment Agreement" ("EA," and together with the RSAs, the
"Agreements") that purported to govern the Company stock they
received. According to the Tax Court's opinion, "the stated purpose
of these agreements was to incentivize petitioners to exchange
their [S corporation] stock and require them to perform future
services in order to secure their full rights in the stock." The
EAs provided that the Company could terminate the Agreements at any
time "for cause." Importantly, the Agreements defined "cause" to
include three categories of employee conduct, the first of which
generally involved "bad acts" by the employee.4 One of
the other two categories of termination "for cause" was: "Failure
or refusal by the employee, after 15 days written notice to the
employee, to cure by faithfully and diligently performing the usual
and customary duties of his employment and adhere to the provisions
of this Agreement."
The RSAs described the consequences of termination. In the case
of termination for cause after December 31, 2003, the employee
would receive 100% of the fair market value of his stock; for
termination for cause prior to January 1, 2004, the employee would
receive a formula value ranging from zero to 50% of the fair market
value of the stock.
On their tax returns, the taxpayers took the position that under
§83, the Company stock was subject to a "substantial risk of
forfeiture" and was therefore "substantially nonvested" and was
properly treated as not outstanding for purposes of the rules
governing S corporations.5 As a result, the
taxpayers claimed that during the relevant periods, the ESOP was
the owner of 100% of the stock of the Company. The IRS challenged
the arrangement on a number of grounds, and the sole issue before
the Tax Court was whether the IRS had correctly asserted that the
stock was in fact "substantially vested" under §83.
The IRS relied on Regs. §1.83-3(c)(2) in support of its
position. That regulation provides, in relevant part, that
"requirements that the property be returned to the employer if the
employee is discharged for cause or for committing a crime will not
be considered to result in a substantial risk of forfeiture."6 The taxpayers, on
the other hand, argued that termination "for cause," as used in the
regulation, is not identical to the "for cause" label used in the
Agreements. Specifically, while the taxpayers conceded that the
"bad acts" prong of the "cause" definition did not cause a
cognizable forfeiture risk under the regulations, the prong
containing the "usual and customary duties" language did in fact
give rise to a forfeiture risk since it did not constitute "cause"
under the regulation.
The Tax Court agreed with the taxpayers and considered the
provision in the Agreements calling for a substantially discounted
repurchase of the restricted stock in the event either taxpayer
left his employment during thef4-year period following the
Company's incorporation a "classic" earnout restriction.
Accordingly, the taxpayers properly treated the stock as
"substantially nonvested" under §83. The court characterized the
§83 "risk of forfeiture" rules as turning on whether there is a
"real possibility that the condition may not be fulfilled." An
example from the regulations of a quintessential "earnout"
restriction is a requirement that an employee surrender stock back
to the employer at cost in the event the employee leaves the employ
of the employer "for any reason" within a 2-year period. The court
concluded that the "for cause" terminology in the regulation
(together with the explicit reference to commission of a crime) was
intended to identify situations where "the risk of forfeiture rests
upon a single possibility which is very unlikely to happen." The
court also cited Tax Court precedents holding that forfeiture risks
were absent because of the "remote" likelihood of certain
forfeiture events. In the words of the Tax Court, "as used in the
regulation, `discharged for cause' refers to termination for
serious conduct that is roughly comparable - in its severity and in
the unlikelihood of its occurrence - to criminal misconduct…and is
thus properly regarded as too remote - as a matter of law - to
create a `substantial risk of forfeiture.'"
The Tax Court in Austin provided a helpful
clarification of the meaning of termination "for cause" under Regs.
§1.83-3(c)(2). Specifically, that regulation describes forfeiture
conditions that are as unlikely (or nearly as unlikely) as the
commission of a crime or other "bad act" by the employee.7 The taxpayers in
Austin were victorious despite some "inartful"
drafting. Indeed, they were forced into a litigating position in
which they had to argue against the language of their own
agreements (namely, that what they designated as termination "for
cause" was not in fact "for cause" under the regulations). Despite
the outcome of the case in favor of the taxpayer,
Austin serves as a reminder that self-serving
language in employment or other agreements that track the
applicable tax regulations will not always hold sway when weighed
against the substance of the arrangement.
For more information, in the Tax Management Portfolios, see
Schwartz, 373 T.M., Employee Benefits for Tax-Exempt
Organizations, Eickman, 383 T.M., Nonstatutory Stock
Options, and Eickman, 384 T.M., Restricted Property-Section 83
and in Tax Practice Series, see ¶5710, Deferred Compensation Tax
Concepts and Structures, and ¶5810, Nonstatutory Stock
Copyright © 2014 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo,
5 Specifically, Regs. §1.1361-1(b)(3) states that
"For purposes of subchapter S, stock that is issued in connection
with the performance of services (within the meaning of [Regs.]
§1.83-3(f)) and that is substantially nonvested (within the meaning
of [Regs.] §1.83-3(b)) is not treated as outstanding stock of the
corporation, and the holder of that stock is not treated as a
shareholder solely by reason of holding the stock, unless the
holder makes an election with respect to the stock under section
6 Under Regs. §1.83-3(c)(1), "Property is not
transferred subject to a substantial risk of forfeiture to the
extent that the employer is required to pay the fair market value
of a portion of such property to the employee upon the return of
such property." Accordingly, the various scenarios requiring a
payment of full value to the taxpayers (namely, termination without
cause or termination for cause after Dec. 31, 2003) were not at
issue in the case because these eventualities clearly did not give
rise to a risk of forfeiture as defined by the regulations.
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