Austin v. Comm'r

• Court: U.S. Tax Court
• Writing for the Court: LAUBER
• Citation: Austin v. Comm'r, 141 T.C. 551, 141 T.C. No. 18 (T.C. 2013)
• Decision Date: 16 December 2013
• Docket Number: 8967–10.,Nos. 8966–10,s. 8966–10
• Parties: Larry E. AUSTIN and Belinda Austin, Petitioners v. COMMISSIONER of INTERNAL REVENUE, Respondent. Estate of Arthur E. Kechijian, Deceased, Susan P. Kechijian and Scott E. Hoehn, Co–Executors, and Susan P. Kechijian, Petitioners v. Commissioner of Internal Revenue, Respondent.

141 T.C. No. 18

141 T.C. 551

Larry E. AUSTIN and Belinda Austin, Petitioners

v.COMMISSIONER of INTERNAL REVENUE, Respondent.Estate of Arthur E. Kechijian, Deceased, Susan P. Kechijian and Scott E. Hoehn, Co–Executors, and Susan P. Kechijian, Petitionersv.Commissioner of Internal Revenue, Respondent.

Nos. 8966–10, 8967–10.

United States Tax Court.

Dec. 16, 2013

Motion denied.

Ps exchanged property for ostensibly restricted stock of a newly formed S corporation (S). The governing agreements provided that Ps, upon termination of employment, would receive less than the full fair market value of their S shares only if they were terminated “for cause” during the initial term of the employment agreement. Section 7(B) of the employment agreement defined termination “for cause” to include termination upon “[f]ailure or refusal by Employee * * * to cure by faithfully and diligently performing the usual and customary duties of his employment.” Section 1.83–3(c)(2), Income Tax Regs., provides that a requirement that stock be forfeited “if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.”

1. Held: The term “discharged for cause,” as used in section 1.83–3(c)(2), does not necessarily have the same meaning the parties have given that term in their private agreements but refers to termination for serious misconduct which, like criminal misconduct, is highly unlikely to occur.

2. Held, further, the risk that Ps would receive less than full fair market value upon forfeiture of their stock if they failed faithfully and diligently to perform the usual and customary duties of their employment during the prescribed period constituted an earnout restriction that could create a “substantial risk of forfeiture” if there existed a sufficient likelihood that the restriction would actually be enforced.

Lynn Forrest Chandler, Jonathan P. Heyl, and Tanya N. Oesterreich, for petitioners.

Patricia Pierce Davis, Nina E. Choi, and Mark L. Hulse, for respondent.

OPINION

LAUBER, Judge:

These consolidated cases are before this Court on respondent's motion for partial summary judgment and petitioner's motion for summary judgment both filed under Rule 121.¹ The sole issue for decision is whether stock petitioners received in December 1998, which was labeled “restricted stock,” was subject to a substantial risk of forfeiture when issued to them or rather was “substantially vested” within the meaning of section 83 and section 1.83–1(a)(1), Income Tax Regs. Under the governing employment agreements, petitioners would forfeit a substantial amount of the value of their stock upon the occurrence of various events, enumerated in a paragraph that addressed termination “for cause.” Under section 1.83–3(c)(2), Income Tax Regs., a requirement that stock be forfeited “if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.” Disposition of the pending motions requires us to determine the scope of the phrase “for cause” as used in section 1.83–3(c)(2), Income Tax Regs., and the proper application of that regulation to the agreements involved here.

Background

The following facts are not in dispute. Larry Austin and Arthur Kechijian (petitioners) resided in North Carolina when they filed petitions.² Belinda Austin and Susan Kechijian are parties to these cases solely by virtue of having filed joint Federal income tax returns with their husbands for the tax years at issue.

Petitioners worked together for more than 15 years in the “distressed debt loan portfolio business.” Before 1998 petitioners were the original shareholders and members of a group of related companies called “the UMLIC Entities.” In December 1998 petitioners formed, and elected subchapter S status for, UMLIC Consolidated, Inc., a North Carolina corporation (UMLIC S–Corp.). In a section 351 transaction, each petitioner 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 petitioners. Thus, as of December 7, 1998, each petitioner owned 47.5% of UMLIC S–Corp., and the ESOP owned 5%. At all relevant times, petitioners were the only directors on the UMLIC S–Corp. board of directors. Petitioners, along with the company's assistant controller, were the initial trustees of the ESOP.

Petitioner Kechijian was employed as the president of UMLIC S–Corp. He had responsibility for general operations and for servicing loan portfolios, including workout strategies, loan sales, foreclosures, and loan modifications. Petitioner Austin was employed as senior executive vice president of UMLIC S–Corp. He had responsibility for loan portfolio acquisitions, including due diligence involved in the evaluation of loan portfolios, foreclosure gain/loss analysis, expected cashflows, bidding strategies, and investor relationships.

As part of the section 351 exchange, each petitioner executed with UMLIC S–Corp. substantially identical agreements denominated “Restricted Stock Agreement” (RSA) and “Employment Agreement.” These agreements were explicitly linked. Section 12 of the employment agreement stated that the employee's ownership of UMLIC S–Corp. shares “shall be governed by * * * [the RSA] entered into simultaneously * * * [and] incorporated herein by reference.”

The stated purpose of these agreements was to incentivize petitioners to exchange their UMLIC interests for UMLIC S–Corp. stock and require them to perform future services in order to secure full rights in this stock. The RSA stated the company's intention “to induce * * * [each petitioner's] continued employment on behalf of * * * [UMLIC S–Corp.] * * * by providing certain financial incentives under this Agreement.” Conversely, each petitioner agreed that, in consideration of UMLIC S–Corp.'s issuance of shares to him, he was “willing to perform future services on behalf of * * * [UMLIC S–Corp.] under the terms of the Employment Agreement.”

The shares issued to petitioners bore the following legend: “The shares represented by this certificate, and the transfer hereof, are subject to the terms of * * * [the RSA].” The RSA permitted limited transfer of the shares to or for the benefit of family members. However, transfer was permitted only if the transferee agreed to be bound by the RSA and hence by any restrictions on full enjoyment of the stock to which the RSA subjected petitioners.

Section 4 of the employment agreement provided that “[t]he initial term of this Agreement shall commence on December 7, 1998 * * * and shall continue until January 1, 2004.” Section 1 of the Agreement, captioned “Employment,” provided:

During the term of this Agreement * * * [employee] will devote all of his efforts to the performance of his duties as * * * [an officer of UMLIC S–Corp.] and any other duties and responsibilities the Board of Directors * * * may assign to him from time to time. Employee agrees to perform such duties and responsibilities faithfully, diligently and in a timely manner and to abide by all * * * [UMLIC S–Corp.] policies relating to its employees generally.

Section 7 of the employment agreement, captioned “Termination,” provided that “[t]his Agreement may be terminated by * * * [UMLIC S–Corp.] at any time for cause.” The Agreement makes no provision for termination by the employee, and it makes no provision for termination by the employer on grounds other than “for cause.” For purposes of the Agreement, “cause” was defined to “include, without limitation,” the following three categories of employee action:

A. Dishonesty, fraud, embezzlement, alcohol or substance abuse, gross negligence or other similar conduct on the part of the Employee. Upon termination of this Agreement, Employee shall be entitled to receive compensation through the date of termination.

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 which* * * [UMLIC S–Corp.] may establish from time to time.

Section 4 of the RSA, captioned “Termination of Employment,” governed the consequences “[i]n the event of termination, voluntary or otherwise,” of the employee's employment with UMLIC S–Corp. Section 4 addressed two types of termination: “termination without cause” and “termination with cause.” If the employee's employment was terminated “without cause, as defined in Section 7 of the Employment Agreement,” ³ he would be deemed by RSA section 4(b) to have offered to sell all of his stock to the company pursuant to RSA section 5(b). The latter provided that, if employment terminated after December 31, 2003—that is, following the end of the initial term of the employment agreement—and the employee was not in material breach of either agreement, he would receive 100% of the fair market value of his stock, as determined by formula. Regardless of his actual termination date, in other words, an employee discharged “without cause” would be treated as if he had terminated employment after December 31, 2003, and he would receive the full value of his shares.

If the employee's employment was terminated by UMLIC S–Corp. “with cause, as defined in Section 7 of the Employment Agreement,” the employee would likewise be deemed to have offered to sell all of his stock to the company under RSA sec. 4(a). However, the purchase price would then depend on the date of the termination. If the employee was terminated for cause after December...