Estate v. Comm'r

• Decision Date: 23 June 2020
• Docket Number: No. 18-2402,No. 18-2277,18-2277
• Citation: 962 F.3d 800
• Parties: ESTATE OF Arthur E. KECHIJIAN, Deceased; Susan P. Kechijian, individually and as co-executor; Scott E. Hoehn, co-executor, Petitioners – Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent – Appellee. Larry E. Austin; Belinda Austin, Petitioners – Appellants, v. Commissioner of Internal Revenue Service, Respondent - Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

962 F.3d 800

ESTATE OF Arthur E. KECHIJIAN, Deceased; Susan P. Kechijian, individually and as co-executor; Scott E. Hoehn, co-executor, Petitioners – Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent – Appellee.

Larry E. Austin; Belinda Austin, Petitioners – Appellants,

v.Commissioner of Internal Revenue Service, Respondent - Appellee.

No. 18-2277

No. 18-2402

United States Court of Appeals, Fourth Circuit.

Submitted: May 8, 2020

Decided: June 23, 2020

Lynn F. Chandler, Stephanie C. Daniel, Lucas D. Garber, SHUMAKER, LOOP & KENDRICK, LLP, Charlotte, North Carolina, for Appellants. Richard E. Zuckerman, Principal Deputy Assistant Attorney General, Richard Farber, Jennifer M. Rubin, Tax Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

Before WILKINSON, NIEMEYER, and KING, Circuit Judges.

Affirmed by published opinion. Judge Wilkinson wrote the opinion, in which Judge Niemeyer and Judge King joined.

WILKINSON, Circuit Judge:

This case concerns the federal income tax consequences arising from a complex set of business transactions orchestrated by petitioners Arthur Kechijian and Larry Austin.¹ The IRS Commissioner maintains that petitioners substantially underreported their taxable income for the 2004 tax year. After a trial, the Tax Court agreed. It held that petitioners had failed to report approximately $41.2 million of compensation income that they realized when certain restricted stockholdings that they owned became substantially vested in January 2004. The Tax Court also upheld the Commissioner's decision to impose accuracy-related penalties for negligence and substantial understatement of tax liability, and it denied petitioners’ post-trial attempt to offset their underreported income with various net operating loss carrybacks. Petitioners challenge each of these holdings. After careful review of the record, we find no error in the Tax Court's rulings and accordingly affirm its judgment. Petitioners cannot be allowed to proceed on any assumption that the sheer complexity of their corporate transactions will assist them in the evasion of their appropriate tax liability.

I.

A.

Petitioners were partners in the distressed debt loan portfolio business for approximately fifteen years, beginning in 1990. At the most basic level, petitioners’ business entailed raising funds from outside investors to finance the acquisition of distressed debt from financial institutions and government agencies. Corporate entities controlled by petitioners would then own and service that debt. Each man brought a different set of skills to their partnership. Austin performed "front-end work," such as acquiring loan portfolios, conducting due diligence on potential acquisitions, formulating bid strategies, performing cashflow analyses, and maintaining investor relationships. On the other hand, Kechijian performed "back-end work," including servicing the loan portfolios, collection activities, human resources, and other back-office operations.

In 1998, petitioners reorganized their business. Prior to that year, petitioners were the owners and operators of a group of corporations and limited liability companies ("LLCs") known as the "UMLIC entities." Petitioners decided to consolidate the separate UMLIC entities into a single holding company known as UMLIC Consolidated, Inc. (the "UMLIC S-Corp."). UMLIC S-Corp. was a North Carolina corporation for which petitioners elected so-called "S corporation status." The goals of this restructuring were threefold: (1) allowing assets to be moved more efficiently between the various entities; (2) reducing the number of tax and financial filings the businesses were required to make; and (3) achieving substantial tax benefits.

To effectuate the contemplated reorganization, petitioners executed a series of transactions relevant to the instant case. First, each man transferred the entirety of his shareholdings in the UMLIC entities, each valued at $142,566, to UMLIC S-Corp. in return for 47,500 shares of UMLIC S-Corp. common stock. Simultaneously, petitioners executed two collateral agreements, the Restricted Stock Agreement ("RSA") and the Employment Agreement ("EA"). Taken together, these agreements provided that either petitioner would lose at least 50% of the value of his UMLIC S-Corp. stock if he voluntarily terminated his employment with the company before January 1, 2004. This five-year "earnout" period was designed to incentivize petitioners to continue working for UMLIC S-Corp. so that the new company would benefit from their diverse skill sets.

The ownership of UMLIC S-Corp. was further divided over the next few years. In December 1998, petitioners created an employee stock ownership plan ("ESOP") for UMLIC S-Corp. The ESOP purchased 5,000 shares of UMLIC S-Corp. common stock at a price of $500,000. In August 1999, petitioners each transferred 24,500 shares of their UMLIC S-Corp. stock to two new, irrevocable trusts established for the benefit of their families. These shares remained subject to the RSA and EA. Thus, as of August 1999, petitioners, their trusts, and the ESOP were the only shareholders of UMLIC S-Corp.

As alluded to above, petitioners had an additional, non-business motive for creating this elaborate corporate shareholding structure, namely the deferral of federal income tax on the profits of UMLIC S-Corp. Four background principles are necessary to understand this intricate scheme. First, I.R.C. § 83 applies where property, including stock, is transferred to a taxpayer "in connection with the performance of services." At the taxpayer's election, he may defer tax inclusion of any gains from such a transfer until the first taxable year in which his rights in the property "are not subject to a substantial risk of forfeiture," 26 U.S.C. § 83(a), i.e. , when his rights become "substantially vested," 26 C.F.R. § 1.83-1. Importantly, such rights "are subject to a substantial risk of forfeiture if ... [they] are conditioned upon the future performance of substantial services by any individual." 26 U.S.C. § 83(c)(1). Second, under the Internal Revenue Code ("IRC"), an S corporation does not itself pay income taxes; rather, it passes any income or losses it makes through to its outstanding shareholders who must then report the same on their individual income tax returns. Third, restricted stock in an S corporation "that is issued in connection with the performance of services ... and that is substantially nonvested ... is not treated as outstanding stock of the corporation" for tax purposes. 26 C.F.R. § 1.1361-1(b)(3). As such, profits or losses of an S corporation will not flow through to a holder of non-vested stock and need not be included on the holder's individual income tax returns. Fourth, an ESOP is a tax-exempt entity.

In combination, these principles allowed petitioners to avoid reporting any income from UMLIC S-Corp. on their federal tax returns from 2000 to 2003, despite the fact that the company was profitable during that period. The Tax Court aptly summarized the functioning of this scheme: "[petitioners] took the position that their stock (and that owned by their grantor trusts) was subject to a ‘substantial risk of forfeiture’ and was thus ‘substantially nonvested’.... Because the 95,000 shares owned by petitioners and their grantor trusts were deemed to be ‘non-outstanding,’ UMLIC S-Corp. for tax years 2000–2003 allocated 100% of its income, losses, deductions, and other tax items to the ESOP. Consistently with the company's reporting, neither petitioner reported any flow-through items from UMLIC S-Corp. on the joint return he filed with his spouse for 2000, 2001, 2002, or 2003. And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from UMLIC S-Corp. for 2000–2003." Austin v. Comm'r , T.C. Memo. 2017-69 at *14–15. In other words, between 2000–2003, no one paid any federal income tax on UMLIC S-Corp.’s profits.

In late 2003, petitioners again undertook to restructure their business operations. This second reorganization was undertaken for two purposes. First, petitioners hoped to attract greater outside investment from hedge funds and private equity firms, which they felt would be difficult while the business continued to operate as an S corporation. Second, Congress had amended the tax laws to close the loophole by which petitioners had avoided reporting taxable income on the earnings of UMLIC S-Corp. As such, the existing structure would cease to provide tax benefits as of January 1, 2005.

To effectuate this restructuring, petitioners formed UMLIC Holdings, LLC ("Holdings"), a Delaware limited liability corporation in which petitioners each held a 50% interest. In November 2003, Holdings purchased all of UMLIC S-Corp.’s operating assets in exchange for a $190 million interest-bearing promissory note and the assumption of various liabilities. Though UMLIC S-Corp. realized $174.6 million of capital gain on this sale, it allocated the entirety of that gain to the tax-exempt ESOP, which, according to petitioners, was still the only outstanding shareholder of UMLIC S-Corp.

On January 1, 2004, the restrictions imposed by the RSA and EA on petitioners’ UMLIC S-Corp. stock lapsed and their shares became fully vested. At this point, the fair market value of the shares held by each petitioner and his respective trust was approximately $45.9 million. But petitioners did not hold these shares for long. On March 30, 2004, petitioners entered into identical "surrender" and "subscription" agreements with UMLIC S-Corp. (the "Surrender Transactions"). Pursuant to the Surrender Transactions, petitioners purported to (1) return the entirety of their newly vested shares to UMLIC S-Corp. and (2) simultaneously repurchase 47,500 identical shares from UMLIC S-Corp. in exchange for a $41.5 million promissory note. On their 2004 income tax returns, petitioners reported $4.5 million in compensation income from this series of transactions,...