Gudmundsson v. U.S.

• Decision Date: 11 February 2011
• Docket Number: Docket No. 09–4869–cv.
• Citation: 634 F.3d 212
• Parties: Olafur GUDMUNDSSON, Sally A. Rudrud, Plaintiffs–Appellants,v.UNITED STATES of America, Defendant–Appellee.
• Court: U.S. Court of Appeals — Second Circuit

634 F.3d 212

107 A.F.T.R.2d 2011-852

2011-1 USTC P 50,218

Olafur GUDMUNDSSON, Sally A. Rudrud, Plaintiffs–Appellants,

v.UNITED STATES of America, Defendant–Appellee.

Docket No. 09–4869–cv.

United States Court of Appeals, Second Circuit.

Argued: Sept. 20, 2010.Decided: Feb. 11, 2011.

Arnold R. Petralia, Petralia, Webb & O'Connell, P.C., Rochester, NY, for Plaintiffs–Appellants.Ellen Page Delsole, Attorney, United States Department of Justice, Tax Division (Kenneth L. Greene, on the brief, William J. Hochul, Jr., United States Attorney for the Western District of New York, of counsel), for John A. DiCicco, Acting Assistant Attorney General, for Defendant–Appellee.Before: CALABRESI, KATZMANN, and CHIN, Circuit Judges.CHIN, Circuit Judge.

In 2000, plaintiffs-appellants Olafur Gudmundsson (“Gudmundsson”) and Sally Rudrud (together, “plaintiffs”) ¹ jointly filed their 1999 federal tax return, reporting income earned on stock Gudmundsson received as compensation from his employer, Aurora Foods, Inc. (“Aurora”), on July 1, 1999. The stock was subject to several contractual and legal restrictions that impeded its marketability for one year—by which point the company's stock value had plummeted. Plaintiffs sought to amend the tax return and obtain a refund, asserting that they had prematurely reported the stock and significantly overvalued it as income under § 83 of the Internal Revenue Code (the “I.R.C.”). After exhausting their administrative remedies, they brought this action against the government in the Western District of New York. In a thoughtful and thorough decision, the district court (Larimer, J.) granted summary judgment in favor of the government. We affirm.

STATEMENT OF THE CASE

A. The Facts

The parties stipulated to the following facts before the district court.

At all relevant times, Gudmundsson was an officer of Aurora, which marketed food products under brand names such as Aunt Jemima, Duncan Hines, and Van de Kamp. Shortly after a corporate reorganization, Aurora made an initial public offering of 14,500,000 registered shares of common stock on July 1, 1998 (the “IPO”). Gudmundsson became entitled to 73,105 unregistered shares (the “Stock”) by virtue of his participation in Aurora's incentive compensation plan. The plan provided for the Stock to be distributed to him one year from the date of the IPO, on July 1, 1999. Gudmundsson received the Stock as planned.

Aurora subsequently provided Gudmundsson a W–2 that calculated his income from the distribution to be a little less than $1.3 million. This figure reflected the mean price of unrestricted shares of Aurora stock trading on the New York Stock Exchange (the “Exchange Price”) on July 1, 1999: $17.6875. Gudmundsson reported this amount as income under I.R.C. § 83—which governs the taxation of property transferred in connection with the performance of services—in the federal tax return he filed jointly with his then-wife, on or before April 15, 2000.

Gudmundsson held the Stock subject to several constraints. First, these were “restricted securities” under Securities and Exchange Commission (“SEC”) Rule 144, 17 C.F.R. § 230.144(a)(3)(i), meaning they were acquired directly from the issuer and not in a public offering, id. Under Rule 144, the Stock could not be sold on a public exchange until the expiration of a holding period that, in Gudmundsson's case, ended on July 1, 2000. See Berckeley Inv. Grp., Ltd. v. Colkitt, 455 F.3d 195, 213 (3d Cir.2006) (discussing the operation of Rule 144). The Stock could, however, be disposed of in a private placement sale or pledged as security or loan collateral. See McDonald v. Comm'r, 764 F.2d 322, 323 n. 3 (5th Cir.1985) (citing 17 C.F.R. § 230.144(a)(3)).

Second, the Stock was subject to an agreement among Aurora's various corporate entities and employee “members,” including Gudmundsson (the “Agreement”). The Agreement prohibited, inter alia, the public disposition of the Stock before the second anniversary of the IPO, July 1, 2000. Until then, transfers could be made only to a group of “permitted transferees,” which included family members and relatives. Permitted transferees were bound by the Agreement and had to agree in writing to abide by its terms. Aurora would treat any transfers other than to permitted transferees as null and void, and in some instances it could intervene to stop a forbidden transfer. Forfeiture of the Stock, however, was not one of the penalties contemplated for violations of the Agreement, whether by Gudmundsson or a permitted transferee.

Finally, Gudmundsson was subject to Aurora's Insider Trading Policy (the “Policy”). Among other things, the Policy required compliance with certain waiting periods and consent procedures prior to trading Aurora stock. Violation of the Policy could result in disciplinary action, including termination of employment.

Conditions at Aurora deteriorated in the year between Gudmundsson's receipt of the Stock and expiration of the restrictions imposed by the Agreement and Rule 144. Unrestricted shares of Aurora stock—which had been worth $17.6875 per share on July 1, 1999—lost a quarter of their value over three days that November following the company's announcement that it would not meet estimated fourth quarter earnings. By December 31, 1999, the Exchange Price had fallen to $9.25.

In February 2000, Aurora's auditors discovered irregularities in the company's financial statements, and the board of directors announced the formation of a committee to investigate Aurora's accounting practices and the possibility of fraud. Several senior-level executives resigned.² The Exchange Price tumbled another fifty percent. That April, Aurora announced an $81 million downward adjustment in pretax earnings previously reported for most of 1998 and 1999. By the time the Stock was freely marketable on July 1, 2000, the Exchange Price had fallen to $3.8375, a decline of almost $14 in one year.

B. Prior Proceedings

In 2003, plaintiffs filed an amended tax return, claiming a refund of $301,834 plus interest based on the mean Exchange price of Aurora stock on December 31, 1999,³ rather than the price on July 1, as originally reported. The Internal Revenue Service (the “IRS”) disallowed the claim in 2006. On March 20, 2008, plaintiffs filed this refund action below, pursuant to 28 U.S.C. § 1346(a)(1) and 26 U.S.C. § 7422.

In the proceedings before the district court, the parties agreed that the transaction was governed by I.R.C. § 83 and that the Stock was “transferred” to Gudmundsson within the meaning of that provision on July 1, 1999. They disagreed as to when the Stock became taxable income. The government argued that the original tax return had properly reported the Stock on July 1, 1999, and properly used the Exchange Price that day as the measure of value. Plaintiffs contended that they had been premature to treat the Stock as income on July 1, 1999, given the restrictions still encumbering it at the time. Alternatively, they argued that if July 1, 1999 was the correct recognition date, then the Stock should not be treated as if it could be sold at the same price as Aurora's unrestricted shares.

The parties cross-moved for summary judgment. On October 27, 2009, the district court (Larimer, J.) entered summary judgment in favor of the government, holding that the Stock was reportable as of July 1, 1999 and that the day's Exchange Price was an appropriate basis for measuring the income received. See Gudmundsson v. United States, 665 F.Supp.2d 227, 236–39 (W.D.N.Y.2009). This appeal followed.

DISCUSSION

A. Standard of Review

This Court reviews a decision granting summary judgment de novo. Beth Israel Med. Ctr. v. Horizon Blue Cross & Blue Shield of N.J., Inc., 448 F.3d 573, 579 (2d Cir.2006). Summary judgment is appropriate “if there is no genuine issue as to any material fact, and if the moving party is entitled to a judgment as a matter of law.” Allianz Ins. Co. v. Lerner, 416 F.3d 109, 113 (2d Cir.2005) (citing Fed.R.Civ.P. 56(c)). The facts of this case were stipulated and therefore only questions of law are presented.

B. Taxation of Property under I.R.C. § 83

At the heart of this case is I.R.C. § 83, which governs the taxation of property transferred in connection with the performance of services.⁴ Section 83 was enacted as part of the Tax Reform Act of 1969, Pub.L. No. 91–172, 83 Stat. 487 (1969). It was designed to “curb the use of sales restrictions to defer taxes on property given in exchange for services,” Robinson v. Comm'r, 805 F.2d 38, 41 (1st Cir.1986), which had become a popular practice among corporations and their employees. The provision's general rule, set forth in § 83(a), has both a timing element and a valuation element. As a matter of timing, property received as compensation is to be recognized as income as soon as the recipient's rights therein are “transferable” or no longer “subject to a substantial risk of forfeiture,” whichever happens first. I.R.C. § 83(a); see also Treas. Reg. § 1.83–3(b). The value of the income received is the property's “fair market value,” measured without regard to any restriction, “other than [a] restriction which by its terms will never lapse,” I.R.C. § 83(a)—also known as a “nonlapse” restriction, as distinguished from one that will “lapse,” see Treas. Reg. § 1.83–3(h), (i).

Both the timing and valuation components are at issue in this case, which presents two questions: (1) when was it appropriate to recognize the Stock as taxable income?, and (2) what was its fair market value on that date? We address these issues in turn.

1. The Recognition Date

Plaintiffs argue that the district court erred in recognizing the Stock as income on July 1, 1999. They contend that the restrictions still in force on that date rendered it both non-transferable and subject to a substantial risk of forfeiture.⁵ To survive summary judgment, plaintiffs needed to show the existence of both these conditions, as § 83(a)...