Theophilos v. C.I.R.

• Decision Date: 31 May 1996
• Docket Number: No. 94-70634,94-70634
• Citation: 85 F.3d 440
• Parties: -2329, 96-1 USTC P 50,293, 29 UCC Rep.Serv.2d 977, 96 Cal. Daily Op. Serv. 3851, 96 Daily Journal D.A.R. 6319 Anthony THEOPHILOS; Patricia A. Theophilos, Petitioners-Appellants, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 440

85 F.3d 440

77 A.F.T.R.2d 96-2329, 96-1 USTC P 50,293,

29 UCC Rep.Serv.2d 977,

96 Cal. Daily Op. Serv. 3851,

96 Daily Journal D.A.R. 6319

Anthony THEOPHILOS; Patricia A. Theophilos, Petitioners-Appellants, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 94-70634.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Jan. 9, 1996.

Decided May 31, 1996.

Lawrence B. Silver, Greene, Radovsky, Maloney & Share, San Francisco, California, for petitioners-appellants.

Bruce R. Ellisen, Tax Division, United States Department of Justice, Washington, DC, for respondent-appellee.

Appeal from a Decision of the United States Tax Court, Tax Ct. No. 8450-91.

Before: LAY, ^* CHOY and PREGERSON, Circuit Judges.

LAY, Circuit Judge:

This appeal is from a deficiency judgment rendered by the Tax Court. The Tax Court found that when the taxpayer ¹ acquired stock in a closely held corporation on December 10, 1986, he incurred taxable income for the excess of the fair market value of the property over the amount paid for the property under § 83(a) of the Internal Revenue Code. ² See Theophilos v. Commissioner, 67

                T.C.M.  (CCH) 2106, 1994 WL 31445 (1994).   The taxpayer does not dispute he received property from his employer under § 83(a), but asserts he possessed a contract to acquire the stock in 1985 when he agreed to resign from his law firm to join Greater Suburban Mortgage (GSM), a California corporation engaged in the mortgage banking business.   At that time, the taxpayer contends, he agreed to pay full value for the stock and, as a result, did not incur any taxable income under § 83(a).   The Commissioner argues the taxpayer did not pay full value for the stock and that all he acquired before December 10, 1986, was an option to purchase stock which is expressly not covered as a transfer of property under § 83(e)(3). 3  The Tax Court found the taxpayer had entered into an executory contract containing conditions yet to be performed.   On this basis, the Tax Court found that the taxpayer did not acquire the stock until December 10, 1986, when the taxpayer received 1,020 shares of GSM's Class B common stock, which was valued at $2,366,479;  that taxpayer had paid only $10,000 for the stock;  and that, therefore, he had a deficiency in income tax to be assessed in the amount of $1,185,415 for the taxable year of 1986 and $2,446 for the taxable year of 1987.   The taxpayer appeals.   We find the taxpayer received property in the form of a binding contract to acquire GSM stock in April 1986.   Thus, we reverse the judgment of the Tax Court and remand for further proceedings consistent with this opinion
                

FACTS

In February 1985, the taxpayer and George Beegle, the sole shareholder of GSM, first discussed the possibility that the taxpayer would leave his law firm and join GSM as its chief executive officer. On May 3, 1985, the taxpayer summarized his understanding of his agreement to join GSM in a letter, which Beegle acknowledged as an accurate reflection of their agreement as of May 1985. The letter stated the parties intended to become partners, but provided that Beegle "will always be the 'controlling' party;" that the partners would split GSM's earnings after April 1, 1985, on a "40/60" basis, forty percent for the taxpayer and sixty percent for Beegle; and that the split would be achieved by the taxpayer's purchase from Beegle of options on forty percent of GSM's stock. The letter recognized the parties had not reached a "meeting of the minds," and negotiations over the terms of the taxpayer's employment with GSM continued.

On October 1, 1985, the taxpayer formally withdrew from his law firm, joined GSM, and soon became its president and chief executive officer. Later that month the parties rejected a draft agreement under which the taxpayer would have purchased 300 shares of GSM stock from Beegle for $240,000 and 125 shares of GSM stock from GSM for $100,000. ⁴ During the last quarter of 1985, Richard Conger, a tax partner at Coopers & Lybrand, recommended that "a portion of GSM's future appreciation could be shifted to [the taxpayer] by creating 'frozen' preferred stock to be retained by Beegle, and [selling] new common stock to [the taxpayer]." 67 T.C.M. at 2109. The Tax Court found that "[u]ltimately, a modified version of Conger's plan was agreed upon--the modification being that two classes of common stock, rather than preferred and common stock, were used." Id. Conger's plan required GSM to restructure its capital stock.

In February 1986, to implement Conger's plan, GSM determined its value as of September 30, 1995, was $2,130,200, and retained its accounting firm, Hood & Strong, to formally review this valuation. In April 1986, after the circulation of several drafts, the taxpayer and Beegle executed a shareholder agreement, two employment agreements, and The April 1986 shareholder agreement, which was back-dated to January 15, 1986, provided:

other documents in connection with the restructuring of GSM's stock. ⁵

C. ... The Company has adopted a Plan of Recapitalization....

D. Immediately following the effective date of the Plan of Recapitalization, (the taxpayer) will purchase from Beegle all of the issued and outstanding 1,020 shares of the Class B Common Stock held by Beegle, at the fair market value of such shares, which the parties have agreed is $10.00 per share, or $10,200.

Joint Ex. 23-W at 1. The agreement also reflected the parties' intent to provide a total $2,120,580 liquidation preference for Class A common stock, to be retained by Beegle. This liquidation preference approximated GSM's value as of September 1985 less the amount to be paid by the taxpayer. ⁶ The agreement restricted the transfer of the taxpayer's rights to buy shares, and gave GSM a right of first refusal to repurchase from the taxpayer his shares or "any right or interest therein." Id. at 2. If GSM terminated the taxpayer, the agreement provided he would sell his shares to GSM or Beegle at a price based on GSM's value, "determined in accordance with generally accepted accounting principles," less the liquidation preference retained by Beegle. Id. at 4.

On October 1, 1986, GSM filed amended articles of incorporation with the state, formally creating two classes of common stock, Class A and Class B. This reorganization was treated as a tax-free reorganization under I.R.C. § 368(a)(1)(E) ⁷ based on Conger's understanding that the taxpayer did not own any GSM stock at that time. In November 1986, Hood & Strong issued a written report confirming the fair market value of $2,130,200 for GSM as of September 30, 1985. Finally, on December 10, 1986, Beegle transferred all 1,020 shares of Class B stock to the taxpayer in exchange for a $10,000 promissory note. The taxpayer paid the note in January 1987. Neither GSM nor the taxpayer reported this transaction in their tax returns for 1985, 1986, or 1987.

The taxpayer resigned as GSM's president in late 1987 after a series of disagreements with Beegle and asked GSM to purchase his stock pursuant to the shareholder agreement. GSM refused, contending the entire shareholder agreement was invalid. In April 1989, the parties agreed GSM would pay the taxpayer $1.75 million and the taxpayer's acquisition of GSM stock would be rescinded. ⁸ After this settlement, however, GSM obtained a financial report from the Newport Group valuing the Class B stock at $3,526,320 as of December 31, 1986, which reflected the dramatic increase in GSM's value during 1986. ⁹ GSM then issued a new W-2c statement The Commissioner determined that the taxpayer received $3,516,320 in income pursuant to I.R.C. § 83 from the receipt of GSM stock on December 10, 1986 and assessed the taxpayer with a tax deficiency along with more than $500,000 in penalties. The Tax Court found the Commissioner had overvalued GSM's servicing portfolio, however, and held that the taxpayer received $2,356,479 in income from the stock on December 10, 1986. The Tax Court also found the taxpayer was not liable for any penalties.

                of corrected income to the taxpayer, indicating that his 1986 wages should be increased by $3,516,320 (the Class B stock's value in the Newport Group's report less the $10,000 paid).   GSM also claimed a $3,516,320 deduction in an amended tax return for 1986. 10
                

THE TAXPAYER'S "PROPERTY" UNDER § 83

On appeal, the taxpayer contends the property he received from GSM was a binding contract to acquire stock in GSM, which he obtained as early as May 1985. ¹¹ The Commissioner, on the other hand, contends that, at best, the taxpayer held an option contract to buy GSM's stock which he did not exercise until December 10, 1986. The Commissioner also argues that even if GSM transferred a binding contractual right to the taxpayer under § 83, the right was subject to a "substantial risk of forfeiture" at least until GSM amended its articles of incorporation to provide for two classes of stock on October 1, 1986.

The Tax Court found that the taxpayer did not pay for his shares until December 10, 1986, and that before such payment the taxpayer had nothing more than an executory contract conditioned on events yet to be performed. The Tax Court relied on a series of cases pre-dating the enactment of § 83 which hold that a person does not acquire a beneficial ownership interest in a company until he has fully performed all conditions precedent to the acquisition or furnished all required consideration for the transfer. ¹² Under this analysis, the Tax Court valued the taxpayer's stock in GSM as of December 10, 1986.

Congress's primary intention in enacting § 83 was to address the disparity created by the favorable treatment of restricted stock plans vis-a-vis other mechanisms for providing deferred compensation. See Alves v. Commissioner, 734 F.2d 478, 480-81 (9th Cir.1984). Nonetheless, "Congress made section 83(a) applicable to all restricted 'property,' not just stock." Id. at 482. For...