141 T.C. 551
T.C.2013Background
- Petitioners (Larry Austin and Arthur Kechijian) transferred their interests in preexisting entities to a newly formed S corporation (UMLIC S‑Corp.) in a Section 351 exchange and received shares subject to a Restricted Stock Agreement (RSA) and Employment Agreement.
- Agreements imposed an initial employment term (Dec 7, 1998–Jan 1, 2004) and required petitioners to perform duties "faithfully, diligently"; shares bore legends and transfer restrictions.
- RSA §5(b) provided that if termination occurred after 12/31/2003 (or termination without cause), the employee would receive 100% of FMV. RSA §5(a) provided that if terminated for cause before 1/1/2004, employee could receive at most 50% (possibly zero) of FMV.
- Employment Agreement §7 defined "cause" in three categories: (A) serious misconduct (dishonesty, embezzlement, etc.); (B) failure/refusal, after 15‑day notice, to cure by performing usual duties faithfully and diligently; (C) failure to comply with reasonable policies after notice.
- Petitioners reported the shares as substantially nonvested (so ESOP owned 100% for S‑status purposes); IRS argued the stock was substantially vested at issuance, relying principally on Treas. Reg. §1.83‑3(c)(2) ("discharged for cause or for committing a crime" exception) and other theories. Summary‑judgment motions addressed whether the regulation precludes a substantial risk of forfeiture here.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether Reg. §1.83‑3(c)(2) ("discharged for cause or for committing a crime") prevents the employment‑based restrictions from creating a substantial risk of forfeiture | The §7(B) termination (failure/refusal to perform usual duties after notice) is an earnout—an enforceable condition on future services that creates a substantial risk of forfeiture | Reg. The regulation's language means any clause labeled "for cause" (including §7(B)) makes forfeiture too remote to be a substantial risk; thus stock was substantially vested | The phrase "discharged for cause" in the regulation is narrow—it denotes serious, remote misconduct comparable to criminal acts; §7(B) (poor or refused performance) is not within that narrow scope and can create a substantial risk of forfeiture if likely to be enforced |
| Whether §7(A) misconduct (dishonesty, embezzlement) falls within the regulation's exception | Petitioners concede serious misconduct should be excluded from substantial‑risk treatment | Respondent says such serious misconduct fits the regulation's per se exception | Court: §7(A) misconduct reasonably falls within the regulation's narrow "for cause" exception |
| Whether the §7(B)+RSA §5(a) combination is an earnout restriction that can postpone income recognition | Petitioners: combined provisions are an earnout that conditions full payment on future services, so rights were substantially nonvested | Respondent: labels and "for cause" language invoke the regulation exception, so no substantial risk exists | Court: §7(B) functions as an earnout enforcement mechanism; because refusal/unsatisfactory performance is not a remote event, the restriction can create a substantial risk of forfeiture |
| Whether summary judgment for respondent is appropriate on this regulatory theory | Petitioners: genuine legal dispute over the meaning of "for cause" and its application; denial requested | Respondent: regulation forecloses substantial‑risk argument as a matter of law | Court: denied respondent's partial summary judgment on this ground; other respondent theories remain for trial |
Key Cases Cited
- Ludden v. Commissioner, 68 T.C. 826 (1977) (holding discharge for cause for intentional dishonesty was too remote to create a substantial risk of forfeiture)
- Burnetta v. Commissioner, 68 T.C. 387 (1977) (holding discharge for theft or embezzlement was too remote to present a substantial risk of forfeiture)
- Strom v. United States, 641 F.3d 1051 (9th Cir. 2011) (discussion of timing of income inclusion under §83 when rights become substantially vested)
- Phillips Petroleum Co. v. Commissioner, 97 T.C. 30 (1991) (regulatory interpretation should avoid inconsistency with statute)