Qinetiq US Holdings, Inc. & Subsidiaries v. Commissioner of Internal Revenue, 2017 U.S. App. LEXIS 272

Background

In December 2002, Julian Chin and Thomas Hume received DTRI stock when DTRI was formed; Chin acquired nearly half the voting shares and took an executive role (EVP/COO). DTRI treated itself as an S corp through 2006 and did not report the 2002 stock as compensation or withhold payroll taxes on it.
DTRI executed a Shareholders Agreement providing repurchase rights on death, disability, termination, or voluntary resignation; repurchase in some events used fair-market-value, while voluntary resignation generally triggered a sliding 5% per-year buyback (full value after 20 years) but lower maximums (25%) if resignation involved competition or termination for cause.
In 2008 QinetiQ purchased DTRI for $123 million; immediately before closing Chin waived certain transfer restrictions and sold his shares. QinetiQ withheld payroll taxes and claimed a §83(h) deduction in its 2009 tax year for the 2002 shares as wages taxed in 2008.
IRS issued a Notice of Deficiency disallowing a $117,777,501 deduction under §83; QinetiQ petitioned the Tax Court arguing (1) the Notice was procedurally insufficient and (2) the stock qualified as §83 property subject to a substantial risk of forfeiture until 2008.
Tax Court ruled the Notice was sufficient and, on the merits, held QinetiQ failed to prove the stock was transferred in connection with services and, alternatively, failed to show the stock was subject to a substantial risk of forfeiture. QinetiQ appealed.
Fourth Circuit affirmed: (1) APA "reasoned explanation" requirement does not apply to IRS Notices of Deficiency because the Code provides a special de novo review scheme; (2) the Notice satisfied §7522(a); and (3) factual finding that Chin’s shares were not subject to a substantial risk of forfeiture was not clearly erroneous.

Issues

Issue	Plaintiff's Argument	Defendant's Argument	Held
Whether APA requires a reasoned explanation in an IRS Notice of Deficiency	APA's requirement for a reasoned explanation for final agency action applies, so the Notice was invalid for lack of reasoning	The Code provides a special, pre-existing de novo review scheme for Notices of Deficiency; APA's final-action reasoned-explanation requirement does not superimpose on that scheme	APA requirement does not apply to Notices of Deficiency; O’Dwyer and Code's de novo review control (affirmed)
Whether the Notice of Deficiency satisfied Code §7522(a) content requirements	Notice was inadequate because it lacked explanation of basis	Notice stated an exact deficiency amount and incorporated an explanation; taxpayer suffered no prejudice	Notice met §7522(a) requirements; not invalidated
Whether Chin’s 2002 stock was transferred "in connection with" services (entitling employer deduction when taxable)	Stock was compensation for services and thus deductible when it became taxable in 2008	Stock was essentially an investment/subscription and not compensation in 2002	Tax Court found insufficient proof stock was transferred in connection with services (alternative basis for denial)
Whether the 2002 stock was subject to a "substantial risk of forfeiture" until 2008 under §83	Shareholders Agreement restrictions and repurchase provisions created a substantial risk of forfeiture until 2008, so deduction in 2008 was proper	Repurchase terms often required fair market value or were unlikely to be enforced; only voluntary resignation could produce a below-market forfeiture, and that risk was not substantial given Chin’s ownership and relationship	Court held stock was not subject to a substantial risk of forfeiture; factual finding that forfeiture risk was not substantial was not clearly erroneous; deduction disallowed

Key Cases Cited

Starnes v. Comm’r, 680 F.3d 417 (4th Cir.) (standards for APA de novo review mention)
O’Dwyer v. Comm’r, 266 F.2d 575 (4th Cir. 1959) (Code’s de novo tax-court review is incompatible with APA-style review)
Bowen v. Massachusetts, 487 U.S. 879 (1988) (general APA remedies do not duplicate detailed statutory schemes)
Fla. Power & Light Co. v. Lorion, 470 U.S. 729 (1985) (reviewing court applies APA standard to administrative record)
FCC v. Fox Television Stations, Inc., 556 U.S. 502 (2009) (administrative actions generally require reasoned explanation)
Bennett v. Spear, 520 U.S. 154 (1997) (definition of final agency action and when legal consequences flow)
INDOPCO, Inc. v. Comm’r, 503 U.S. 79 (1992) (taxpayer’s burden to show entitlement to deductions)
Strom v. United States, 641 F.3d 1051 (9th Cir.) (discussing §83 substantial-risk requirement)
United States v. Bergbauer, 602 F.3d 569 (4th Cir.) (same)