Employees must report as income compensation paid to them in either cash or property. The employer is entitled to a corresponding deduction. If the property is restricted, IRC section 83 determines how much income the employee must report and the timing of the deduction. The Federal Circuit Court of Appeals recently reversed a Court of Claims decision concerning the deduction for compensation paid with restricted property. This reversal also conflicts with a prior Tax Court decision in Venture Funding Ltd., 100 TC 236 (1998).
James and Barbara Robinson are the sole shareholders of a group of S corporations known as Morgan Creek. In 1995 Morgan Creek entered into an employment contract with Gary Barber, its chief operating officer. As part of the contract Barber was to receive a 10% stock interest in the corporation that would vest over time. Barber paid $2 million for the stock. In the year of receipt he made a section 83(b) election to report the income immediately rather than when the shares vested. Barber concluded the stock was worth only $2 million; therefore his reportable income was zero. Under the regulations, he notified himself, as chief operating officer, of the election.
In 1998 Morgan Creek ended Barber’s employment contract before its scheduled termination date. The corporation repurchased the vested stock Barber owned for $13.2 million. After Barber’s termination, the Robinsons discovered he had made the section 83(b) election. They concluded the stock Barber received in 1995 was worth $26,760,000, which would have resulted in $24,760,000 of reportable income. The corporation could have deducted this same amount. Morgan Creek filed a refund claim, which the IRS denied. The Robinsons filed suit. The Court of Claims ruled for the IRS and the taxpayer appealed.
Result. For the taxpayer. Section 83(a) says a service provider must report income paid in property when his or her rights to the property vest. Section 83(b) allows the recipient to report the income in the year he or she receives the property rather than when it vests. Section 83(h) permits the employer a compensation deduction under IRC section 162 equal to the amount the service provider “included” in income. The dispute in this case is over the word “included.” The Robinsons argued it meant includible by law; the IRS argued it meant the amount actually included in income. Based on the taxpayer’s argument, it could have deducted the full amount of reportable income regardless of how much the recipient actually reported. Under the IRS interpretation, the deduction would have been limited to the amount Barber reported.
The Federal Circuit ruled there was more support for the taxpayer’s argument than for the government’s.
IRC section 61 requires the taxpayer to “include” income under section 71 and following sections. Thus, section 61 uses the word to mean “included as a matter of law.”
Section 83 refers to section 162 to determine the deduction. Section 162 operates as a matter of law regardless of the reporting by the other parties. This implies section 83 should do the same. In other words, the relevant code sections (61 and 162) use included to mean “by operation of law,” which is consistent with the taxpayer’s interpretation.
The committee reports discussing section 83 indicate Congress intended for the full amount of property transferred to be deductible and for the deduction not to be limited to the amount of income the recipient actually reported.
The original draft of the regulations under section 83 allowed the full deduction.
The government argued the final regulations specifically limited the deduction to the amount reported as income and the courts should defer to the regulation under the Chevron doctrine. Under this doctrine—known as deference—the courts assume the regulations are valid and enforce them as written. The court acknowledged this rule but pointed out it does not apply if the code is clear and contrary to the regulations. In the court’s opinion, that was the case here. Therefore the full amount should be deductible, not the amount the employee reported as income.
This decision is very “pro taxpayer.” There is a question whether other circuits will follow it given the contrary Court of Claims and Tax Court conclusions. Assuming others follow it, the IRS can be “whipsawed”—that is, the courts allow a taxpayer to deduct one amount while another taxpayer reports a lesser amount of income. To prevent this, the government is likely to try to consolidate cases involving both sides so the courts can determine a single income-and-deduction amount. CPAs can expect additional litigation on this issue.
James G. Robinson v. United States, Court of Appeals for the Federal Circuit, 2003.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.