In two more of at least four similar cases, former Ernst & Young consulting partners were denied refunds of tax they paid on stock received from a merger with Cap Gemini that lost most of its value while in restricted accounts.
In 2000, Cap Gemini agreed to purchase E&Y’s consulting practice for stock. The tax, audit and consulting partners received stock, and the consulting partners agreed to work for Cap Gemini. The purchase contract specifically classified the transaction as a taxable purchase.
The contract permitted the partners to sell 25% of their shares to pay their tax liability from the sale. The remaining 75% was put into a restricted account and could not be sold for more than four years. If partners left Cap Gemini or were fired for specified reasons, they would forfeit stock in the restricted account under a liquidated damages schedule. The sales contract provided that the fair market value of the restricted stock was 95% of its closing price on the date of the transaction (May 23, 2000), or $148.53 per share.
One of the partners, Robert Bergbauer, received 10,740 shares of Cap Gemini. On his 2000 tax return, Bergbauer reported his entire gross proceeds from the sale of $1,613,379 and a total tax liability of $676,493.
Throughout the negotiations, E&Y distributed the proposed documents to its partners. It held a meeting to discuss thetransaction and to allow the partners to ask questions. The reason the transaction was structured as a currently taxable sale was to prevent the IRS from reclassifying some of the restricted stock as compensation for services and to ensure favorable tax treatment for the consulting partners on its future sale. Included in the transaction documents signed by Bergbauer and the other partners was a form that stated that the partners would report the transaction as a taxable sale at the stated value.
By two years after the sale, the value of the restricted stock had fallen to $16 per share. Bergbauer filed an amended return claiming that the sale was not fully taxable at closing and obtained a refund of $276,510, including interest. The IRS sued in 2005 to recover it. The case was stayed for more than a year while other cases of the estimated more than 200 similarly situated taxpayers were resolved.
Bergbauer argued that as a cash method taxpayer, under section 451, he did not have to report the restricted stock until received.
The U.S. District Court for Maryland, where the case was tried, pointed out that two other district courts had ruled previously on similar arguments brought by other former E&Y partners. In U.S. v. Culp (99 AFTR2d 2007-618), a district court in Tennessee found the contract documents unambiguous and applied the Danielson rule to determine if a taxpayer could report the transaction differently than provided in the documents. Under Danielson (19 AFTR2d 1356 (3d Cir. 1967)), the taxation may vary from the documents only if there was “mistake, undue influence, fraud or duress.” Given the steps E&Y took to ensure all the partners understood the contract, the Culp court ruled for the IRS. In U.S. v. Fletcher (101 AFTR2d 2008-588), a district court in Illinois also applied the “strong proof” doctrine. Under it, the taxpayer must have strong proof that the partners intended a transaction different from the one in the contract. The Illinois court also considered Treas. Reg. § 1.451-2, which provides that constructive receipt of income does not occur when a taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The provision does not bar enforcement of the contract as contrary to public policy, the court said in also ruling for the IRS.
In Bergbauer, the court did not use either doctrine. Instead, it followed the Fourth Circuit Court of Appeals’ approach (stated in Wrangler Apparel Corp. v. U.S., 78 AFTR2d 96-5674), first examining the tax consequences contemplated by the parties and then the economic substance of the agreement. Based on the negotiations, meetings and signed documents, it was clear that the parties intended a fully taxable transaction, the court said. To test for economic substance, the court examined whether there was independent value grounded in economic reality behind the contract. The restrictions were intended to protect Cap Gemini from immediate sale of the stock, which would have harmed the stock’s value. The restrictions also kept the partners working for Cap Gemini and provided them with anticipated upward growth of the stock value. For the third time, a court ruled for the IRS.
After the Bergbauer decision, the U.S. District Court for New Hampshire ruled similarly in a case brought by another partner, Nancy R. Berry. This court also used the strong proof rule. It rejected Berry’s argument that because she was not a party to the negotiations she had no choice in the transaction. The court also rejected the argument that the true value of the restricted stock and not the agreed value should have been used. The actual value was immaterial, according to the court, since the parties agreed to use the 95% valuation.
Normally, a cash method taxpayer does not have to report an item of income if it is restricted or forfeitable. However, taxpayers can agree to report it in spite of these limitations. If it turns out that the restrictions cause an economic loss, it is highly unlikely that the courts will allow taxpayers to revise how they reported the transaction originally—all the more so if the Fourth Circuit upholds Bergbauer (notice of appeal has been given).
n U.S. v. Robert L. Bergbauer, 102 AFTR2d 2008-5932
n U.S. v. Berry, 102 AFTR2d 2008-5365
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.