An employment agreement’s requirements constitute an “earnout” provision that could create a substantial risk of forfeiture under Sec. 83.
In consolidated cases, the Tax Court denied the IRS summary judgment, concluding that the phrase “termination for cause” in the taxpayers’ restricted stock and employment agreements did not have the same meaning as “discharged for cause” in Regs. Sec. 1.83-3(c)(2).
Facts: In 1998, pursuant to a Sec. 351 exchange, Larry Austin and Arthur Kechijian exchanged property for restricted stock of a newly formed S corporation. As part of the exchange, each taxpayer and the S corporation entered into a restricted stock agreement (RSA) and an employment agreement providing that each taxpayer would receive less than the full fair market value (FMV) of his S corporation stock if he were terminated “for cause” before Dec. 31, 2003. The employment agreement broadly defined “for cause” in one section as for dishonesty, fraud, embezzlement, alcohol or substance abuse, gross negligence, or similar conduct. Another part of the agreement further defined “for cause” as including a failure or refusal to faithfully and diligently perform the usual and customary duties of the employment and to adhere to the provisions of the employment agreement. A third section also included any failure or refusal to comply with the S corporation’s reasonable policies, standards, and regulations.
On their individual tax returns for 2000 through 2003, the taxpayers took the position that their stock was subject to a substantial risk of forfeiture and was thus substantially nonvested within the meaning of Regs. Sec. 1.83-3(b). Therefore, neither taxpayer reported any income or other flowthrough items from the S corporation on his individual income tax return for those years.
Issues: The IRS argued that the taxpayers’ stock was not subject to a substantial risk of forfeiture and therefore was substantially vested when issued.
Sec. 83 requires an individual who receives property in exchange for services to include in gross income the amount by which the property’s FMV exceeds any amount the individual paid for it. That income is recognized in the first year in which the individual’s rights to the property are not subject to a substantial risk of forfeiture. Thus, taxpayers are allowed under Sec. 83 to defer recognition of income until their rights in the restricted property become substantially vested.
Under Sec. 83, the rights of a person in property are generally subject to a substantial risk of forfeiture if rights to its full enjoyment are conditioned upon the future performance of substantial services by any person. The requirement that an employee perform future services as a condition of obtaining full enjoyment of restricted property is sometimes called an “earnout” restriction. Because of the real possibility that this condition may not be fulfilled, an earnout restriction normally creates a substantial risk of forfeiture until the restriction lapses. Under Regs. Sec. 1.83-3(c)(2), however, a requirement that the stock be forfeited if the employee is discharged “for cause” is not considered a substantial risk of forfeiture.
According to the IRS, the sole provision of the RSA that could create a substantial risk of forfeiture was the employment agreement’s provision for termination for cause, and Regs. Sec. 1.83-3(c)(2) therefore precluded a substantial risk of forfeiture. The taxpayers contended that the scope of “for cause” in the regulation is not necessarily identical to the scope the parties had given the phrase in the employment agreements.
Holding: “For cause” is not defined in Sec. 83, the implementing regulations, or the legislative history. Using the text and evolution of the regulation, the Tax Court held that the phrase as used in Regs. Sec. 1.83-3(c)(2) refers to a narrow and serious form of employee misconduct comparable to criminal misconduct in severity and unlikelihood of its occurrence. Such misconduct is thus properly regarded as too remote, as a matter of law, to create a substantial risk of forfeiture—not necessarily the same meaning that parties in private negotiations might give it.
The court therefore held that the employment agreement’s provision of termination for dishonesty, fraud, embezzlement, and alcohol or substance abuse was reasonably characterized as a discharge for cause within the meaning of Regs. Sec. 1.83-3(c)(2). It agreed with the taxpayers, however, that termination for the other specified reasons should not be so characterized, but rather, in conjunction with the terms of the RSA, appeared to constitute a classic earnout restriction that could give rise to a substantial risk of forfeiture under Sec. 83.
By Robin Clark, J.D., clinical instructor of
business law, and Darlene Pulliam, CPA, Ph.D.,
Regents Professor and McCray Professor of Accounting, both of the
College of Business, West Texas A&M University, Canyon, Texas.