Earnout Restriction Precludes S Shareholders from Being Taxed on S Corp Income.
(Parker Tax Publishing December 2013)

A requirement that an employee perform future services as a condition of obtaining full enjoyment of restricted property, known as an "earnout" restriction, creates a "substantial risk of forfeiture" that postpones taxation until the restriction lapses. Austin v. Comm'r, 141 T.C. No. 18 (12/16/13).

Larry Austin and Arthur Kechijian worked together for more than 15 years in the distressed debt loan portfolio business. Before 1998, Larry and Arthur were the original shareholders and members of a group of related companies called the UMLIC Entities. In December 1998, Larry and Arthur formed, and elected subchapter S status for, UMLIC Consolidated, Inc. (UMLIC S-Corp.). In a Code Sec. 351 transaction, Larry and Arthur transferred their unrestricted ownership interests in the UMLIC Entities to UMLIC S-Corp. in exchange for 47,500 shares of its common stock. Concurrently, UMLIC S-Corp. issued 5,000 shares of its common stock, in exchange for a note, to an employee stock ownership plan (ESOP) for its employees, including Larry and Arthur. After this transaction, Larry and Arthur each owned 47.5 percent of UMLIC S-Corp. and the ESOP owned 5 percent.

As part of the Code Sec. 351 exchange, Larry and Arthur each executed with UMLIC S-Corp. substantially identical agreements called "Restricted Stock Agreement" (RSA) and "Employment Agreement." Section 7(A) of the Employment Agreement provided that the agreement could be terminated at any time "for cause." For purposes of the agreement, "for cause" was defined to include dishonesty, fraud, embezzlement, and alcohol or substance abuse. Under Section 7(B), "for cause" was defined to include termination upon the failure or refusal by the employee "to cure by faithfully and diligently performing the usual and customary duties of his employment."

If Arthur or Larry was terminated for cause after December 31, 2003, he would receive 100 percent of the fair market value of his stock under RSA Section 5(b). If the employee was terminated for cause before January 1, 2004, the purchase price would be governed by RSA Section 5(a), which provided that, if employment terminated before January 1, 2004--that is, during the initial term of the employment agreement--the employee would receive at most 50 percent of the fair market value of his stock, with the possibility of receiving nothing, as determined by the applicable formula.

For purposes of Subchapter S, Reg. Sec. 1.1361-1(b)(3) generally provides that S stock that is issued in connection with the performance of services and that is substantially nonvested (within the meaning of Reg. Sec. 1.83-3(b)), is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock.

On their individual income tax returns for 2000-2003, Larry and Arthur took the position that their UMLIC S-Corp. stock was subject to a substantial risk of forfeiture and was thus substantially nonvested within the meaning of Reg. Sec. 1.83-3(b). According to Larry and Arthur, 100 percent of the outstanding stock of UMLIC S-Corp. was owned by the ESOP during 2000-2003 and, thus, 100 percent of the company's income was allocable to it. Accordingly, they did not report any income or other flowthrough items from UMLIC S-Corp. on their individual income tax returns for 2000-2003. And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from UMLIC S-Corp. during 2000-2003.

The IRS disagreed and issued notices of deficiency to Larry and Arthur that challenged, on a variety of grounds, the tax structure that they and UMLIC S-Corp. had implemented. One of the IRS's arguments was that Larry and Arthur's stock was substantially vested by virtue of Reg. Sec. 1.183-3(c)(2) when it was issued to them. Reg. Sec. 1.83-3(c)(2) provides that a requirement that stock be forfeited if the employee is discharged for cause or for committing a crime is not considered to result in a substantial risk of forfeiture.

Larry and Arthur argued that the scope of "for cause," as used in Reg. Sec. 1.83-3(c)(2) was not necessarily identical to the scope the parties have given that phrase in their agreements. Section 7 of the employment agreement broadly defined several categories of employee action justifying "termination with cause." Larry and Arthur agreed that discharge for an activity specified in Section 7(A) (e.g., dishonesty, fraud, embezzlement, or alcohol or substance abuse) was reasonably characterized as a "discharge for cause" within the meaning of the regulation. On the other hand, they argued, termination for the activity specified in Section 7(B) (i.e., for refusal to perform faithfully the usual and customary duties of the employee's employment) should not be deemed a "discharge for cause" under Reg. Sec. 1.83-3(c)(2). Rather, they contended, Section 7(B) was the mechanism adopted, clumsily perhaps, to enforce the central requirement of the RSAthat they would continue their employment with UMLIC S-Corp. for the four-year term of the employment agreement in order to secure the full value of their stock. Such a requirement, Larry and Arthur argued, necessarily creates a "substantial risk of forfeiture" under the statute and its implementing regulations.

The question before the Tax Court was whether Reg. Sec. 1.83-3(c)(2) precluded the agreements at issue from giving rise to a substantial risk of forfeiture, with the result that the income from UMLIC S-Corp. would be includible in Larry and Arthur's income.

The Tax Court rejected the IRS's request for summary judgment. The court noted that the requirement that an employee perform future services as a condition of obtaining full enjoyment of restricted property is sometimes called an "earnout" restriction. Citing Example 1 of Reg. Sec. 1.83-3(c)(4), the court observed that, because of the real possibility that such a condition may not be fulfilled, an earnout restriction will normally create a "substantial risk of forfeiture" that postpones taxation until the restriction lapses.

The Tax Court held that, while Section 5(a) of the RSA and Section 7(B) of the Employment Agreement were inartfully drafted, those provisions constituted an earnout restriction that gave rise to a substantial risk of forfeiture under Code Sec. 83.

In analyzing Reg. Sec. 1.83-3(c)(2), the court concluded that the employee activity specified in Section 7(B) of the Employment Agreement fell outside the scope of discharge "for cause or for committing a crime" within the meaning of Reg. Sec. 1.83-3(c)(2). That was so, the court said, because an employee's inability or disinclination to work for the agreed-upon term of his employment contract is not a "remote" event that is unlikely to occur. Even more clearly, the court said, that is so because a conclusion that Reg. Sec. 1.83-3(c)(2) precludes an earnout restriction from creating a "substantial risk of forfeiture" would make that subparagraph of the regulation inconsistent with the statute.

OBSERVATION: The Tax Court noted that the IRS had advanced a number of other theories that can still go to trial. For example, as an alternative to the theory based on Reg. Sec. 1.83-3(c)(2), the IRS argued that Arthur and Larry's stock was "substantially vested" on the theory that their status as the sole directors of UMLIC S-Corp. enabled them to remove at will any ownership restrictions to which their stock was subject, so that the forfeiture conditions were unlikely to be enforced.

For a discussion of substantial risk of forfeiture where property is transferred in connection with services, see Parker Tax ¶124,515. (Staff Editor Parker Tax Publishing)

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