Austin v. Commissioner, 141 T. C. No. 18 (U. S. Tax Court 2013)

In Austin v. Commissioner, the U. S. Tax Court clarified the meaning of ‘for cause’ termination in the context of tax law under Section 83. The court ruled that the term ‘for cause’ in tax regulations does not necessarily align with private contractual definitions, focusing instead on serious misconduct unlikely to occur. This decision impacts how earnout restrictions on stock are treated for tax purposes, potentially allowing for deferred taxation if the risk of forfeiture is substantial due to future service requirements.

Parties

Larry E. Austin and Belinda Austin, and the Estate of Arthur E. Kechijian, deceased, with Susan P. Kechijian and Scott E. Hoehn as co-executors, and Susan P. Kechijian (collectively, Petitioners) v. Commissioner of Internal Revenue (Respondent).

Facts

Larry Austin and Arthur Kechijian exchanged their ownership interests in the UMLIC Entities for ostensibly restricted stock in UMLIC Consolidated, Inc. , a newly formed S corporation, in December 1998. The stock was subject to a Restricted Stock Agreement (RSA) and an Employment Agreement, both stipulating that the petitioners would receive less than full fair market value of their stock if terminated ‘for cause’ before January 1, 2004. The employment agreement defined ‘for cause’ as including dishonesty, fraud, gross negligence, or failure to perform usual and customary duties after 15 days’ notice to cure. The RSA provided that upon termination without cause, petitioners would receive full value, but if terminated with cause before January 1, 2004, they would receive at most 50% of the stock’s value. Petitioners reported no income from the S corporation on their tax returns for 2000-2003, asserting that their stock was subject to a substantial risk of forfeiture.

Procedural History

The IRS issued notices of deficiency to petitioners, challenging their tax treatment of the UMLIC S-Corp. stock. Both parties filed motions for summary judgment in the U. S. Tax Court regarding whether the stock was subject to a substantial risk of forfeiture under Section 83 at the time of issuance. The Tax Court’s decision focused solely on the interpretation of ‘for cause’ under Section 1. 83-3(c)(2) of the Income Tax Regulations.

Issue(s)

Whether the term ‘for cause’ as used in Section 1. 83-3(c)(2) of the Income Tax Regulations necessarily encompasses the same definition as provided in the employment agreement between the petitioners and UMLIC S-Corp.

Rule(s) of Law

Section 83 of the Internal Revenue Code governs the tax treatment of property transferred in connection with the performance of services. Under Section 83(c)(1), property rights are subject to a substantial risk of forfeiture if conditioned upon the future performance of substantial services. Section 1. 83-3(c)(2) of the Income Tax Regulations states that a requirement for property to be returned if an employee is discharged for cause or commits a crime does not result in a substantial risk of forfeiture.

Holding

The U. S. Tax Court held that the term ‘discharged for cause’ in Section 1. 83-3(c)(2) does not necessarily align with the contractual definition of ‘for cause’ but refers to termination for serious misconduct akin to criminal behavior. The court further held that the risk of forfeiture due to failure to perform substantial services, as stipulated in the employment agreement, constituted an earnout restriction potentially creating a ‘substantial risk of forfeiture’ under Section 83.

Reasoning

The court analyzed the evolution of the regulations and the context in which ‘for cause’ was used, noting that the term in Section 1. 83-3(c)(2) was intended to denote a narrow category of serious misconduct unlikely to occur. The court distinguished between the broad contractual definition of ‘for cause’ and the narrower regulatory definition, focusing on the likelihood of the event occurring. The court found that the employment agreement’s provision for termination due to failure to perform duties diligently was an earnout restriction, which could create a substantial risk of forfeiture if enforced. The court referenced prior cases and the legislative history of the regulations to support its interpretation, emphasizing the need for consistency with the statutory purpose of Section 83 to defer taxation until rights become substantially vested.

Disposition

The Tax Court denied the Commissioner’s motion for partial summary judgment, which was based solely on the theory that Section 1. 83-3(c)(2) precluded the stock from being subject to a substantial risk of forfeiture. The court left other IRS theories, including whether the petitioners’ control over the corporation affected the enforceability of the forfeiture conditions, to be decided at trial.

Significance/Impact

The Austin decision clarifies the scope of ‘for cause’ under Section 1. 83-3(c)(2), impacting how earnout restrictions on stock are treated for tax purposes. It establishes that contractual definitions of ‘for cause’ do not control the tax treatment under Section 83, which focuses on the likelihood of the event leading to forfeiture. This ruling may influence how future employment agreements and stock plans are structured to achieve desired tax outcomes, particularly in the context of S corporations and other closely held businesses. Subsequent courts and practitioners must consider this distinction when analyzing the tax implications of stock subject to forfeiture conditions.