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In December 1998, the taxpayers received stock in a newly formed S corporation. The agreement provided that the stock was “restricted stock” and was subject to a substantial risk of forfeiture.
The taxpayers would receive, on termination of employment, less than the full fair market value of their S shares if they were terminated “for cause” during the initial term of the employment agreement (and might forfeit a substantial amount of the value of their stock on the occurrence of various events listed as termination “for cause”).
- If terminated for cause after December 31, 2003, the taxpayers would receive 100% of the fair market value of the stock.
- However, if terminated for cause before January 1, 2004, the taxpayers would receive at most 50% of the fair market value of the stock, with the possibility of receiving nothing.
In the employment agreement, the definition of termination “for cause” included termination upon an employee’s failure or refusal “to cure by faithfully and diligently performing the usual and customary duties of his employment.”
Reg. section 1.83-3(c)(2), however, provides that stock may be forfeited “if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.”
The taxpayers took a position that 100% of the outstanding stock was owned by an ESOP during 2000-2003 and that 100% of the company’s income was allocable to it. The taxpayers thus asserted that the stock was not substantially vested, and reported neither any income nor other flowthrough items from the S corporation on their individual income tax returns for 2000-2003.
Also, because the ESOP was a tax-exempt entity, it reported no taxable income from the S corporation during 2000-2003.
The IRS issued a notice of deficiency asserting several grounds, including that the stock was substantially vested when issued.
On competing cross-motions filed by the parties, the Tax Court turned to address the scope of the phrase what is termination “for cause” for purposes of the Reg. section 1.83-3(c)(2).
Tax Court’s opinion
The Tax Court in this determination held that the term “discharged for cause” as used by Reg. section 1.83-3(c)(2) refers to a termination for “serious misconduct” which, like criminal misconduct, is highly unlikely to occur.
The Tax Court, thus, found that termination for an activity specified in the taxpayers’ employment agreement was not within the scope of discharge “for cause or for committing a crime.”
The court further held that the risk that the taxpayers would receive less than the full fair market value upon forfeiture of their stock if they failed faithfully and diligently to perform the usual and customary duties of their employment constituted an earn-out restriction that could create a “substantial risk of forfeiture” if there existed a sufficient likelihood that the restriction would actually be enforced. The Tax Court, accordingly, concluded that provisions of the employment agreement “however inartfully drafted” constituted an earn-out restriction that could give rise to a “substantial risk of forfeiture” under section 83.
In denying the parties’ cross-motions, the court noted there were material issues of disputed fact which must be resolved.