Larry E. & Belinda Austin v. Commissioner , 141 T.C. No. 18 ( 2013 )

141 T.C. No. 18
UNITED STATES TAX COURT
LARRY E. AUSTIN AND BELINDA AUSTIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
ESTATE OF ARTHUR E. KECHIJIAN, DECEASED, SUSAN P. KECHIJIAN
AND SCOTT E. HOEHN, CO-EXECUTORS, AND SUSAN P. KECHIJIAN,
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 8966-10, 8967-10. Filed December 16, 2013.
Ps exchanged property for ostensibly restricted stock of a
newly formed S corporation (S). The governing agreements provided
that Ps, upon termination of employment, would receive less than the
full fair market value of their S shares only if they were terminated
“for cause” during the initial term of the employment agreement.
Section 7(B) of the employment agreement defined termination “for
cause” to include termination upon “[f]ailure or refusal by Employee
* * * to cure by faithfully and diligently performing the usual and
customary duties of his employment.” Section 1.83-3(c)(2), Income
Tax Regs., provides that a requirement that stock 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.”
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1. Held: The term “discharged for cause,” as used in section
1.83-3(c)(2), does not necessarily have the same meaning the parties
have given that term in their private agreements but refers to
termination for serious misconduct which, like criminal misconduct,
is highly unlikely to occur.
2. Held, further, the risk that Ps would receive less than 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 during the prescribed period constituted an earnout
restriction that could create a “substantial risk of forfeiture” if there
existed a sufficient likelihood that the restriction would actually be
enforced.
Lynn Forrest Chandler, Jonathan P. Heyl, and Tanya N. Oesterreich, for
petitioners.
Patricia Pierce Davis, Nina E. Choi, and Mark L. Hulse, for respondent.
OPINION
LAUBER, Judge: These consolidated cases are before this Court on
respondent’s motion for partial summary judgment and petitioner’s motion for
summary judgment both filed under Rule 121.1 The sole issue for decision is
1
Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code) in effect for the tax years 2000, 2001, 2002, 2003 and 2004,
and all Rule references are to the Tax Court Rules of Practice and Procedure.
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whether stock petitioners received in December 1998, which was labeled
“restricted stock,” was subject to a substantial risk of forfeiture when issued to
them or rather was “substantially vested” within the meaning of section 83 and
section 1.83-1(a)(1), Income Tax Regs. Under the governing employment
agreements, petitioners would forfeit a substantial amount of the value of their
stock upon the occurrence of various events, enumerated in a paragraph that
addressed termination “for cause.” Under section 1.83-3(c)(2), Income Tax Regs.,
a requirement that stock 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.” Disposition of the pending motions requires us to determine the scope
of the phrase “for cause” as used in section 1.83-3(c)(2), Income Tax Regs., and
the proper application of that regulation to the agreements involved here.
Background
The following facts are not in dispute. Larry Austin and Arthur Kechijian
(petitioners) resided in North Carolina when they filed petitions.2 Belinda Austin
and Susan Kechijian are parties to these cases solely by virtue of having filed joint
Federal income tax returns with their husbands for the tax years at issue.
2
Petitioner Arthur E. Kechijian died while the summary judgment motions
were pending. On October 24, 2013, we substituted his estate as a party petitioner.
His estate is being probated in North Carolina.
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Petitioners worked together for more than 15 years in the “distressed debt
loan portfolio business.” Before 1998 petitioners were the original shareholders
and members of a group of related companies called “the UMLIC Entities.” In
December 1998 petitioners formed, and elected subchapter S status for, UMLIC
Consolidated, Inc., a North Carolina corporation (UMLIC S-Corp.). In a section
351 transaction, each petitioner transferred his unrestricted ownership interest 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 petitioners. Thus, as of December 7, 1998, each petitioner
owned 47.5% of UMLIC S-Corp., and the ESOP owned 5%. At all relevant times,
petitioners were the only directors on the UMLIC S-Corp. board of directors.
Petitioners, along with the company’s assistant controller, were the initial trustees
of the ESOP.
Petitioner Kechijian was employed as the president of UMLIC S-Corp. He
had responsibility for general operations and for servicing loan portfolios, includ-
ing workout strategies, loan sales, foreclosures, and loan modifications. Petitioner
Austin was employed as senior executive vice president of UMLIC S-Corp. He
had responsibility for loan portfolio acquisitions, including due diligence involved
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in the evaluation of loan portfolios, foreclosure gain/loss analysis, expected
cashflows, bidding strategies, and investor relationships.
As part of the section 351 exchange, each petitioner executed with UMLIC
S-Corp. substantially identical agreements denominated “Restricted Stock Agree-
ment” (RSA) and “Employment Agreement.” These agreements were explicitly
linked. Section 12 of the employment agreement stated that the employee’s
ownership of UMLIC S-Corp. shares “shall be governed by * * * [the RSA]
entered into simultaneously * * * [and] incorporated herein by reference.”
The stated purpose of these agreements was to incentivize petitioners to
exchange their UMLIC interests for UMLIC S-Corp. stock and require them to
perform future services in order to secure full rights in this stock. The RSA stated
the company’s intention “to induce * * * [each petitioner’s] continued
employment on behalf of * * * [UMLIC S-Corp.] * * * by providing certain
financial incentives under this Agreement.” Conversely, each petitioner agreed
that, in consideration of UMLIC S-Corp.’s issuance of shares to him, he was
“willing to perform future services on behalf of * * * [UMLIC S-Corp.] under the
terms of the Employment Agreement.”
The shares issued to petitioners bore the following legend: “The shares
represented by this certificate, and the transfer hereof, are subject to the terms of
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* * * [the RSA].” The RSA permitted limited transfer of the shares to or for the
benefit of family members. However, transfer was permitted only if the transferee
agreed to be bound by the RSA and hence by any restrictions on full enjoyment of
the stock to which the RSA subjected petitioners.
Section 4 of the employment agreement provided that “[t]he initial term of
this Agreement shall commence on December 7, 1998 * * * and shall continue
until January 1, 2004.” Section 1 of the Agreement, captioned “Employment,”
provided:
During the term of this Agreement * * * [employee] will devote all of
his efforts to the performance of his duties as * * * [an officer of
UMLIC S-Corp.] and any other duties and responsibilities the Board
of Directors * * * may assign to him from time to time. Employee
agrees to perform such duties and responsibilities faithfully, diligently
and in a timely manner and to abide by all * * * [UMLIC S-Corp.]
policies relating to its employees generally.
Section 7 of the employment agreement, captioned “Termination,” provided
that “[t]his Agreement may be terminated by * * * [UMLIC S-Corp.] at any time
for cause.” The Agreement makes no provision for termination by the employee,
and it makes no provision for termination by the employer on grounds other than
“for cause.” For purposes of the Agreement, “cause” was defined to “include,
without limitation,” the following three categories of employee action:
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A. Dishonesty, fraud, embezzlement, alcohol or substance
abuse, gross negligence or other similar conduct on the part of the
Employee. Upon termination of this Agreement, Employee shall be
entitled to receive compensation through the date of termination.
B. Failure or refusal by Employee, after 15 days written notice
to Employee, to cure by faithfully and diligently performing the usual
and customary duties of his employment and adhere to the provisions
of this Agreement.
C. Failure or refusal by Employee, after 15 days written notice
to Employee, to cure by complying with the reasonable policies,
standards and regulations applicable to employees which * * *
[UMLIC S-Corp.] may establish from time to time.
Section 4 of the RSA, captioned “Termination of Employment,” governed
the consequences “[i]n the event of termination, voluntary or otherwise,” of the
employee’s employment with UMLIC S-Corp. Section 4 addressed two types of
termination: “termination without cause” and “termination with cause.” If the
employee’s employment was terminated “without cause, as defined in Section 7 of
the Employment Agreement,”3 he would be deemed by RSA section 4(b) to have
offered to sell all of his stock to the company pursuant to RSA section 5(b). The
latter provided that, if employment terminated after December 31, 2003--that is,
following the end of the initial term of the employment agreement--and the
employee was not in material breach of either agreement, he would receive 100%
3
In fact, section 7 of the employment agreement does not define termination
“without cause,” and those words do not appear in that section.
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of the fair market value of his stock, as determined by formula. Regardless of his
actual termination date, in other words, an employee discharged “without cause”
would be treated as if he had terminated employment after December 31, 2003,
and he would receive the full value of his shares.
If the employee’s employment was terminated by UMLIC S-Corp. “with
cause, as defined in Section 7 of the Employment Agreement,” the employee
would likewise be deemed to have offered to sell all of his stock to the company
under RSA sec. 4(a). However, the purchase price would then depend on the date
of the termination. If the employee was terminated for cause after December 31,
2003, he would receive 100% 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). It 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% of the fair
market value of his stock, with the possibility of receiving nothing, as determined
by formula.
For purposes of filing their individual income tax returns for 2000-2003,
petitioners took the position that their UMLIC S-Corp. stock was subject to a
“substantial risk of forfeiture” and was thus “substantially nonvested” within the
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meaning of section 1.83-3(b), Income Tax Regs. Section 1.1361-1(b)(3), Income
Tax Regs., generally provides that, for purposes of subchapter S, “stock that is
issued in connection with the performance of services * * * and that is
substantially nonvested (within the meaning of § 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.”4 Petitioners thus took the
position that 100% of the outstanding stock of UMLIC S-Corp. was owned by the
ESOP during 2000-2003 and that 100% of the company’s income was allocable to
it. Accordingly, neither petitioner reported any income or other flowthrough items
from UMLIC S-Corp. on his individual income tax return 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 Internal Revenue Service (IRS or respondent) issued to petitioners
timely notices of deficiency that challenged, on a variety of grounds, the tax
structure that petitioners and UMLIC S-Corp. had implemented. In this Opinion,
we address only one of the theories the IRS has advanced--namely, that peti-
4
A holder of restricted S corporation stock may elect to be treated as a
shareholder, sec. 1.1361-1(b)(3), Income Tax Regs., but neither petitioner made
such an election.
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tioners’ stock when issued to them was “substantially vested” by virtue of section
1.83-3(c)(2), Income Tax Regs.
Discussion
I. Summary Judgment Standard
Summary judgment is intended to expedite litigation and avoid unnecessary
and expensive trials. See FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73,
74 (2001). Either party may move for summary judgment upon all or any part of
the legal issues in controversy. Rule 121(a). A motion for summary judgment or
partial summary judgment will be granted only if it is shown that there is no
genuine dispute as to any material fact and that a decision may be rendered as a
matter of law. See Rule 121(b); Elec. Arts, Inc. v. Commissioner, 118 T.C. 226,
238 (2002). The moving party bears the burden of proving that there is no
genuine dispute as to any material fact, and the Court views all factual materials
and inferences in the light most favorable to the nonmoving party. Dahlstrom v.
Commissioner, 85 T.C. 812, 821 (1985).
The parties agree that there are no disputes of material fact affecting the
question addressed in this Opinion--namely, whether section 1.83-3(c)(2), Income
Tax Regs., precludes the agreements at issue from giving rise to a “substantial risk
of forfeiture.” Our disposition of this question turns entirely on legal determina-
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tions and the interpretation of the governing agreements. We accordingly
conclude that we may decide this question summarily.
II. Status of Petitioners’ Stock Under Section 83
The RSA provides that each petitioner, upon termination of employment,
will be deemed to have offered to sell his stock to UMLIC S-Corp. at the “pur-
chase price” specified in section 5. Section 5(b), wherever it applies, specifies that
the employee will receive 100% of the fair market value of his stock, determined
by formula. Section 1.83-3(c)(1), Income Tax Regs., states that “[p]roperty is not
transferred subject to a substantial risk of forfeiture to the extent that the employer
is required to pay the fair market value * * * to the employee upon the return of
such property.” The parties accordingly agree that section 5(b) cannot create a
substantial risk of forfeiture.
That being so, the only provision of the RSA that could create a substantial
risk of forfeiture is section 5(a), under which the employee will receive at most
50% of the fair market value of his stock. Section 5(a) comes into play upon “ter-
mination of * * * employment.” This subject is governed, apparently compre-
hensively, by section 4 of the RSA, captioned “Termination of Employment,”
which applies “[i]n the event of termination, voluntary or otherwise.” The only
situation in which section 4 triggers the 50% discount mandated by section 5(a) is
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a termination “with cause” occurring before January 1, 2004. Under the regula-
tions, a requirement that stock be forfeited “if the employee is discharged for
cause * * * will not be considered to result in a substantial risk of forfeiture.” Sec.
1.83-3(c)(2), Income Tax Regs. Respondent accordingly concludes that no
provision of the RSA gives rise to a substantial risk of forfeiture.
Petitioners contend that the scope of “for cause,” as used in section 1.83-
3(c)(2), is not necessarily identical to the scope the parties have given that phrase
in their agreements. Section 7 of the employment agreement broadly defines three
categories of employee action justifying “termination with cause.” Petitioners
agree that discharge for activity specified in section 7(A)--e.g., for “[d]ishonesty,
fraud, embezzlement, alcohol or substance abuse”--is reasonably characterized as
a “discharge for cause” within the meaning of the regulation. On the other hand,
petitioners contend that termination for 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 section 1.83-
3(c)(2). Rather, according to petitioners, section 7(B) is the mechanism the parties
have adopted, clumsily perhaps, to enforce the central requirement of the RSA--
that petitioners 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.
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Such a requirement, petitioners contend, necessarily creates a “substantial risk of
forfeiture” under the statute and its implementing regulations.
A. The Statute and the Regulations
Section 83(a) applies where, as concededly occurred here, property is
transferred to a taxpayer “in connection with the performance of services.” Upon
such a transfer, the excess of the fair market value of the property over the amount
(if any) paid for the property shall be included in the taxpayer’s gross income in
the first taxable year in which the taxpayer’s rights in the property “are not subject
to a substantial risk of forfeiture.” Sec. 83(a). The statute thus permits a taxpayer
to defer recognition of any gain until his rights in the restricted property become
“substantially vested.” Sec. 1.83-1(a)(1), Income Tax Regs.; see Storm v. United
States, 641 F.3d 1051, 1056 (9th Cir. 2011).5
Section 83(c) provides that “[t]he rights of a person in property are subject
to a substantial risk of forfeiture if such person’s rights to full enjoyment of such
5
Because petitioners received their UMLIC-S Corp. shares in a section 351
exchange, they were relieved of any obligation to recognize gain upon receipt of
the shares. The relevance of determining whether the shares were “substantially
vested” upon receipt is that this determination controls whether petitioners’ shares
are treated during 2000-2003 as “outstanding stock of the corporation,” sec.
1.1361.1(b)(3), Income Tax Regs., for purposes of allocating UMLIC-S Corp.
income to petitioners.
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property are conditioned upon the future performance of substantial services by
any individual.” The regulations echo the statutory definition:
For purposes of section 83 and the regulations thereunder, whether a
risk of forfeiture is substantial or not depends upon the facts and
circumstances. A substantial risk of forfeiture exists where rights in
property that are transferred are conditioned, directly or indirectly,
upon the future performance (or refraining from performance) of
substantial services by any person * * *
Sec. 1.83-3(c)(1), Income Tax Regs.
The requirement that an employee perform future services as a condition of
obtaining full enjoyment of restricted property is sometimes called an “earnout”
restriction. See Campbell v. Commissioner, T.C. Memo. 1990-162, 59 T.C.M.
(CCH) 236, 251, aff’d in part, rev’d in part, 943 F.2d 815 (8th Cir. 1991).
Because of the real possibility that this condition may not be fulfilled, an earnout
restriction will normally create a “substantial risk of forfeiture” that postpones
taxation until the restriction lapses. The regulations provide a clear example of an
earnout restriction:
On November 1, 1971, corporation X transfers in connection with the
performance of services to E, an employee, 100 shares of corporation
X stock for $90 per share. Under the terms of the transfer, E will be
subject to a binding commitment to resell the stock to corporation X
at $90 per share if he leaves the employment of corporation X for any
reason prior to the expiration of a 2-year period from the date of such
transfer. Since E must perform substantial services for corporation X
and will not be paid more than $90 for the stock, regardless of its
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value, if he fails to perform such services during such 2-year period,
E’s rights in the stock are subject to a substantial risk of forfeiture
during such period.
Sec. 1.83-3(c)(4), Example (1), Income Tax Regs.
Section 1.83-3(c)(2) of the regulations, the focus of the present con-
troversy, provides several illustrations of substantial risks of forfeiture. It
provides in pertinent part:
Where an employee receives property from an employer subject to a
requirement that it be returned if the total earnings of the employer do
not increase, such property is subject to a substantial risk of
forfeiture. On the other hand, requirements that the property be
returned to the employer if the employee is discharged for cause or
for committing a crime will not be considered to result in a substantial
risk of forfeiture. * * *
Read in isolation, the term “for cause” is susceptible to a broad construc-
tion. In the employment law context, “for cause” expresses “a common standard
governing the removal of a civil servant or an employee under contract.” Black’s
Law Dictionary 717 (9th ed. 2009). Generally, “[a]n employer has cause for early
termination of an agreement for a definite term of employment if the employee has
engaged in misconduct, other malfeasance, or other material breach of the
agreement, such as persistent neglect of duties, gross negligence, or failure to
perform the duties of the position due to a permanent disability.” Restatement,
Employment 3d, Tentative Draft No. 2, sec. 2.04 (2009). According to the
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Restatement, the parties to an employment agreement are free to define the term
“for cause” as they believe appropriate to the particular employment setting. Id.
The employment law definition of “for cause” can thus cover termination for a
wide range of reasons.
The history of a regulation may be helpful in resolving ambiguities in it.
See Wallace v. Commissioner, 128 T.C. 132 (2007); Anderson v. Commissioner,
123 T.C. 219, 233 (2004), aff’d, 137 Fed. Appx. 373 (1st Cir. 2005). The
Department of the Treasury issued proposed regulations under section 83 in 1971.
36 Fed. Reg. 10787 (June 3, 1971). Section 1.83-3(c), Proposed Income Tax
Regs., 36 Fed. Reg. 10790 (June 3, 1971), did not contain the phrase “discharged
for cause.” Rather, the proposed regulation read in pertinent part: “On the other
hand, a requirement that the property be returned to the employer if the employee
commits a crime will not be considered to result in a substantial risk of forfeiture.”
Sec. 1.83-3(c)(1), Proposed Income Tax Regs., supra.
When issuing these regulations in proposed form, the Secretary stated that
“[p]rior to the final adoption of such regulations, consideration will be given to
any comments or suggestions pertaining thereto.” 36 Fed. Reg. 10787. The IRS
received 374 pages of public comments, several of which bear on the question
here. Comments submitted by the New York State Bar Association, received by
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the IRS on January 10, 1972, suggested that “the Regulations should not attempt
to create presumptions or draw lines, except in the clearest situations (such as
forfeiture conditioned only on committing a crime), because to do so is to make a
rule of law where none was authorized by Congress.” Comments submitted by
Cravath, Swaine & Moore, received by the IRS on July 8, 1971, suggested that the
exception for “committing a crime” was sound because “the risk of forfeiture rests
upon a single possibility which is very unlikely to happen.”
After the public comments were received, but before any final regulations
were issued, this Court decided two cases that addressed the meaning of
“substantial risk of forfeiture” under section 83. In Ludden v. Commissioner, 68
T.C. 826 (1977), aff’d, 620 F.2d 700 (9th Cir. 1980), we were required to
determine the tax consequences when a corporation contributed funds to trusts that
failed to qualify under section 401(a). As a collateral matter, we had to determine
whether property was subject to a substantial risk of forfeiture under section 83.
See id. at 835. The terms of both trusts provided that “[i]f a participating
employee has been discharged by the Company for cause, such as any intentional
act of proven dishonesty or any other intentional act which would injure the
Company,” the employee would forfeit the entire amount allocated to him. Id. at
836. We held that “the probability that either of the petitioners would be
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discharged for cause from their wholly owned corporation, thereby forfeiting
benefits * * *, is too remote to constitute a substantial risk of forfeiture.” Ibid.
In Burnetta v. Commissioner, 68 T.C. 387 (1977), we determined that a
corporation’s pension plan did not qualify under section 401(a) and again had to
decide whether the employer’s contributions to that plan were includable in the
employee’s gross income under section 83. The plan provided that the property
would be forfeited if the employee was “discharged for theft of company property
or embezzlement.” Id. at 390, 403. We held that the property was not subject to a
substantial risk of forfeiture because the possibility that an employee would be
discharged for theft or embezzlement “is too remote to present any substantial risk
that the amounts contributed on his behalf will be forfeited.” Id. at 405. We noted
that the Department of the Treasury had issued proposed regulations under section
83 and stated our belief that our holding was consistent with those regulations. Id.
(citing sec. 1.83-3(c)(1), Proposed Income Tax Regs., supra).
The following year, the Department of the Treasury issued the section 83
regulations in final form. T.D. 7554, 1978-2 C.B. 71. The final regulations added
the phrase “discharged for cause” to what is now section 1.83-3(c)(2), Income Tax
Regs., modifying the sentence in question to read as it currently does: “On the
other hand, requirements that the property be returned to the employer if the
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employee is discharged for cause or for committing a crime will not be considered
to result in a substantial risk of forfeiture.” T.D. 7554, 1978-2 C.B. at 78.
When issuing the final regulations, the Department of the Treasury
explained the principal changes it had made to the proposed regulations. T.D.
7554, 1978-2 C.B. at 72-73. The insertion of “discharged for cause” into section
1.83-3(c)(2), Income Tax Regs., was not among the changes so discussed. “In
addition to the changes already mentioned,” the Secretary stated: “[S]everal
changes of less significance were made in response to public comments.” T.D.
7554, 1978-2 C.B. at 73. The insertion of “discharged for cause” into section
1.83-3(c)(2) was evidently regarded as one of these “less significant” changes.
B. Discharge “for Cause or for Committing a Crime”
Because the term “for cause” as used in section 1.83-3(c)(2) is not defined
in the statute, the regulations, or the legislative history, we employ the standard
tools of construction to discern its scope. Regulations are interpreted in the same
manner as statutes. See Black & Decker Corp. v. Commissioner, 986 F.2d 60, 65
(4th Cir. 1993), aff’g T.C. Memo. 1991-557. The starting point is the language
itself. Greyhound Corp. v. Mt. Hood Stages, Inc., 437 U.S. 322, 330 (1978). In
determining “the plain meaning of the statute, the court must look to the particular
statutory language at issue, as well as the language and design of the statute as a
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whole.” K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291 (1988); Norfolk Energy,
Inc. v. Hodel, 898 F.2d 1435, 1442 (9th Cir. 1990). When a statute is ambiguous,
the court must find the interpretation that “can most fairly be said to be embedded
in the statute, in the sense of being most harmonious with its scheme and with the
general purposes that Congress manifested.” NLRB v. Lion Oil Co., 352 U.S.
282, 297 (1957). “We interpret * * * regulations in toto rather than phrase by
phrase.” Microsoft Corp. v. Commissioner, 115 T.C. 228, 248-249 (2000) (citing
Norfolk Energy, Inc., 898 F.2d at 1442). In the end, a regulation will be
interpreted to avoid conflict with a statute. See Phillips Petroleum Co. v.
Commissioner, 97 T.C. 30, 35 (1991), aff’d without published opinion, 70 F.3d
1282 (10th Cir. 1995).
The text and evolution of section 1.83-3(c)(2) indicate that the term “dis-
charged for cause,” as used therein, does not necessarily have the same scope that
parties to a particular contract may have given this term in their negotiations.
Rather, as used in the regulation, “discharged for cause” refers to termination for
serious misconduct that is roughly comparable--in its severity and in the
unlikelihood of its occurrence--to criminal misconduct. The 1971 proposed
regulations mentioned discharge “for committing a crime” as the only illustration
of an employment-related contingency that failed, as a matter of law, to create a
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“substantial risk of forfeiture.” Whether a risk of forfeiture is “substantial” gene-
rally “depends upon the facts and circumstances.” Sec. 1.83-3(c)(1), Income Tax
Regs. Despite this general rule, commenters on the proposed regulations agreed
that the proposed exception for “committing a crime” was reasonable, since this
limited per se rule comprised a narrow, well-defined category of event that was
very unlikely to occur.
We may never know for certain what prompted the Department of the
Treasury, in the 1978 final regulations, to revise this exception to read “discharged
for cause or for committing a crime.” However, a fair inference is that this
revision was implemented to codify the results in Ludden and Burnetta, both of
which were decided the previous year. In Ludden, we held that a “substantial risk
of forfeiture” did not exist where the employment-related contingency was
“discharge[] * * * for cause, such as any intentional act of proven dishonesty or
any other intentional act which would injure the Company.” 68 T.C. 836. In
Burnetta, we held that a “substantial risk of forfeiture” did not exist where the
employment-related contingency was “discharge[] for theft of company property
or embezzlement.” In both cases, we viewed the contingency in question as “too
remote” to create a “substantial risk of forfeiture.” Ludden, 68 T.C. 836;
Burnetta, 68 T.C. 405.
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This history of section 1.83-3(c)(2), Income Tax Regs., strongly suggests
that discharge “for cause,” like discharge “for committing a crime,” refers to a
narrow and serious form of employee misconduct that is very unlikely to occur
and is thus properly regarded as too remote--as a matter of law--to create a
“substantial risk of forfeiture.” The fact that the Department of the Treasury did
not view the insertion of “discharged for cause” into the final regulations as a
change of significance supports this interpretation. And respondent in his
posthearing memorandum agrees with this construction:
It is respondent’s position that the phrase “for cause or for
committing a crime” was intended to capture risks that are too
remote to be considered a substantial risk of forfeiture. Respon-
dent further contends that the addition of the “for cause” provision
was intended to clarify that contingencies resulting in an involun-
tary termination that are too remote to be considered substantial
risks go beyond terminations for committing a crime, and include
other conduct that results in a termination, but that is very unlikely
to occur.
In short, it seems clear that the term “for cause,” as used in section 1.83-3(c)(2),
does not necessarily have the same meaning as, and may have a narrower meaning
than, the terminology employed by particular parties during private negotiations.6
6
The canon of construction “noscitur a sociis”--a Latin phrase meaning “it is
known by its associates”--supports the construction set forth in the text. This
canon of construction “hold[s] that the meaning of an unclear word or phrase
should be determined by the words immediately surrounding it.” Black’s Law
(continued...)
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C. Application of the Regulation to the Agreements
Section 14 of the employment agreement provides that it “shall be construed
in accordance with and governed by the internal law * * * of the State of North
Carolina.” In interpreting a contract under North Carolina law, the intention of the
parties generally controls. Jones v. Palace Realty Co., 37 S.E.2d 906, 907 (N.C.
6
(...continued)
Dictionary 1160-1161 (9th ed. 2009). While this canon does not set forth an
inescapable rule, it is often wisely applied to avoid giving unintended breadth to a
word susceptible to multiple meanings. See James v. United States, 550 U.S. 192,
222 (2007) (“[The] various possible meanings a word should be given must be
determined in a manner that makes it ‘fit’ with the words with which it is closely
associated.”); Jarecki v. G.D. Searle & Co., 367 U.S. 303, 307 (1961) (“noscitur a
sociis” is a commonsense cannon); Wallace v. Commissioner, 128 T.C. 132, 141
(2007) (“[T]he meaning of an unclear word or phrase should be determined by the
words immediately surrounding it.”). For example, in G.D. Searle & Co., the
Court interpreted the word “discovery” as used in section 456(a)(2)(B) of the
Internal Revenue Code of 1939, which imposed tax on “income resulting from
exploration, discovery, or prospecting.” Whereas “discovery” is a broad term that
in other contexts can include geographical and scientific discoveries, the Court
held that its association with “exploration” and “prospecting” suggested that the
term, as used in this statute, had the narrower meaning of “discovery of mineral
resources.” Id. at 307. While “noscitur a sociis” is most commonly applied to lists
of three or more terms, it may apply “when two or more words are grouped
together.” 2A Norman J. Singer & J.D. Shambie Singer, Sutherland Statutory
Construction, sec. 47:16, at 347 (7th ed. 2007). Here, the term “for cause” is
susceptible to a wide variety of meanings under private contracts. Applying the
“noscitur a sociis” canon, we can surmise that the Department of the Treasury, by
associating the phrase “for cause” with “for committing a crime,” intended
“discharge for cause” in section 1.83-3(c)(2), Income Tax Regs., to have a
narrower meaning and to denote termination for serious misconduct that is roughly
comparable to criminal misconduct.
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1946) (“The heart of a contract is the intention of the parties.”); Bueltel v. Lumber
Mut. Ins. Co., 518 S.E.2d 205, 209 (N.C. Ct. App. 1999) (“The court is to interpret
a contract according to the intent of the parties to the contract, unless such intent is
contrary to law.”). The intention of the parties “is to be gathered from the entire
instrument, viewing it from its four corners.” Jones, 37 S.E.2d at 907.
We review the employment agreement and the RSA as an integrated whole.
Petitioners were the key contributors to their distressed debt loan portfolio business
before the UMLIC Entities were consolidated into UMLIC S-Corp. The stated
purpose of these agreements was to “provid[e] certain financial incentives” to
induce petitioners to continue their employment with the consolidated company for
an initial term of four years. As a condition of receiving the UMLIC S-Corp. stock,
petitioners affirmed that they were “willing to perform future services” on behalf of
the company. Section 1 of the employment agreement required each petitioner to
“devote all of his efforts to the performance of his duties” for UMLIC S-Corp. for
the four-year term of the Agreement and to perform such duties “faithfully,
diligently and in a timely manner.” These provisions are most naturally read to
express the parties’ intention that petitioners were required to perform substantial
future services for UMLIC S-Corp. in exchange for their stock.
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The termination provisions of the employment agreement and the RSA must
be evaluated in the light of the parties’ expressed intention and the construction of
the regulation that we have adopted above. Applying these parameters, and
looking only within the four corners of the agreements, we believe that termination
for activity specified in section 7(A) of the employment agreement--e.g., for
“[d]ishonesty, fraud, embezzlement, alcohol or substance abuse”--is reasonably
characterized as a discharge “for cause” within the meaning of section 1.83-3(c)(2).
However, we agree with petitioners that termination for activity specified in section
7(B) of the employment agreement does not fall within the scope of discharge “for
cause or for committing a crime” for purposes of this regulation.
Section 7(B) permits termination for “[f]ailure or refusal by Employee, after
15 days written notice to Employee, to cure by faithfully and diligently performing
the usual and customary duties of his employment.” The conditions stated in this
section are the conditions that commonly lead employers throughout our economy
to terminate at-will employees--namely, unsatisfactory job performance. This is
not a “remote” category of event that is unlikely to occur.
More specifically, under the peculiar drafting of these instruments, section
7(B) appears to constitute, in conjunction with RSA section 5(a), a classic “earnout
restriction.” The employment agreement states that it can be terminated only by
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UMLIC S-Corp. and only for reasons denominated “for cause.” Given proscrip-
tions against involuntary servitude, there must be some way that petitioners could
voluntarily cease working for that company. Section 7(B) seems to be the
mechanism that the drafters intended to cover this situation.
If one of petitioners announced his intention to leave his employment before
January 1, 2004, section 7(B) contemplates that UMLIC S-Corp. would issue him a
“notice to cure.” He would then have 15 days to cure “by faithfully and diligently
performing the usual and customary duties of his employment and adhere to the
provisions of this Agreement.” This language tracks section 1 of the employment
agreement, wherein each petitioner agreed, during the four-year term of that
Agreement, “to perform * * *[his] duties and responsibilities faithfully, diligently
and in a timely manner and to abide by all * * * [UMLIC S-Corp.] policies relating
to its employees generally.” What petitioner would have to “cure,” in other words,
was his refusal to continue performing the duties specified in the employment
agreement, which he had pledged diligently to discharge for four years. If
petitioner did not cure this breach within 15 days, UMLIC S-Corp. was entitled
under section 7(B) to terminate the employment agreement “for cause.”7
7
Technically speaking, by acting under section 7(B), UMLIC S-Corp. would
not be terminating the employee for cause, but rather would be terminating the
(continued...)
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In short, section 7(B) of the employment agreement appears to be the
linchpin of the mechanism by which petitioners would receive less than full fair
market value upon forfeiture of their stock if they did not continue to perform
substantial services for UMLIC S-Corp. for the four-year initial term of that
agreement. As a general rule, “[t]he rights of a person in property are subject to a
substantial risk of forfeiture if such person’s rights to full enjoyment of such
property are conditioned upon the future performance of substantial services by any
individual.” Sec. 83(c)(1). The regulations make clear that an earnout restriction
creates “a substantial risk of forfeiture” if there is a sufficient likelihood that the
restriction will actually be enforced. Compare sec. 1.83-3(c)(4), Example (1),
Income Tax Regs., with sec. 1.83-3(c)(3), Income Tax Regs.
We thus conclude that RSA section 5(a) in conjunction with section 7(B) of
the employment agreement--however inartfully drafted--constitutes an earnout
restriction that may give rise to a “substantial risk of forfeiture” under section 83.
Notwithstanding section 7(B)’s appearance in a contractual provision addressing
termination “for cause,” the employee activity specified in section 7(B) falls
outside the scope of discharge “for cause or for committing a crime” within the
7
(...continued)
employment agreement for cause, with “cause” consisting of the employee’s
breach of that Agreement by refusing to work for the agreed-upon four-year term.
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meaning of section 1.83-3(c)(2), Income Tax Regs. That is so 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, that is so because a conclusion that section 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. See sec. 83(c)(1);
Phillips Petroleum Co. v. Commissioner, 97 T.C. 35.
Conclusion
For these reasons, we will deny respondent’s motion for partial summary
judgment, which is based solely on the theory that section 1.83-3(c)(2), Income Tax
Regs., caused petitioners’ UMLIC S-Corp. stock to be “substantially vested” at the
time it was issued to them. Respondent has advanced a number of other theories,
addressed both to the overall structure that petitioners implemented and to the
specific question of whether their stock was “substantially vested “ upon issuance.
For example, as an alternative to his theory based on section 1.83-3(c)(2), respon-
dent contends that petitioners’ stock was “substantially vested” on the theory that
petitioners’ 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. See sec. 1.83-3(c)(3), Income
- 29 -
Tax Regs. This theory, like respondent’s other theories, remains for trial on the
merits. Because petitioners’ cross-motion seeks summary judgment on one or more
of these other IRS theories, which involve material issues of disputed fact,
petitioners’ cross-motion will be denied.
An appropriate order will
be issued.