The Tax Court, Restricted Stock, and ESOPs
The Tax Court’s recent decision in Larson v. Commissioner involved a frequent tax issue in the context of S corporations and control persons: Whether restricted stock of an S-corporation contributed to an employee stock ownership plan (ESOP) for the benefit of a control person was subject to substantial risk of forfeiture? What follows is a short synopsis of the case and the key points of law:
Short Summary: Restricted stock of an S corporation that was placed into an employee stock ownership plan for the benefit of a control person of the S corporation was includable in the control person’s taxable income. The restrictions associated with the stock were not likely to be enforced such that there was no “substantial risk of forfeiture” to the beneficial owner, i.e., the control person. And, the control person, also a trustee of the ESOP, failed to perform fiduciary duties associated with the ESOP, further indicating the lack of any risk of forfeiture to the stock in question. Thus, the income of the S corporation should have passed through, pro rata, to the control person in the tax years in question.
- Whether the Commissioner erred in finding that pass-through income from an S corporation, Morley, Inc., was includable in John Larson’s taxable income for tax years 1999 and 2000 when Larson, a control person, was the beneficial owner of Morley, Inc. stock that was contributed to an employee stock ownership plan (ESOP) but restricted by employment performance requirements and strict voting procedures?
- Whether the Commissioner erred in denying as ordinary and necessary business expenses deductible under section 162, certain expenses incurred and paid by S corporation, Morley, Inc.
Short Answers: No, and no.
- Under the facts and circumstances of the case, the value of the stock in the S corporation was not subject to a substantial risk of forfeiture for the years in question as required by 26 U.S.C. § 83. Larson, along with the other control persons of Morley and the ESOP, failed to enforce employment performance restrictions, and Larson “grotesquely” failed to perform his fiduciary duties associated with the ESOP. Therefore, the Commissioner was correct in assessing the value of the stock in Larson’s taxable income for the applicable tax years.
- Larson’s “relationship to the officers and directors of the [S] corporation and their actions [to waive restrictions associated with the stock and to breach fiduciary duties owed to the ESOP] revealed an effort to collectively avoid enforcement of the restrictions. . . . . Mr. Larson did not put forward any convincing evidence that he could possibly lose control over the S corporation[,]” and therefore, the value of the Morley, Inc. stock was includable in Larson’s income as there was no substantial risk of forfeiture associated with the stock.
- Larson’s self-serving declarations, unreliable hearsay, and uncorroborated testimony was insufficient to establish a deduction for the business expenses in issue.
Key Points of Law:
- The Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of providing that those determinations are erroneous.
- An S corporation is defined as a small business corporation for which an election under 26 U.S.C. § 1362(a) is in effect for the relevant tax year. Like partnership income, income from an S corporation flows to its shareholders, resulting in only one level of taxation. at § 1363(a). An S corporation shareholder generally determines his or her tax liability by taking into account a pro rata share of the S corporation’s income, losses, deductions, and credits. See id. at § 1366(a)(1). When qualified ESOPs meet the requirements of 26 U.S.C. § 401(a), their related trusts are generally exempt from income taxation pursuant to 26 U.S.C. § 501(a). Outstanding shares of an S corporation may be owned by an ESOP, effectively allowing S corporation profits to escape immediate federal income taxation.
- Section 83(a) governs the tax treatment of property transferred “in connection with performance of services.” Upon such a transfer, the value of such property is taxable in the first year in which the taxpayer’s rights in the property are “transferable or are not subject to a substantial risk of forfeiture.” 26 U.S.C. § 83(a)(1) (emphasis added); Reg. § 1.83-1(a)-(b). A taxpayer can defer recognition of income until his or her rights in the restricted property become “substantially vested.” Treas. Reg. § 1.83-1(a)(1).
- “[A] substantial risk of forfeiture exists only if 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.” Reg. § 1.83-3(c)(1). Whether a substantial risk of forfeiture exists depends on the facts and circumstances.
- An employment agreement made in conjunction with a restricted stock agreement is considered an “earnout restriction” whereby the property cannot be fully enjoyed until, for example, the future performance of substantial services. For purposes of subchapter S, “stock that is issued in connection with the performance of services . . . and that is substantially nonvested . . . 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.” Reg. § 1.1361-1(b)(3). When structured and performed properly, earnout restrictions can give rise to a substantial risk of forfeiture within the meaning of section 83. When such stock is not subject to a substantial risk of forfeiture, the stock so issued constitutes a passthrough income from the issuing company to the stockholder. In evaluating these requirements under section 83, the courts consider, primarily, whether there is a sufficient likelihood that the earnout restrictions (i.e., performance requirements) would be enforced.
- When restricted property is transferred to an employee “who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation,” the IRS and courts consider factors of control, not just stock ownership percentages; de facto power to control is a focus. See Reg. § 1.83-3(c)(3)-(c)(3)(v).
- Reg. § 1.83-3(c)(3) provides five factors to consider when determining whether an employee’s interest in transferred property is subject to a substantial risk of forfeiture in instances where an employee of a corporation owns a significant amount of stock of the employer corporation:
- the employee’s relationship to other stockholders and the extent of their control, potential control and possible loss of control of the corporation,
- the position of the employee in the corporation and the extent to which he is subordinate to other employees,
- the employee’s relationship to the officers and directors of the corporation,
- the person or persons who must approve the employee’s discharge, and
- past actions of the employer in enforcing the provisions of the restrictions.
- Note: In 2001, the Internal Revenue Code was amended to require that income or loss that had previously been allocable to the ESOP be attributable to certain non-ESOP shareholders of a closely held corporation. The change, however, was prospective; it did not apply to plan years before 2005 for an ESOP that existed before 2001.
- To deduct an expense under section 162 of the Code, a taxpayer must establish that the amount was an ordinary and necessary expense paid or incurred in carrying on a trade or business. See 26 U.S.C. § 162(a). Taxpayers must substantiate the amount of any claimed deduction by maintaining the records needed to establish entitlement to such a deduction; self-serving declarations, unreliable hearsay, and uncorroborated testimony are generally insufficient means to establish such entitlement.