Company Not Entitled to Deduction under Code Sec. 83 for Stock Transferred to Officer

(Parker Tax Publishing January 2017)

The Fourth Circuit affirmed a Tax Court decision disallowing a company's deduction under Code Sec. 83 for stock issued to an officer. After noting that forfeiture provisions triggered by termination for cause or by engaging in competition do not constitute a "substantial risk of forfeiture," the Fourth Circuit concluded that the remaining ground for forfeiturethe taxpayer's voluntary resignationwas unlikely to happen. QinetiQ US Holdings Inc. v. Comm'r, 2017 PTC 6 (4th Cir. 2017).

Background

In March 2002, Thomas Hume formed Thomas G. Hume, Inc. A few months later, Hume created new classes of voting and nonvoting stock and changed the name of the corporation to DTRI to facilitate Julian Chin joining the business. On December 12, 2002, Hume executed a "Consent in Lieu of the Organizational Meeting" which offered the issuance and sale of 4,500 shares of voting stock to himself, 4,455 shares of voting stock to Chin, and 45 shares of nonvoting stock to Chin. Included in the consent was authorization for the company to enter into a shareholder and employment agreements with Hume and Chin. Attached to the consent were signed acknowledgements by Hume and Chin of their intent to subscribe to the stated number of shares.

The shareholder agreement calculated the value of the shares and gave the company the option of repurchasing Hume's or Chin's shares at the calculated value in the event of their death, disability, or termination of employment. In the case of voluntary resignation, the company had the option to purchase the stock at 5 percent of the calculated value for every year of the departing employee's employment up to a maximum of 100 percent. However, the maximum was reduced to 25 percent if the departing employee voluntarily resigned and engaged in competition with the company, or was terminated for cause.

From 2002 through 2007, the company did not report the stock issued to Hume and Chin in 2002 as compensation, and did not withhold federal payroll taxes on the value of the issued stock. On the other hand, Hume and Chin did report as compensation shares later granted to them. In 2008, DTRI merged into another corporation, QinetiQ. Before the merger closed, Hume and Chin executed agreements waiving DTRI's rights with respect to stock transfer restrictions or partially vested stock. QinetiQ withheld payroll taxes on the value of the stock received by Hume and Chin in 2002, and claimed deductions under Code Sec. 83(h) for the value of the shares issued to them in December 2002.

In its notice of deficiency, the IRS determined that QinetiQ had not established that it was entitled to a deduction under Code Sec. 83, and increased QinetiQ's taxable income for the year by more than $117 million. The Tax Court held that QinetiQ was not entitled to the deduction because the stock was not property "transferred in connection with the performance of services," and was not "subject to a substantial risk of forfeiture" when Chin acquired the shares.

Analysis

QinetiQ argued that the value of the stock issued to Chin in 2002 qualified as a trade or business expense in 2008, because the stock was issued in connection with Chin's employment and was subject to a substantial risk of forfeiture until Chin sold the shares in 2008 as part of the merger. The IRS responded that Chin subscribed to the stock as an investment and not in connection with his employment, and the stock was not issued subject to a substantial risk of forfeiture.

The Fourth Circuit noted that Code Sec. 83(a) generally treats property transferred in connection with the performance of services as income of the person performing the services (the service provider), in which case the employer is entitled to a deduction for the value of the property as a trade or business expense. This rule is modified when the property is subject to a substantial risk of forfeiture. In that case, the property is not treated as income of the service provider until the first tax year in which the property is no longer subject to a substantial risk of forfeiture.

Therefore, to claim a 2008 deduction for the value of the stock transferred to Chin in 2002, QinetiQ had to show that the stock was transferred in connection with the performance of services, and was subject to a substantial risk of forfeiture from the time it was transferred until the merger closed in 2008. The failure to establish either of these two required elements would nix QinetiQ's desired deduction.

Under Reg. Sec. 1.83-3(c), property is not subject to a substantial risk of forfeiture if the facts demonstrate that the forfeiture condition is unlikely to be enforced, or the employer is required to pay the employee the value of the property upon its return. Conditions imposed at the time of transfer that require the return of property if the employee is discharged for cause or for committing a crime, or accepts a job with a competing firm, are not sufficient to constitute a substantial risk of forfeiture.

The Fourth Circuit concluded that the only circumstance in which Chin would be required to forfeit his stock at a below-market price would be if Chin voluntarily resigned before 20 years of employment, voluntarily resigned and entered into competition with the company, or was terminated for cause. Because the regulation provides that forfeiture provisions triggered by termination for cause or by engaging in competition do not constitute a substantial risk of forfeiture, the only remaining ground for forfeiture would be Chin's voluntary resignation.

The Tax Court made a factual determination that Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event of Chin's voluntary departure. Based on Chin's significant ownership position, important roles as chief operating officer and executive vice president, and strong relationship with Hume, the Fourth Circuit concluded that this factual determination was supported by the record and was not clearly erroneous. It therefore held that the Tax Court did not err in concluding that QinetiQ failed to establish its entitlement to the claimed deduction.

For a discussion of substantially vested and substantially nonvested property, see Parker Tax ¶124,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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