In Qinetiq US Holdings, Inc. v. Commissioner, No. 15-2192 (4th Cir. 2017), the court addresses the situation where a taxpayer acquired a target corporation and then claimed a substantial tax deduction for expenses the target corporation had paid prior to the acquisition. There are rules intended to prevent taxpayers from being able to deduct pre-acquisition expenses. The stock compensation rules can be an exception to these rules, which is addressed in the case.
Facts & Procedural History
Thomas Hume (“Hume”) formed a corporation in 2002 and elected to have it treated as a Subchapter S corporation.
He admitted Julian Chin (“Chin”) as a shareholder of the corporation later in 2002.
As part of this, the corporation issued two shares of stock–Class A voting stock and Class B non-voting stock.
The corporate records included a consent that authorized the corporation to offer to sell the shares of the Class A voting stock to Hume and Chin.
The consent also authorized the corporation to enter into shareholder and employment agreements with Hume and Chin.
The consent did not authorize the corporation to enter into restrictive stock agreements with Hume and Chin.
The shareholder agreement with Hume and Chin included terms restricting the sale or transfer of stock and for returning stock to the corporation in the event of either Hume’s or Chin’s death, disability, or termination of employment with the corporation.
The employment agreements with Hume and Chin did not have any reference to stock issued as compensation.
Hume and Chin purchased the Class A voting stock.
In 2008, the corporation was acquired by the Taxpayer.
In 2009, the Taxpayer reported a $117,777,501 deduction for the stock Hume and Chin received in 2002.
The tax court ruled that the Taxpayer had not demonstrated entitlement to the deduction on two independent bases, namely, that the stock was not property “transferred in connection with the performance of services” and was not “subject to a substantial risk of forfeiture” at the time Chin acquired the shares.
The Taxpayer appealed the decision, which brings us to the current case.
The question for the appeals court was whether the Taxpayer was entitled to a deduction in 2009 for the stock Hume and Chin received in 2002.
Substantial Risk of Forfeiture
Compensation for services is usually deductible to the employer in the year it is paid and reported as income to the recipient in the same year. There is an exception for compensation for services that are subject to a substantial risk of forfeiture. This compensation is deductible and taxable in the year that it is no longer subject to forfeiture. The regulations include a number of rules that explain when compensation is subject to a substantial risk of forfeiture.
The appeals court cited two of these rules, namely, that there is no substantial risk of forfeiture if (1) the employer is required to pay the fair market value of such property to the employee upon the return of such property and, (2) at the time of the transfer, the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.
Restrictions that are Not Substantial
The appeals court noted that the shareholder agreement obligated the corporation to pay the fair market value of such property to the employee upon the return of such property upon Chin’s death, disability, or termination without cause. These restrictions failed the fair market value rule cited by the court.
The other restrictions in the shareholder agreement showed that the only circumstances in which Chin would be required to forfeit his stock at a below-market price would be if he voluntarily resigned before 20 years of employment, if he voluntarily resigned and entered into competition with the Taxpayer, or if he was terminated for cause.
The regulations say that termination for cause does not apply, so the court focused on the restriction imposed if Chin voluntarily resigned. This is the crux of the case. The tax court concluded that this risk was not “substantial” given its conclusion that Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event Chin voluntary resigned. The tax court based this decision on Chin’s early role in the company and the close relationship between Hume and Chin. The appeals court accepted this conclusion.
Structuring Stock Compensation
The takeaway is that stock restrictions have to be carefully considered in determining whether it is subject to a substantial risk of forfeiture. The regulations should be reviewed as they contain detailed rules that help clarify these rules. But the regulations (and case law) cannot be relied on in isolation. For restrictions such as voluntary resignation terms, facts, such as the close relationship identified in this case, should be considered in determining whether the risk is substantial.
It should also be noted that the appeals court did not have to address the investor vs. employee compensation issue in this case. This is yet another hurdle that taxpayers seeking to deduct this type of expense from a prior year have to overcome. This is especially true where the employees pay for their stock rather than being awarded stock pursuant to an established plan or arrangement based on some pre-defined criteria.
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