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It has long been a basic tenet of federal tax law that, in order to be respected for tax purposes, a transaction must have economic substance. In a recent decision, the Tax Court once again held that a purported sale or exchange lacking in economic substance will not be respected. The case also demonstrates that taxpayers who engage in transactions lacking in economic substance may be liable for additional penalties.
In Austin, the Tax Court held that a transaction in which stock was surrendered and then immediately repurchased lacked economic substance and that the Taxpayers acted with negligence in failing to include the full value of the stock in their 2004 gross income.
The case involves a complex set of transactions that give rise to five principle issues. The first issue is whether stock received by the Taxpayers in December 1998 was subject to a substantial risk of forfeiture when it was issued to them, as they contend, or rather was “substantially vested” within the meaning of Section 83 as argued by the IRS. The second issue is whether certain transactions between the Taxpayers’ closely-held S corporation and related employee stock ownership plan (“ESOP”) lacked economic substance. The third issue focuses on the Taxpayers’ reported “surrender” and “repurchase” of stock, and whether the transaction lacked economic substance. The fourth question concerned whether a “special dividend” that the S corporation paid in 2004 resulted in the Taxpayers recognizing income. The last question presented in the case is whether the Taxpayers were liable for accuracy-related penalties imposed under Section 6662 for 2004.
The Taxpayers, two unrelated individuals, worked together for more than fifteen years in the distressed debt loan portfolio business. The Taxpayers initially created a number of entities (both S corporations and LLCs) to avoid cross-collateralization and facilitate discrete financing arrangements for each loan portfolio. In December 1998, the Taxpayers organized, and elected S corporation status for, a holding company called UMLIC Consolidated, Inc. (“UMLIC S-Corp”). Immediately following formation of UMLIC S-Corp, each of the Taxpayers transferred his respective ownership interests in the various entities, with a cost basis of $142,566, in exchange for shares of the new holding company’s common stock. There were three primary reasons for the consolidation: to reduce the number of tax return filings and financial statement reports; to allow assets to be moved more efficiently among the subsidiary entities; and to take the first step down the road toward achieving other substantial tax benefits.
As part of the Section 351 exchange, each Taxpayer executed with UMLIC S-Corp a “Restricted Stock Agreement” (“RSA”) and an Employment Agreement. A principal purposes of these Agreements was to require the Taxpayers to perform future services for UMLIC S-Corp in order to secure full rights in their stock. These agreements together specified a five-year “earnout” period and provided that either Taxpayer would forfeit fifty percent (50%) of the value of his shares if he voluntarily terminated his employment with UMLIC S-Corp before January 1, 2004. The waiver or removal of this restriction required consent of the holders of 100% of the shares entitled to vote (therefore requiring the affirmative vote of both shareholders).
In a predecessor case, the Tax Court rejected the IRS’s motion for summary judgment that the stock was “substantially vested” when issued to them by virtue of Regulation Section 1.83-3(c)(2). Under that regulation, 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.” However, the Tax Court reserved for trial a number of other issues, including the IRS’s alternative argument that the Taxpayers’ stock was substantially vested because their status as UMLIC S-Corp’s sole directors 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. The Taxpayers were the sole directors and primary officers of UMLIC S-Corp throughout the tax years in issue.
Pursuant to the Small Business Job Protection Act of 1996, certain tax-exempt entities, including ESOPs, became eligible to be shareholders of S corporations. In December 1998, with the stated goal of encouraging long-term job retention, the Taxpayers caused UMLIC S-Corp to form an ESOP for its employees, including the Taxpayers. The ESOP initially had three (3) Co-Trustees, each of the Taxpayers and David Faber, UMLIC S-Corp’s Assistant Controller.
In December 1998, the corporation funded the ESOP with a $500,000 loan, which funds were used to purchase a number of shares of the Corporation’s common stock. At that time, the two Taxpayers each owned 47.5% of the corporation’s common stock and the ESOP owned the remaining five percent (5%). Subsequently, in August 1999, each Taxpayer established an irrevocable grantor trust and transferred the shares held by them individually to their respective grantor trusts. From August, 1999 until March, 2004, Taxpayers, their grantor trusts and the ESOP were the only shareholders of UMLIC S-Corp.
In late 2003, the Taxpayers reorganized the ownership structure of the business. Two primary concerns prompted the restructuring. First, the Taxpayers thought it would be desirable to bring in outside investors, such as private equity and hedge funds, to provide additional capital for the acquisition of distressed loan assets. The Taxpayers believed that such investors would be reluctant or unwilling to purchase shares in an S corporation partially owned by an ESOP. Second, because of a change to the Internal Revenue Code scheduled to take effect in January 2005, the S Corporation/ESOP structure that the Taxpayers had adopted would lose much of its tax benefit. The restructuring plan envisioned selling all of UMLIC S-Corp’s assets, consisting principally of its operating subsidiaries, to a new holding company wholly-owned (directly or indirectly) by Taxpayers. The new holding company, which thereafter would continue to conduct the distressed loan business, would be organized as a limited liability company, thus facilitating possible investment by sophisticated private investors. UMLIC S-Corp would be left with cash equivalents, essentially freezing its value, and the value of the five percent (5%) stake held by the ESOP, as of the date of the sale. The new holding company would in turn acquire a stepped-up basis in the acquired assets for purposes of claiming future deductions for depreciation and amortization expense.
Subsequently, in October 2003, the Taxpayers formed UMLIC Holdings, LLC (“Holdings”), as the acquiring company. Each of the Taxpayers (through intermediaries) owned a fifty percent (50%) membership interest in Holdings and was its sole directors. Because UMLIC S-Corp proposed to sell substantially all of its assets to Holdings, the transaction had to be approved by the former shareholders, including the ESOP. In order to avoid any potential conflicts of interest, the Taxpayers (on advice of counsel) resigned their roles as Co-Trustees of the ESOP. Additionally, before voting on the asset sale, the ESOP secured (again on advice of counsel) a fairness opinion that approved the terms as fair to the ESOP participants. In November 2003, the Taxpayers and the ESOP unanimously approved the sale of UMLIC S-Corp’s operating assets to Holdings in exchange for a $190,000,000 interest-bearing promissory note and the assumption of certain liabilities. UMLIC S-Corp realized gained of $174.6 million on the sale, elected out of the installment sales method under Section 453, and allocated 100% of the gain to the ESOP, the sole shareholder of its then-outstanding shares.
As a condition of approving the sale, the ESOP required that its five percent (5%) stake be redeemed within one (1) year. The redemption price was set at five percent (5%) of UMLIC S-Corp’s value on November 30, 2003 ($10,397,688), or five percent (5%) of its value on the redemption date, whichever sum was larger.
In December 2003, the Taxpayers engaged in a series of transactions that caused UMLIC S-Corp to be reincorporated in South Carolina and renamed UMLIC Consolidated, Inc. (“New UMLIC S-Corp”). At such time, all of the stock held by the Taxpayers and their grantor trusts was converted to New UMLIC S-Corp stock. The purported purpose for the reincorporation was to take advantage of lower corporate franchise taxes in South Carolina.
The Taxpayers discharged their obligations under the RSA and their Employment Agreements through December 31, 2003, and on January 1, 2004, the restrictions on their stock (now, the New UMLIC S-Corp stock) accordingly lapsed. As of that date, the fair market value of the shares of stock held by each Taxpayer and his grantor trust was $45,857,434. Thereafter, the Taxpayers’ executed a series of transactions in order to avoid having to report the income realized on the vesting of their shares in New UMLIC S-Corp stock as compensation subject to income and employment tax. Specifically, on March 30, 2004, each Taxpayer entered into a “Surrender Agreement” and a “Subscription Agreement” with New UMLIC S-Corp. These agreements provided that each Taxpayer would surrender his existing “and now unrestricted” shares and simultaneously repurchase identical shares in exchange for a $41.5 million Promissory Note with a 10-year term.
The redemption of the ESOP’s shares of New UMLIC S-Corp occurred on June 22, 2004. The redemption price was set at $10,397,688, approximately $9.1 million dollars of which inured to the benefit of 101 ESOP participants other than the Taxpayers. The ESOP was subsequently terminated and its assets were merged into a Section 401(k) plan. Following the redemption of the ESOP shares, New UMLIC S-Corp declared and paid, on June 30, 2004, a distribution (referred to as the “special dividend”) of $35,000,000 to the Taxpayers.
Taxpayers did not report any income from UMLIC S-Corp on their 2000-2003 Federal Income tax returns as they took the position that their stock (and that owned by their respective grantor trusts) was subject to a “substantial risk of forfeiture” and was thus “substantially non-vested” within the meaning of Reg. Section 1.83-3(b). Under Reg. Section 1.1361-1(b)(3), for purposes of Subchapter S, stock that is issued in connection with the performance of services and that is substantially non-vested 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. As such, UMLIC S-Corp allocated 100% of its income, losses, deductions and other tax items to the ESOP for tax years 2000 through 2003. Because the ESOP was a tax-exempt entity, it reported no taxable income from UMLIC S-Corp for tax years 2000 through 2003.
For 2004, each Taxpayer took the position that he had “surrendered” his original shares and acquired replacement shares worth $46,000,000 in exchange for a $41.5 million promissory note. As such, each Taxpayer reported the difference between those amounts, or $4.5 million, as compensation income under Section 83. The Taxpayers also took the position that they had acquired an increased basis in the New UMLIC S-Corp’s shares by virtue of the $41.5 million promissory notes so that the $35,000,000 “special dividend” would reduce their respective bases in their shares of stock of New UMLIC S-Corp, but would generate no additional income to either Taxpayer.
The IRS examined the Taxpayers’ returns for the tax years 2000 through 2004, and determined that the Taxpayers’ stock in UMLIC S-Corp was substantially vested upon receipt in 1998 and therefore their stock and that of their respective grantor trusts was outstanding for tax years 2000 through 2004. Accordingly, the IRS found that the Taxpayers were required to report their prorata shares of UMLIC S-Corp’s income for each such year. The IRS further determined that the Taxpayers did not have sufficient bases in their New UMLIC S-Corp stock to make the 2004 special dividend non-taxable and it determined accuracy-related penalties for all five (5) years.
The IRS issued timely notices of deficiency for tax years 2000-2004 to each of the Taxpayers. In July 2012, the Court granted the IRS leave to amend its answer to assert lack of economic substance as an alternative basis for the adjustments determined in the Notice of Deficiency.
Whether Taxpayers’ Stock Was Subject to a Substantial Risk of Forfeiture
Under Section 83(a), where property is transferred to a taxpayer “in connection with the performance of services,” the excess of the fair market value of the property over the amount (if any) paid for the property is included in the taxpayer’s gross income for the first taxable year in which the taxpayers’ rights in the property are transferrable or “are not subject to a substantial risk of forfeiture.” Thus, the statute permits a taxpayer to defer recognition of income until his rights in the restricted property becomes “substantially vested.”
Section 83(c) provides that the rights of a person in property are subject to a substantial risk of forfeiture if that person’s rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual. The risk of forfeiture analysis requires a court to determine whether the property interest transferred by the employer is capable of being forfeited. The Taxpayers argued that their stock in UMLIC S-Corp was subject to a substantial risk of forfeiture when they received it in December 1998 and remained subject to a substantial risk of forfeiture until January 1, 2004, when the five (5) year earnout restriction lapsed. On the other hand, the IRS contended that the Taxpayers’ stock was substantially vested when they received it in December 1998 and was outstanding for subchapter S purposes throughout the tax years in issue, and as such, the Taxpayers were required to report their prorata shares of UMLIC S-Corp’s income on their 2000 through 2003 Tax Returns.
The IRS first contended that Section 83 was inapplicable because the Taxpayer supplied only property, and no substantial future services, in exchange for the UMLIC S-Corp stock. The Tax Court quickly rejected this argument, finding that the RSAs and the Employment Agreements by their terms required the Taxpayers to perform substantial future services for UMLIC S-Corp as a condition of receiving the full value of their stock.
Second, the IRS argued that the Taxpayers could not have received stock that was “substantially non-vested” for Section 83 purposes, yet concurrently have “owned” at least eight percent (80%) of the total combined voting power of all classes of UMLIC S-Corp’s stock as was necessary to qualify for non-recognition treatment under Section 351. The Tax Court again was not persuaded by this argument and specifically pointed out that the applicable regulations simply states that stock that is issued in connection with a performance with services that is substantially non-vested is not treated as outstanding stock of the corporation for purposes of Subchapter S.
The court next turned its attention to whether there was a sufficient likelihood that the “earnout” restriction in the RSAs and the Employment Agreements would actually be enforced. Under the regulations, in situations where nominally 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, several factors must be considered in determining whether the possibility of forfeiture is substantial. These factors include the employee’s relationship to other shareholders, the extent of the other stockholders’ control, potential control and possible loss of control of the corporation, the position of the employee in the corporation, his relationship to the officers and directors of the corporation, the identity of the person or persons who must approve discharge, and past actions of the employer enforcing the restrictions. The specific question before the court was whether if either Taxpayer had quit his job before the end of the five year earnout period, UMLIC S-Corp would likely have enforced the restriction requiring that such Taxpayer forfeit fifty percent (50%) of the value of his shares. Based on the facts and circumstances, the Tax Court concluded that the answer to this question was yes.
The Tax Court pointed out that the skill sets of the two Taxpayers were quite different and that the Taxpayers therefore recognized that the success of their business depended on their both remaining with the Company. In order to incentivize this, they executed reciprocal agreements (the RSAs and the Employment Agreements) whereby each would lose fifty percent (50%) of the value of his stock if he left the Company within five (5) years. Removal or waiver of this forfeiture provision required the consent of the holders of 100% of the corporation’s shares. As such, neither Taxpayer could act unilaterally to remove the forfeiture restriction affecting his stock. The court also pointed out that if either Taxpayer threatened to leave during the five (5) year earnout period, the other Taxpayer had a strong incentive to insist that the forfeiture restriction be enforced as written. Additionally, the removal or waiver of the forfeiture provision would require the approval of the ESOP and the court found that the ESOP would have a strong economic incentive to refuse such consent. First, if one of the Taxpayers left the corporation, the corporation might well fail, and the ESOP beneficiaries would then lose their jobs. Second, if a Taxpayer forfeited fifty percent (50%) of the value of their stock, the value of the ESOP stock would be increased “astronomically.”
The IRS countered that the Taxpayers could control the ESOP because they served as two of its initial three Trustees and that Mr. Faber (the third Trustee) was subordinate to them. The Tax Court found that the IRS ignored the fiduciary duties that all three owed to the ESOP and that under ERISA, the Trustees were required to refrain from self-dealing in the ESOP’s assets for their own benefit and were required to discharge their duties with the care, skill, prudence and diligence that a prudent man acting in a like capacity would use. The court concluded that because approving removal of the forfeiture provision affecting either Taxpayer’s shares would have been directly contrary to the economic interest of the ESOP, it would have been a “grotesque” conflict of interest for Taxpayers to have acted as ESOP Trustees for such a vote. The Tax Court went on to state that they were confident that the Taxpayers in such circumstances would have resigned as Trustees, as they in fact did in 2003, rather than face the consequences of a self-dealing charge.
The Tax Court went on to reject a number of other arguments made by the IRS, including its reliance on QinetiQ U.S. Holdings, Inc., and concluded that the Taxpayers’ stock was subject to a substantial risk of forfeiture when it was issued to them in 1998 and remained subject to that risk until the restrictions lapsed on January 1, 2004.
Economic Substance of S Corporation/ESOP Structure
In order to disregard a transaction for lack of economic substance, a court must find: (1) that the Taxpayer was motivated by no business purpose other than obtaining tax benefits; and (2) that the transaction had no economic substance because it offered no reasonable possibility of profit. Both of these requirements are directed to the same question: “whether the transaction contained economic substance aside from the tax consequences.” A transaction must fail to pass muster under both prongs of this test in order for the court to disregard the transaction.
The IRS contended that the incorporation of UMLIC S-Corp in December, 1998 as a holding company for the UMLIC entities lacked a legitimate business purpose and was devised solely to avoid taxes. The Tax Court found no merit in the IRS’s argument and found that the Taxpayers had legitimate business purposes forming a holding company, including reducing the number of financial and tax filings and allowing tax-free movement of assets among the subsidiary entities. The Tax Court also found it immaterial that the Taxpayers’ intended to use UMLIC S-Corp as part of a plan to achieve income tax and estate planning benefits. In short, the Tax Court found that the Taxpayers’ observed all corporate formalities in creating and operating the holding company structure, and found that it had economic substance apart from its tax considerations.
The IRS went on to contend that the ESOP lacked economic substance because it was a mere “accommodation party” that enabled the Taxpayers to defer receipt of income from UMLIC S-Corp. The Tax Court found that although one could question the wisdom of Congress’ decision to create the statutory framework of which the Taxpayers’ took advantage, that framework did exist and the Taxpayers’ implementation of it clearly had economic substance (the ESOP provided meaningful benefits not only to the Taxpayers but also to its 101 other employee participants).
The IRS also argued that the Taxpayers could have chosen alternative ways to incentivize its employees other than an ESOP. The Tax Court was unpersuaded by this argument, citing the fact that the Taxpayers already had a Section 401(k) plan in place and decided that additional incentives were desirable in an effort to retain existing employees, many of whom had years of useful experience. To this end, the court noted that the Taxpayers created and funded the ESOP, whose beneficiaries included all of the company’s eligible employees, and that when stock was redeemed from the ESOP in June 2004, $9.1 million of the proceeds inured to the benefit of the ESOP participants other than the Taxpayers. Under such circumstances, the Tax Court stated that the IRS simply had made no plausible argument that the ESOP lacked economic substance.
Sale of UMLIC S-Corp’s Assets to Holdings
The IRS also challenged the economic substance of the November 2003 sale of UMLIC S-Corp’s operating assets to Holdings. In particular, the IRS stated that this enabled UMLIC S-Corp to realize its built-in gain and allocate 100% of that gain to the ESOP while the ESOP remained its only outstanding shareholder, while Holdings was able to acquire a stepped-up basis in the transferred assets for purposes of claiming future deductions for depreciation and amortization expense.
The Tax Court, however, found that the Taxpayers had legitimate business purposes for the sale of assets to Holdings, including facilitating future investment by hedge funds and private equity funds, and unwinding the S Corporation/ESOP structure because of a change in law that no longer made it as beneficial of a tax-planning device as prior to such change.
Stock Surrender and Repurchase
The Tax Court did find that the IRS aimed its “economic substance” arrow at a more “promising target” when it attacked the “surrender” and “repurchase” transactions that Taxpayers executed in March 2004. On January 1, 2004, the restrictions on Taxpayers’ stock expired, and they became fully vested owners of their shares. Under the express terms of Section 83, the excess of the fair market value of the restricted property at the time a taxpayer becomes substantially vested in the property over the amount, if any, paid for the property by the taxpayer must be reported as compensation income by the taxpayer for the taxable year in which the restrictions lapse. The fair market value of each Taxpayer’s shares as of January 1, 2004 was $45,857,434 while their cost basis in such shares was only $142,566. Under Section 83, each Taxpayer was thus required to report on his 2004 return compensation income of $45,714,868.
The only business purpose the Taxpayers alleged for the surrender and repurchase of the stock was the need for New UMLIC S-Corp to avoid paying employment taxes on $45,714,868 of compensation to each Taxpayer, which the Tax Court found itself to be a tax-avoidance purpose. The Tax Court also found that the purported “surrender” and “repurchase” of stock failed for a variety of reasons, the first of which is that the taxable event occurred on January 1, 2004, and that subsequent actions with respect to the stock could not “unring this bell.” Additionally, the Tax Court found that in any event, the simultaneous “surrender” and “repurchase” transactions were clearly lacking in economic substance because there was no business purpose in surrendering and immediately repurchasing their stock other than obtaining tax benefits. Additionally, the Tax Court found that neither Taxpayer could envision a reasonable possibility of profit by surrendering, for no consideration, stock worth $45.8 million and that no rational person would incur debt of $41.5 million to acquire stock that he already owned free and clear.
Because the Tax Court found that the surrender and repurchase transactions lacked economic substance, it held that each Taxpayer was required to include in gross income for 2004 the fair market value of his New UMLIC S-Corp shares as of the date the earnout restriction lapsed to the extent that value exceeded his basis in such shares ($45,714,868 each).
Taxability of Special Dividend
Because the Tax Court found that each Taxpayer was required to include $45,714,868 in income, the basis in their New UMLIC S-Corp shares was increased by that same amount, and as such, the distribution was non-taxable under the provisions of Section 1368(b).
The final determination to be made by the Tax Court was whether to impose the twenty percent (20%) accuracy-related penalty under Section 6662. As discussed above, the accuracy-related penalty is not imposed with respect to any portion of underpayment if it is shown that there was a reasonable cause for such portion and that the Taxpayer acted in good faith with respect to it. A taxpayer may be able to establish reasonable cause and good faith by showing reliance on the advice of a professional tax advisor, provided that the taxpayer shows the advisor was a competent professional who had sufficient expertise to justify reliance, the taxpayer provided necessary and accurate information to the advisor, and the taxpayer actually relied in good faith on the tax advisor’s judgments.
The Tax Court found that the Taxpayers failed to present any evidence that they relied on a tax professional’s advice with respect to the surrender and repurchase transaction, and further that the taxpayers were sophisticated business men with extensive experience in financial markets and complex tax planning. The Tax Court went on the state that even if the Taxpayers had secured such an opinion, it is hard to imagine that such an opinion would pass the “straight-face test.”
Consequently, the Tax Court found that that the Taxpayers did not act with reasonable cause and good faith in failing to include in gross income on their 2004 tax returns the full value of the stock of New UMLIC S-Corp, and accordingly, found that the portion of each underpayment stemming from this failure was attributable to negligence. Additionally, based on the amounts involved, the Tax Court concluded that the underpayments were alternatively attributable to substantial understatements of income tax for which the Taxpayers had not shown reasonable cause.
About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at firstname.lastname@example.org.
 Austin v. Comm’r, TCM 2017-69.
 This “road” involved the formation of an ESOP which would own stock in UMLIC S-Corp.
 Austin v. Comm’r, 141 T.C. 551 (2013).
 See also, Reg. Section 1.83-3(c).
 Reg. Section 1.83-3(c)(3).
 QinetiQ U.S. Holdings, Inc. & Subs. V. Comm’r, T.C. Memo 2015-123, aff’d, 845 F.3d 555 (4th Cir. 2017).
 The Tax Court used the test prescribed in Rice’s Toyota World, Inc. v. Comm’r, 81 T.C. 184 (1983), aff’d on this issue, 752 F.2d 89 (4th Cir. 1985), since the case would be appealable to the Fourth Circuit Court of Appeals.
 Under Section 1368(b), distributions by an S corporation having no subchapter C earnings and profits are nontaxable to the extent they do not exceed a shareholder’s basis in the S corporation, and are treated as gain from the sale or exchange of property to the extent the distribution exceeds the shareholder’s adjusted basis in the S corporation.