On February 2, 2022, the Tax Court issued a Memorandum Opinion in the case of Larson v. Commissioner (T.C. Memo. 2022-3). The primary issue presented in Larson was whether stock in an S corporation was subject to a substantial risk of forfeiture.
Background (and not a Particularly Flattering One for the petitioner) in Larson v. Commissioner
Mr. Larson is a criminal.
That’s not my opinion. That was the decision of the Southern District of New York in 2009, which sentenced him to 121 months in prison for tax evasion, three years of supervised release, and a fine. According to the Department of Justice, John Larson, a former senior manager at KPMG (Curly), and Robert Pfaff, a former partner at KPMG (Moe), were the founders and partners in an “investment advisor” firm for various tax shelter products.
Along with R.J. Ruble, a partner at the law firm of Brown & Wood (Larry), from at least 1998 through 2000, the three tax stooges were involved in the design, marketing, and implementation of a tax shelter known as BLIPS.
The Three Stooges represented that BLIPS could be used to completely eliminate either the capital gains or ordinary income tax of tax shelter clients who had at least $20 million in income in that year, thus purporting to eliminate millions of dollars in taxes otherwise due and owing. Larson and Pfaff were convicted of twelve counts of tax evasion relating to clients who used BLIPS, including two counts of evading their own taxes through use of the BLIPS tax shelter. All told, over $100 million in taxes were evaded.
In addition, Mr. Larson, Mr. Pfaff, and David Makov—one assumes that Mr. Makov was the Shemp of the group— organized an S corporation, Morley, Inc. (Morley), and an Employee Stock Option Plan (ESOP). They were the trustees of the Morley ESOP and caused it to be a 5% shareholder of Morley. Simultaneously, they caused Morley to enter into a three-year employment agreement and restricted stock agreement whereby they had to forfeit their Morley stock if they were terminated within that timeframe.
All Morley income for the 1999 and 2000 taxable years was allocated to the Morley ESOP according to the restricted stock agreements Mr. Larson, Mr. Pfaff, and Mr. Makov signed. Mr. Larson did not report any income related to the BLIPS transactions on his tax returns for 1999 and 2000 on the basis that his Morley stock was not substantially vested for the purposes of IRC § 83.
On September 5, 2000, the IRS issued Notice 2000-44, which advised that tax shelters such as BLIPS were not bona fide and that penalties might be imposed on the promoters of these transactions. On January 2, 2001, Mr. Larson, Mr. Pfaff, and Mr. Makov voted to terminate the restrictions on the Morley stock.
They did not inform the members of the Morley ESOP, allow the Morley ESOP to consent to the removal of the restrictions, or resign as Morley ESOP trustees before voting to remove the restrictions. In a notice of deficiency dated April 4, 2011, the IRS disallowed deferral of Mr. Larson’s distributive share of Morley income, resulting in deficiencies of $6,867,653, $2,431,749, and $1,253,344 for the 1999, 2000, and 2001 tax years, respectively.
Larson’s Tax Position – Stock was non-Vested
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.” Mr. Larson did not report any pro rata share of passthrough income from Morley for the 1999 and 2000 taxable years on the basis of his position that his outstanding stock was subject to a substantial risk of forfeiture and therefore was nonvested.
IRS’s Position – Nice Try, Curly
The IRS determined that the restrictions on Mr. Larson’s Morley stock were not respected by the parties and accordingly disallowed deferral of Mr. Larson’s distributive shares of Morley income. In the alternative, the IRS disregarded the Morley stock restrictions on the basis that the entire arrangement was entered into primarily to reduce taxes, was a sham, and must be disregarded for income tax purposes. The IRS also determined that all or parts of Mr. Larson’s underpayments of tax for the 1999, 2000, and 2001 tax years were due to fraud.
S Corporations and ESOPs
An S corporation is a “small business corporation” for which an election under IRC § 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. 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.
When qualified ESOPs meet the IRC § 401(a) requirements, their related trusts are generally exempt from income taxation pursuant to IRC § 501(a). Effective January 1, 1998, Congress provided that certain tax-exempt entities, including ESOPs, were permitted to be shareholders of S corporations. These provisions enacted a framework which allowed all of the outstanding shares of an S corporation to be owned by an ESOP, effectively allowing S corporation profits to escape federal income taxation.
To address concerns about ownership structures involving S corporations and ESOPs, Congress amended the Code in 2001 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. However, this change was prospective and did not generally apply it to plan years before 2005 for an ESOP (as in the instant case) that existed before 2001.
Shareholders of an S corporation could use the above framework to defer income if they owned “substantially nonvested” stock because it is considered to be “non-outstanding.” When shares are “non-outstanding,” an S corporation can allocate 100% of its income, losses, deductions, and other tax items to an ESOP.
The Substantial Vesting of Stock
IRC § 83(a) governs the tax treatment of property transferred “in connection with performance of services,” and it generally provides that 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.”
Thus, a taxpayer can defer recognition of income until his rights in the restricted property become “substantially vested.” Shares of stock are subject to a substantial risk of forfeiture if the owner’s rights to their full enjoyment are conditioned upon the future performance of substantial services by any individual.
The requirement that an employee render future services as a precondition for obtaining full enjoyment of restricted property is often referred to as an “earnout” restriction. The regulations provide that “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.” Whether a substantial risk of forfeiture exists depends on the facts and circumstances.
Five factors are considered 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.
Thus, in order for IRC § 83 to apply to Mr. Larson’s Morley stock for the 1999 and 2000 taxable years, the facts and circumstances must show that it was subject to a substantial risk of forfeiture during that period.
The Stooges’ Ownership and Interests in the ESOP
Mr. Larson, Mr. Pfaff, and Mr. Makov, through their respective grantor trusts, owned 95% of Morley’s common stock, with the Morley ESOP owning the remaining 5%. In situations in which 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,” Treasury Regulation § 1.83-3(c)(3) directs the Tax Court to consider several factors. The regulation emphasizes the importance not just of stock ownership percentages, but of the de facto power to control.
Mr. Larson, along with Mr. Pfaff and Mr. Makov, formed Morley and promoted the BLIPS business together. The Tax Court observed that the Stooges had a close working relationship and were “in this together.” Rather than allow Mr. Makov to leave and implement the stock restrictions, Mr. Larson and Mr. Pfaff collectively released their restrictions.
This lack of enforcement aligns with Mr. Larson’s testimony that they were going to act “as one, unanimously” when lifting the restrictions. When the arrangement was no longer beneficial, they terminated it.
The Tax Court found that Mr. Larson failed to show that there was sufficient likelihood that the earnout restrictions would be enforced. In fact, his relationship to the officers and directors of the corporation and their actions revealed an effort to collectively avoid enforcement of the restrictions.
What’s more, removal or waiver of the forfeiture provision required the consent of the holders of 100% of the company’s shares. As a holder of a 5% interest, Morley had to obtain the consent of the Morley ESOP before lifting the stock forfeiture restrictions. Mr. Larson did not cause it to do so. Thus, Mr. Larson, along with the other Stooges, had complete control over Morley, and Mr. Larson did not put forward any convincing evidence that he could possibly lose control over the S corporation.
Curly Puts the Douche in Fiduciary
The Tax Court next noted that Mr. Larson’s casual treatment (read: utter contempt) of his fiduciary duties was particularly telling. Under ERISA, the plan’s trustees were required to refrain from self-dealing in the plan’s assets and to “discharge [their] duties…with the care, skill, prudence, and diligence…that a prudent man acting in a like capacity…would use.”
A trustee of an ERISA-qualified plan has a fiduciary duty to inform participants and beneficiaries of their rights under the plan as a result of general fiduciary standards of loyalty and care borrowed from the common law. Despite having been both a CPA and an attorney, Mr. Larson testified that he was unaware of his duties as a fiduciary of the Morley ESOP.
The Tax Court did “not find [Curly’s] testimony credible on these points” and ultimately held that his actions were a “grotesque conflict of interest.” From Judge Jones’ mouth to God’s ears…
Finally, the Tax Court observed that “the record does not show a pattern of open and fair dealing with regard to the Morley ESOP participants.” A smidge of an understatement, but we’ll allow it.
The Morley ESOP participants were woefully ill-informed of their rights and seemed oblivious to the existence of stock forfeiture restrictions. Consequently, it was unsurprising that they were unaware that Mr. Larson had released the restrictions or that they had the right to vote upon such a release. The Morley ESOP participants would have had a strong economic incentive to enforce the forfeiture clauses, but they were not given the opportunity to do so.
Curly’s actions with regard to the Morley ESOP participants make it evident that he, Moe, and Shemp had complete control of Morley. Therefore, the facts and circumstances “compel the conclusion” that the stock forfeiture restrictions were never likely to be enforced, and, consequently, the Morley stock was not subject to a substantial risk of forfeiture under IRC § 83, meaning that the IRS’s determinations were sustained.
Game, set, match – Staplers.
- See Treas. Reg. § 1.1361-1(b)(3). ↑
- IRC § 1361(a)(1). ↑
- See § 1363(a); Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202, 204 (2009) (quoting Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001)), aff’d, 679 F.3d 1109 (9th Cir. 2012). ↑
- IRC § 1366(a)(1). ↑
- See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1316(a), 110 Stat. 1755, 1785-86. ↑
- See Austin v. Commissioner (Austin II), T.C. Memo. 2017-69, *33, aff’d sub nom. Estate of Kechijian v. Commissioner, 962 F.3d 800 (4th Cir. 2020). ↑
- See Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, § 656, 115 Stat. 38, 131-35. ↑
- See id. § 656(d). ↑
- See Austin II, at *13-14, *32-33; Treas. Reg. § 1.1361-1(b)(3). ↑
- See Austin II, at *14, *32-33. ↑
- Austin v. Commissioner (Austin I), 141 T.C. 551, 559 (2013); Treas. Reg. § 1.83-1(a)(1). ↑
- QinetiQ U.S. Holdings, Inc. & Subs. v. Commissioner, T.C. Memo. 2015-123, at *24, aff’d, 845 F.3d 555 (4th Cir. 2017). ↑
- Austin I, 141 T.C. at 559-60 (citing Campbell v. Commissioner, T.C. Memo. 1990-162, aff’d in part, rev’d in part, 943 F.2d 815 (8th Cir. 1991)). ↑
- Treas. Reg. § 1.83-3(c)(1). ↑
- Id. ↑
- Treas. Reg. § 1.83-3(c)(3). ↑
- See T.C. Memo. 2017-69, at *21. ↑
- See Treas. Reg. § 1.83-3(c)(3). ↑
- See id. ↑
- 29 U.S.C. §§ 1104(a)(1) and 1106(b). ↑
- See §§ 401(a), 4975(e)(7); Cent. States, Se. and Sw. Areas Pension Fund v. Cent. Transp., Inc., 472 U.S. 559, 571-72 (1985); Petersen v. Commissioner, 148 T.C. 463, 475-76 (2017), aff’d and remanded, 924 F.3d 1111 (10th Cir. 2019). ↑
- See Treas. Reg. § 1.83-3(c)(3). ↑
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