LARRY E. AUSTIN AND BELINDA AUSTIN, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
ESTATE OF ARTHUR E. KECHIJIAN, DECEASED, SUSAN P.
KECHIJIAN AND SCOTT E. HOEHN, CO-EXECUTORS,
AND SUSAN P. KECHIJIAN, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE,
RESPONDENT
Docket Nos. 8966–10, 8967–10. Filed December 16, 2013.
Ps exchanged property for ostensibly restricted stock of a
newly formed S corporation (S). The governing agreements
provided that Ps, upon termination of employment, would
551
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552 141 UNITED STATES TAX COURT REPORTS (551)
receive less than the full fair market value of their S shares
only if they were terminated ‘‘for cause’’ during the initial
term of the employment agreement. Section 7(B) of the
employment agreement defined termination ‘‘for cause’’ to
include termination upon ‘‘[f]ailure or refusal by Employee
* * * to cure by faithfully and diligently performing the usual
and customary duties of his employment.’’ Section 1.83–
3(c)(2), Income Tax Regs., provides that 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.’’
1. Held: The term ‘‘discharged for cause,’’ as used in section
1.83–3(c)(2), does not necessarily have the same meaning the
parties have given that term in their private agreements but
refers to termination for serious misconduct which, like
criminal misconduct, is highly unlikely to occur.
2. Held, further, the risk that Ps would receive less than
full fair market value upon forfeiture of their stock if they
failed faithfully and diligently to perform the usual and cus-
tomary duties of their employment during the prescribed
period constituted an earnout restriction that could create a
‘‘substantial risk of forfeiture’’ if there existed a sufficient like-
lihood that the restriction would actually be enforced.
Lynn Forrest Chandler, Jonathan P. Heyl, and Tanya N.
Oesterreich, for petitioners.
Patricia Pierce Davis, Nina E. Choi, and Mark L. Hulse, for
respondent.
OPINION
LAUBER, Judge: These consolidated cases are before this
Court on respondent’s motion for partial summary judgment
and petitioner’s motion for summary judgment both filed
under Rule 121. 1 The sole issue for decision is whether stock
petitioners received in December 1998, which was labeled
‘‘restricted stock,’’ was subject to a substantial risk of for-
feiture when issued to them or rather was ‘‘substantially
vested’’ within the meaning of section 83 and section 1.83–
1(a)(1), Income Tax Regs. Under the governing employment
agreements, petitioners would forfeit a substantial amount of
the value of their stock upon the occurrence of various
1 Unless
otherwise indicated, all statutory references are to the Internal
Revenue Code (Code) in effect for the tax years 2000, 2001, 2002, 2003,
and 2004, and all Rule references are to the Tax Court Rules of Practice
and Procedure.
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(551) AUSTIN v. COMMISSIONER 553
events, enumerated in a paragraph that addressed termi-
nation ‘‘for cause.’’ Under section 1.83–3(c)(2), Income Tax
Regs., 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.’’ Dis-
position of the pending motions requires us to determine the
scope of the phrase ‘‘for cause’’ as used in section 1.83–3(c)(2),
Income Tax Regs., and the proper application of that regula-
tion to the agreements involved here.
Background
The following facts are not in dispute. Larry Austin and
Arthur Kechijian (petitioners) resided in North Carolina
when they filed petitions. 2 Belinda Austin and Susan
Kechijian are parties to these cases solely by virtue of having
filed joint Federal income tax returns with their husbands
for the tax years at issue.
Petitioners worked together for more than 15 years in the
‘‘distressed debt loan portfolio business.’’ Before 1998 peti-
tioners were the original shareholders and members of a
group of related companies called ‘‘the UMLIC Entities.’’ In
December 1998 petitioners formed, and elected subchapter S
status for, UMLIC Consolidated, Inc., a North Carolina cor-
poration (UMLIC S-Corp.). In a section 351 transaction, each
petitioner transferred his unrestricted ownership interest in
the UMLIC Entities to UMLIC S-Corp. in exchange for
47,500 shares of its common stock. Concurrently, UMLIC S-
Corp. issued 5,000 shares of its common stock, in exchange
for a note, to an employee stock ownership plan (ESOP) for
its employees, including petitioners. Thus, as of December 7,
1998, each petitioner owned 47.5% of UMLIC S-Corp., and
the ESOP owned 5%. At all relevant times, petitioners were
the only directors on the UMLIC S-Corp. board of directors.
Petitioners, along with the company’s assistant controller,
were the initial trustees of the ESOP.
Petitioner Kechijian was employed as the president of
UMLIC S-Corp. He had responsibility for general operations
and for servicing loan portfolios, including workout strate-
2 Petitioner Arthur E. Kechijian died while the summary judgment mo-
tions were pending. On October 24, 2013, we substituted his estate as a
party petitioner. His estate is being probated in North Carolina.
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554 141 UNITED STATES TAX COURT REPORTS (551)
gies, loan sales, foreclosures, and loan modifications. Peti-
tioner Austin was employed as senior executive vice presi-
dent of UMLIC S-Corp. He had responsibility for loan port-
folio acquisitions, including due diligence involved in the
evaluation of loan portfolios, foreclosure gain/loss analysis,
expected cashflows, bidding strategies, and investor relation-
ships.
As part of the section 351 exchange, each petitioner
executed with UMLIC S-Corp. substantially identical agree-
ments denominated ‘‘Restricted Stock Agreement’’ (RSA) and
‘‘Employment Agreement.’’ These agreements were explicitly
linked. Section 12 of the employment agreement stated that
the employee’s ownership of UMLIC S-Corp. shares ‘‘shall be
governed by * * * [the RSA] entered into simultaneously
* * * [and] incorporated herein by reference.’’
The stated purpose of these agreements was to incentivize
petitioners to exchange their UMLIC interests for UMLIC S-
Corp. stock and require them to perform future services in
order to secure full rights in this stock. The RSA stated the
company’s intention ‘‘to induce * * * [each petitioner’s]
continued employment on behalf of * * * [UMLIC S-Corp.]
* * * by providing certain financial incentives under this
Agreement.’’ Conversely, each petitioner agreed that, in
consideration of UMLIC S-Corp.’s issuance of shares to him,
he was ‘‘willing to perform future services on behalf of * * *
[UMLIC S-Corp.] under the terms of the Employment Agree-
ment.’’
The shares issued to petitioners bore the following legend:
‘‘The shares represented by this certificate, and the transfer
hereof, are subject to the terms of * * * [the RSA].’’ The RSA
permitted limited transfer of the shares to or for the benefit
of family members. However, transfer was permitted only if
the transferee agreed to be bound by the RSA and hence by
any restrictions on full enjoyment of the stock to which the
RSA subjected petitioners.
Section 4 of the employment agreement provided that
‘‘[t]he initial term of this Agreement shall commence on
December 7, 1998 * * * and shall continue until January 1,
2004.’’ Section 1 of the Agreement, captioned ‘‘Employment,’’
provided:
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(551) AUSTIN v. COMMISSIONER 555
During the term of this Agreement * * * [employee] will devote all of
his efforts to the performance of his duties as * * * [an officer of UMLIC
S-Corp.] and any other duties and responsibilities the Board of Directors
* * * may assign to him from time to time. Employee agrees to perform
such duties and responsibilities faithfully, diligently and in a timely
manner and to abide by all * * * [UMLIC S-Corp.] policies relating to
its employees generally.
Section 7 of the employment agreement, captioned ‘‘Termi-
nation,’’ provided that ‘‘[t]his Agreement may be terminated
by * * * [UMLIC S-Corp.] at any time for cause.’’ The Agree-
ment makes no provision for termination by the employee,
and it makes no provision for termination by the employer
on grounds other than ‘‘for cause.’’ For purposes of the Agree-
ment, ‘‘cause’’ was defined to ‘‘include, without limitation,’’
the following three categories of employee action:
A. Dishonesty, fraud, embezzlement, alcohol or substance abuse, gross
negligence or other similar conduct on the part of the Employee. Upon
termination of this Agreement, Employee shall be entitled to receive
compensation through the date of termination.
B. Failure or refusal by Employee, after 15 days written notice to
Employee, to cure by faithfully and diligently performing the usual and
customary duties of his employment and adhere to the provisions of this
Agreement.
C. Failure or refusal by Employee, after 15 days written notice to
Employee, to cure by complying with the reasonable policies, standards
and regulations applicable to employees which * * * [UMLIC S-Corp.]
may establish from time to time.
Section 4 of the RSA, captioned ‘‘Termination of Employ-
ment,’’ governed the consequences ‘‘[i]n the event of termi-
nation, voluntary or otherwise,’’ of the employee’s employ-
ment with UMLIC S-Corp. Section 4 addressed two types of
termination: ‘‘termination without cause’’ and ‘‘termination
with cause.’’ If the employee’s employment was terminated
‘‘without cause, as defined in Section 7 of the Employment
Agreement,’’ 3 he would be deemed by RSA section 4(b) to
have offered to sell all of his stock to the company pursuant
to RSA section 5(b). The latter provided that, if employment
terminated after December 31, 2003—that is, following the
end of the initial term of the employment agreement—and
the employee was not in material breach of either agreement,
3 In fact, section 7 of the employment agreement does not define termi-
nation ‘‘without cause,’’ and those words do not appear in that section.
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556 141 UNITED STATES TAX COURT REPORTS (551)
he would receive 100% of the fair market value of his stock,
as determined by formula. Regardless of his actual termi-
nation date, in other words, an employee discharged ‘‘without
cause’’ would be treated as if he had terminated employment
after December 31, 2003, and he would receive the full value
of his shares.
If the employee’s employment was terminated by UMLIC
S-Corp. ‘‘with cause, as defined in Section 7 of the Employ-
ment Agreement,’’ the employee would likewise be deemed to
have offered to sell all of his stock to the company under
RSA sec. 4(a). However, the purchase price would then
depend on the date of the termination. If the employee was
terminated for cause after December 31, 2003, he would
receive 100% of the fair market value of his stock under RSA
section 5(b). If the employee was terminated for cause before
January 1, 2004, the purchase price would be governed by
RSA section 5(a). It provided that, if employment terminated
before January 1, 2004—that is, during the initial term of
the employment agreement—the employee would receive at
most 50% of the fair market value of his stock, with the
possibility of receiving nothing, as determined by formula.
For purposes of filing their individual income tax returns
for 2000–2003, petitioners took the position that their
UMLIC S-Corp. stock was subject to a ‘‘substantial risk of
forfeiture’’ and was thus ‘‘substantially nonvested’’ within the
meaning of section 1.83–3(b), Income Tax Regs. Section
1.1361–1(b)(3), Income Tax Regs., generally provides that, for
purposes of subchapter S, ‘‘stock that is issued in connection
with the performance of services * * * and that is substan-
tially nonvested (within the meaning of § 1.83–3(b)) 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.’’ 4 Petitioners thus took the posi-
tion that 100% of the outstanding stock of UMLIC S-Corp.
was owned by the ESOP during 2000–2003 and that 100% of
the company’s income was allocable to it. Accordingly, nei-
ther petitioner reported any income or other flowthrough
items from UMLIC S-Corp. on his individual income tax
4 A holder of restricted S corporation stock may elect to be treated as a
shareholder, sec. 1.1361–1(b)(3), Income Tax Regs., but neither petitioner
made such an election.
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(551) AUSTIN v. COMMISSIONER 557
return for 2000–2003. And because the ESOP was a tax-
exempt entity, it likewise reported no taxable income from
UMLIC S-Corp. during 2000–2003.
The Internal Revenue Service (IRS or respondent) issued
to petitioners timely notices of deficiency that challenged, on
a variety of grounds, the tax structure that petitioners and
UMLIC S-Corp. had implemented. In this Opinion, we
address only one of the theories the IRS has advanced—
namely, that petitioners’ stock when issued to them was
‘‘substantially vested’’ by virtue of section 1.83–3(c)(2),
Income Tax Regs.
Discussion
I. Summary Judgment Standard
Summary judgment is intended to expedite litigation and
avoid unnecessary and expensive trials. See FPL Grp., Inc. &
Subs. v. Commissioner, 116 T.C. 73, 74 (2001). Either party
may move for summary judgment upon all or any part of the
legal issues in controversy. Rule 121(a). A motion for sum-
mary judgment or partial summary judgment will be granted
only if it is shown that there is no genuine dispute as to any
material fact and that a decision may be rendered as a
matter of law. See Rule 121(b); Elec. Arts, Inc. v. Commis-
sioner, 118 T.C. 226, 238 (2002). The moving party bears the
burden of proving that there is no genuine dispute as to any
material fact, and the Court views all factual materials and
inferences in the light most favorable to the nonmoving
party. Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985).
The parties agree that there are no disputes of material
fact affecting the question addressed in this Opinion—
namely, whether section 1.83–3(c)(2), Income Tax Regs., pre-
cludes the agreements at issue from giving rise to a
‘‘substantial risk of forfeiture.’’ Our disposition of this ques-
tion turns entirely on legal determinations and the
interpretation of the governing agreements. We accordingly
conclude that we may decide this question summarily.
II. Status of Petitioners’ Stock Under Section 83
The RSA provides that each petitioner, upon termination of
employment, will be deemed to have offered to sell his stock
to UMLIC S-Corp. at the ‘‘purchase price’’ specified in sec-
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558 141 UNITED STATES TAX COURT REPORTS (551)
tion 5. Section 5(b), wherever it applies, specifies that the
employee will receive 100% of the fair market value of his
stock, determined by formula. Section 1.83–3(c)(1), Income
Tax Regs., states that ‘‘[p]roperty is not transferred subject
to a substantial risk of forfeiture to the extent that the
employer is required to pay the fair market value * * * to
the employee upon the return of such property.’’ The parties
accordingly agree that section 5(b) cannot create a substan-
tial risk of forfeiture.
That being so, the only provision of the RSA that could
create a substantial risk of forfeiture is section 5(a), under
which the employee will receive at most 50% of the fair
market value of his stock. Section 5(a) comes into play upon
‘‘termination of * * * employment.’’ This subject is governed,
apparently comprehensively, by section 4 of the RSA, cap-
tioned ‘‘Termination of Employment,’’ which applies ‘‘[i]n the
event of termination, voluntary or otherwise.’’ The only situa-
tion in which section 4 triggers the 50% discount mandated
by section 5(a) is a termination ‘‘with cause’’ occurring before
January 1, 2004. Under the regulations, a requirement that
stock be forfeited ‘‘if the employee is discharged for cause
* * * will not be considered to result in a substantial risk of
forfeiture.’’ Sec. 1.83–3(c)(2), Income Tax Regs. Respondent
accordingly concludes that no provision of the RSA gives rise
to a substantial risk of forfeiture.
Petitioners contend that the scope of ‘‘for cause,’’ as used
in section 1.83–3(c)(2), is not necessarily identical to the
scope the parties have given that phrase in their agreements.
Section 7 of the employment agreement broadly defines three
categories of employee action justifying ‘‘termination with
cause.’’ Petitioners agree that discharge for activity specified
in section 7(A)—e.g., for ‘‘[d]ishonesty, fraud, embezzlement,
alcohol or substance abuse’’—is reasonably characterized as
a ‘‘discharge for cause’’ within the meaning of the regulation.
On the other hand, petitioners contend that termination for
activity specified in section 7(B)—i.e., for refusal to perform
faithfully ‘‘the usual and customary duties of [the employee’s]
employment’’—should not be deemed a ‘‘discharge for cause’’
under section 1.83–3(c)(2). Rather, according to petitioners,
section 7(B) is the mechanism the parties have adopted,
clumsily perhaps, to enforce the central requirement of the
RSA—that petitioners continue their employment with
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(551) AUSTIN v. COMMISSIONER 559
UMLIC S-Corp. for the four-year term of the employment
agreement in order to secure the full value of their stock.
Such a requirement, petitioners contend, necessarily creates
a ‘‘substantial risk of forfeiture’’ under the statute and its
implementing regulations.
A. The Statute and the Regulations
Section 83(a) applies where, as concededly occurred here,
property is transferred to a taxpayer ‘‘in connection with the
performance of services.’’ Upon such a transfer, the excess of
the fair market value of the property over the amount (if
any) paid for the property shall be included in the taxpayer’s
gross income in the first taxable year in which the taxpayer’s
rights in the property ‘‘are not subject to a substantial risk
of forfeiture.’’ Sec. 83(a). The statute thus permits a taxpayer
to defer recognition of any gain until his rights in the
restricted property become ‘‘substantially vested.’’ Sec. 1.83–
1(a)(1), Income Tax Regs.; see Storm v. United States, 641
F.3d 1051, 1056 (9th Cir. 2011). 5
Section 83(c) provides that ‘‘[t]he rights of a person in prop-
erty are subject to a substantial risk of forfeiture if such per-
son’s rights to full enjoyment of such property are condi-
tioned upon the future performance of substantial services by
any individual.’’ The regulations echo the statutory defini-
tion:
For purposes of section 83 and the regulations thereunder, whether a
risk of forfeiture is substantial or not depends upon the facts and cir-
cumstances. A substantial risk of forfeiture exists where rights in prop-
erty that are transferred are conditioned, directly or indirectly, upon the
future performance (or refraining from performance) of substantial serv-
ices by any person * * * [Sec. 1.83–3(c)(1), Income Tax Regs.]
The requirement that an employee perform future services
as a condition of obtaining full enjoyment of restricted prop-
erty is sometimes called an ‘‘earnout’’ restriction. See
Campbell v. Commissioner, T.C. Memo. 1990–162, 59 T.C.M.
5 Because petitioners received their UMLIC–S Corp. shares in a section
351 exchange, they were relieved of any obligation to recognize gain upon
receipt of the shares. The relevance of determining whether the shares
were ‘‘substantially vested’’ upon receipt is that this determination controls
whether petitioners’ shares are treated during 2000–2003 as ‘‘outstanding
stock of the corporation,’’ sec. 1.1361–1(b)(3), Income Tax Regs., for pur-
poses of allocating UMLIC–S Corp. income to petitioners.
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560 141 UNITED STATES TAX COURT REPORTS (551)
(CCH) 236, 251, aff ’d in part, rev’d in part, 943 F.2d 815 (8th
Cir. 1991). Because of the real possibility that this condition
may not be fulfilled, an earnout restriction will normally
create a ‘‘substantial risk of forfeiture’’ that postpones tax-
ation until the restriction lapses. The regulations provide a
clear example of an earnout restriction:
On November 1, 1971, corporation X transfers in connection with the
performance of services to E, an employee, 100 shares of corporation X
stock for $90 per share. Under the terms of the transfer, E will be sub-
ject to a binding commitment to resell the stock to corporation X at $90
per share if he leaves the employment of corporation X for any reason
prior to the expiration of a 2-year period from the date of such transfer.
Since E must perform substantial services for corporation X and will not
be paid more than $90 for the stock, regardless of its value, if he fails
to perform such services during such 2-year period, E’s rights in the
stock are subject to a substantial risk of forfeiture during such period.
[Sec. 1.83–3(c)(4), Example (1), Income Tax Regs.]
Section 1.83–3(c)(2) of the regulations, the focus of the
present controversy, provides several illustrations of substan-
tial risks of forfeiture. It provides in pertinent part:
Where an employee receives property from an employer subject to a
requirement that it be returned if the total earnings of the employer do
not increase, such property is subject to a substantial risk of forfeiture.
On the other hand, requirements that the property be returned to the
employer if the employee is discharged for cause or for committing a
crime will not be considered to result in a substantial risk of forfeiture.
* * *
Read in isolation, the term ‘‘for cause’’ is susceptible to a
broad construction. In the employment law context, ‘‘for
cause’’ expresses ‘‘a common standard governing the removal
of a civil servant or an employee under contract.’’ Black’s
Law Dictionary 717 (9th ed. 2009). Generally, ‘‘[a]n employer
has cause for early termination of an agreement for a defi-
nite term of employment if the employee has engaged in mis-
conduct, other malfeasance, or other material breach of the
agreement, such as persistent neglect of duties, gross neg-
ligence, or failure to perform the duties of the position due
to a permanent disability.’’ Restatement, Employment 3d,
Tentative Draft No. 2, sec. 2.04 (2009). According to the
Restatement, the parties to an employment agreement are
free to define the term ‘‘for cause’’ as they believe appropriate
to the particular employment setting. Id. The employment
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(551) AUSTIN v. COMMISSIONER 561
law definition of ‘‘for cause’’ can thus cover termination for
a wide range of reasons.
The history of a regulation may be helpful in resolving
ambiguities in it. See Wallace v. Commissioner, 128 T.C. 132
(2007); Anderson v. Commissioner, 123 T.C. 219, 233 (2004),
aff ’d, 137 Fed. Appx. 373 (1st Cir. 2005). The Department of
the Treasury issued proposed regulations under section 83 in
1971. 36 Fed. Reg. 10787 (June 3, 1971). Section 1.83–3(c),
Proposed Income Tax Regs., 36 Fed. Reg. 10790 (June 3,
1971), did not contain the phrase ‘‘discharged for cause.’’
Rather, the proposed regulation read in pertinent part: ‘‘On
the other hand, a requirement that the property be returned
to the employer if the employee commits a crime will not be
considered to result in a substantial risk of forfeiture.’’ Sec.
1.83–3(c)(1), Proposed Income Tax Regs., supra.
When issuing these regulations in proposed form, the Sec-
retary stated that ‘‘[p]rior to the final adoption of such regu-
lations, consideration will be given to any comments or
suggestions pertaining thereto.’’ 36 Fed. Reg. 10787. The IRS
received 374 pages of public comments, several of which bear
on the question here. Comments submitted by the New York
State Bar Association, received by the IRS on January 10,
1972, suggested that ‘‘the Regulations should not attempt to
create presumptions or draw lines, except in the clearest
situations (such as forfeiture conditioned only on committing
a crime), because to do so is to make a rule of law where
none was authorized by Congress.’’ Comments submitted by
Cravath, Swaine & Moore, received by the IRS on July 8,
1971, suggested that the exception for ‘‘committing a crime’’
was sound because ‘‘the risk of forfeiture rests upon a single
possibility which is very unlikely to happen.’’
After the public comments were received, but before any
final regulations were issued, this Court decided two cases
that addressed the meaning of ‘‘substantial risk of forfeiture’’
under section 83. In Ludden v. Commissioner, 68 T.C. 826
(1977), aff ’d, 620 F.2d 700 (9th Cir. 1980), we were required
to determine the tax consequences when a corporation
contributed funds to trusts that failed to qualify under sec-
tion 401(a). As a collateral matter, we had to determine
whether property was subject to a substantial risk of for-
feiture under section 83. See id. at 835. The terms of both
trusts provided that ‘‘[i]f a participating employee has been
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562 141 UNITED STATES TAX COURT REPORTS (551)
discharged by the Company for cause, such as any inten-
tional act of proven dishonesty or any other intentional act
which would injure the Company,’’ the employee would for-
feit the entire amount allocated to him. Id. at 836. We held
that ‘‘the probability that either of the petitioners would be
discharged for cause from their wholly owned corporation,
thereby forfeiting benefits * * *, is too remote to constitute
a substantial risk of forfeiture.’’ Ibid.
In Burnetta v. Commissioner, 68 T.C. 387 (1977), we deter-
mined that a corporation’s pension plan did not qualify under
section 401(a) and again had to decide whether the
employer’s contributions to that plan were includable in the
employee’s gross income under section 83. The plan provided
that the property would be forfeited if the employee was ‘‘dis-
charged for theft of company property or embezzlement.’’ Id.
at 390, 403. We held that the property was not subject to a
substantial risk of forfeiture because the possibility that an
employee would be discharged for theft or embezzlement ‘‘is
too remote to present any substantial risk that the amounts
contributed on his behalf will be forfeited.’’ Id. at 405. We
noted that the Department of the Treasury had issued pro-
posed regulations under section 83 and stated our belief that
our holding was consistent with those regulations. Id. (citing
sec. 1.83–3(c)(1), Proposed Income Tax Regs., supra).
The following year, the Department of the Treasury issued
the section 83 regulations in final form. T.D. 7554, 1978–2
C.B. 71. The final regulations added the phrase ‘‘discharged
for cause’’ to what is now section 1.83–3(c)(2), Income Tax
Regs., modifying the sentence in question to read as it cur-
rently does: ‘‘On the other hand, requirements that the prop-
erty be returned to the employer if the employee is dis-
charged for cause or for committing a crime will not be
considered to result in a substantial risk of forfeiture.’’ T.D.
7554, 1978–2 C.B. at 78.
When issuing the final regulations, the Department of the
Treasury explained the principal changes it had made to the
proposed regulations. T.D. 7554, 1978–2 C.B. at 72–73. The
insertion of ‘‘discharged for cause’’ into section 1.83–3(c)(2),
Income Tax Regs., was not among the changes so discussed.
‘‘In addition to the changes already mentioned,’’ the Sec-
retary stated: ‘‘[S]everal changes of less significance were
made in response to public comments.’’ T.D. 7554, 1978–2
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(551) AUSTIN v. COMMISSIONER 563
C.B. at 73. The insertion of ‘‘discharged for cause’’ into sec-
tion 1.83–3(c)(2) was evidently regarded as one of these ‘‘less
significant’’ changes.
B. Discharge ‘‘for Cause or for Committing a Crime’’
Because the term ‘‘for cause’’ as used in section 1.83–3(c)(2)
is not defined in the statute, the regulations, or the legisla-
tive history, we employ the standard tools of construction to
discern its scope. Regulations are interpreted in the same
manner as statutes. See Black & Decker Corp. v. Commis-
sioner, 986 F.2d 60, 65 (4th Cir. 1993), aff ’g T.C. Memo.
1991–557. The starting point is the language itself. Grey-
hound Corp. v. Mt. Hood Stages, Inc., 437 U.S. 322, 330
(1978). In determining ‘‘the plain meaning of the statute, the
court must look to the particular statutory language at issue,
as well as the language and design of the statute as a
whole.’’ K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291
(1988); Norfolk Energy, Inc. v. Hodel, 898 F.2d 1435, 1442
(9th Cir. 1990). When a statute is ambiguous, the court must
find the interpretation that ‘‘can most fairly be said to be
embedded in the statute, in the sense of being most harmo-
nious with its scheme and with the general purposes that
Congress manifested.’’ NLRB v. Lion Oil Co., 352 U.S. 282,
297 (1957). ‘‘We interpret * * * regulations in toto rather
than phrase by phrase.’’ Microsoft Corp. v. Commissioner,
115 T.C. 228, 248–249 (2000) (citing Norfolk Energy, Inc.,
898 F.2d at 1442). In the end, a regulation will be inter-
preted to avoid conflict with a statute. See Phillips Petroleum
Co. v. Commissioner, 97 T.C. 30, 35 (1991), aff ’d without
published opinion, 70 F.3d 1282 (10th Cir. 1995).
The text and evolution of section 1.83–3(c)(2) indicate that
the term ‘‘discharged for cause,’’ as used therein, does not
necessarily have the same scope that parties to a particular
contract may have given this term in their negotiations.
Rather, as used in the regulation, ‘‘discharged for cause’’
refers to termination for serious misconduct that is roughly
comparable—in its severity and in the unlikelihood of its
occurrence—to criminal misconduct. The 1971 proposed regu-
lations mentioned discharge ‘‘for committing a crime’’ as the
only illustration of an employment-related contingency that
failed, as a matter of law, to create a ‘‘substantial risk of for-
feiture.’’ Whether a risk of forfeiture is ‘‘substantial’’ gen-
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564 141 UNITED STATES TAX COURT REPORTS (551)
erally ‘‘depends upon the facts and circumstances.’’ Sec. 1.83–
3(c)(1), Income Tax Regs. Despite this general rule, com-
menters on the proposed regulations agreed that the pro-
posed exception for ‘‘committing a crime’’ was reasonable,
since this limited per se rule comprised a narrow, well-
defined category of event that was very unlikely to occur.
We may never know for certain what prompted the Depart-
ment of the Treasury, in the 1978 final regulations, to revise
this exception to read ‘‘discharged for cause or for committing
a crime.’’ However, a fair inference is that this revision was
implemented to codify the results in Ludden and Burnetta,
both of which were decided the previous year. In Ludden, we
held that a ‘‘substantial risk of forfeiture’’ did not exist where
the employment-related contingency was ‘‘discharge[ ] * * *
for cause, such as any intentional act of proven dishonesty or
any other intentional act which would injure the Company.’’
68 T.C. at 836. In Burnetta, we held that a ‘‘substantial risk
of forfeiture’’ did not exist where the employment-related
contingency was ‘‘discharge[ ] for theft of company property
or embezzlement.’’ In both cases, we viewed the contingency
in question as ‘‘too remote’’ to create a ‘‘substantial risk of
forfeiture.’’ Ludden, 68 T.C. at 836; Burnetta, 68 T.C. at 405.
This history of section 1.83–3(c)(2), Income Tax Regs.,
strongly suggests that discharge ‘‘for cause,’’ like discharge
‘‘for committing a crime,’’ refers to a narrow and serious form
of employee misconduct that is very unlikely to occur and is
thus properly regarded as too remote—as a matter of law—
to create a ‘‘substantial risk of forfeiture.’’ The fact that the
Department of the Treasury did not view the insertion of
‘‘discharged for cause’’ into the final regulations as a change
of significance supports this interpretation. And respondent
in his posthearing memorandum agrees with this construc-
tion:
It is respondent’s position that the phrase ‘‘for cause or for committing
a crime’’ was intended to capture risks that are too remote to be consid-
ered a substantial risk of forfeiture. Respondent further contends that
the addition of the ‘‘for cause’’ provision was intended to clarify that
contingencies resulting in an involuntary termination that are too
remote to be considered substantial risks go beyond terminations for
committing a crime, and include other conduct that results in a termi-
nation, but that is very unlikely to occur.
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(551) AUSTIN v. COMMISSIONER 565
In short, it seems clear that the term ‘‘for cause,’’ as used in
section 1.83–3(c)(2), does not necessarily have the same
meaning as, and may have a narrower meaning than, the
terminology employed by particular parties during private
negotiations. 6
C. Application of the Regulation to the Agreements
Section 14 of the employment agreement provides that it
‘‘shall be construed in accordance with and governed by the
internal law * * * of the State of North Carolina.’’ In inter-
preting a contract under North Carolina law, the intention of
the parties generally controls. Jones v. Palace Realty Co., 37
S.E.2d 906, 907 (N.C. 1946) (‘‘The heart of a contract is the
intention of the parties.’’); Bueltel v. Lumber Mut. Ins. Co.,
518 S.E.2d 205, 209 (N.C. Ct. App. 1999) (‘‘The court is to
6 The
canon of construction ‘‘noscitur a sociis’’—a Latin phrase meaning
‘‘it is known by its associates’’—supports the construction set forth in the
text. This canon of construction ‘‘hold[s] that the meaning of an unclear
word or phrase should be determined by the words immediately sur-
rounding it.’’ Black’s Law Dictionary 1160–1161 (9th ed. 2009). While this
canon does not set forth an inescapable rule, it is often wisely applied to
avoid giving unintended breadth to a word susceptible to multiple mean-
ings. See James v. United States, 550 U.S. 192, 222 (2007) (‘‘[The] various
possible meanings a word should be given must be determined in a man-
ner that makes it ‘fit’ with the words with which it is closely associated.’’);
Jarecki v. G.D. Searle & Co., 367 U.S. 303, 307 (1961) (‘‘noscitur a sociis’’
is a commonsense cannon); Wallace v. Commissioner, 128 T.C. 132, 141
(2007) (‘‘[T]he meaning of an unclear word or phrase should be determined
by the words immediately surrounding it.’’). For example, in G.D. Searle
& Co., the Court interpreted the word ‘‘discovery’’ as used in section
456(a)(2)(B) of the Internal Revenue Code of 1939, which imposed tax on
‘‘income resulting from exploration, discovery, or prospecting.’’ Whereas
‘‘discovery’’ is a broad term that in other contexts can include geographical
and scientific discoveries, the Court held that its association with ‘‘explo-
ration’’ and ‘‘prospecting’’ suggested that the term, as used in this statute,
had the narrower meaning of ‘‘discovery of mineral resources.’’ Id. at 307.
While ‘‘noscitur a sociis’’ is most commonly applied to lists of three or more
terms, it may apply ‘‘when two or more words are grouped together.’’ 2A
Norman J. Singer & J.D. Shambie Singer, Sutherland Statutory Construc-
tion, sec. 47:16, at 347 (7th ed. 2007). Here, the term ‘‘for cause’’ is suscep-
tible to a wide variety of meanings under private contracts. Applying the
‘‘noscitur a sociis’’ canon, we can surmise that the Department of the
Treasury, by associating the phrase ‘‘for cause’’ with ‘‘for committing a
crime,’’ intended ‘‘discharge for cause’’ in section 1.83–3(c)(2), Income Tax
Regs., to have a narrower meaning and to denote termination for serious
misconduct that is roughly comparable to criminal misconduct.
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566 141 UNITED STATES TAX COURT REPORTS (551)
interpret a contract according to the intent of the parties to
the contract, unless such intent is contrary to law.’’). The
intention of the parties ‘‘is to be gathered from the entire
instrument, viewing it from its four corners.’’ Jones, 37
S.E.2d at 907.
We review the employment agreement and the RSA as an
integrated whole. Petitioners were the key contributors to
their distressed debt loan portfolio business before the
UMLIC Entities were consolidated into UMLIC S-Corp. The
stated purpose of these agreements was to ‘‘provid[e] certain
financial incentives’’ to induce petitioners to continue their
employment with the consolidated company for an initial
term of four years. As a condition of receiving the UMLIC S-
Corp. stock, petitioners affirmed that they were ‘‘willing to
perform future services’’ on behalf of the company. Section 1
of the employment agreement required each petitioner to
‘‘devote all of his efforts to the performance of his duties’’ for
UMLIC S-Corp. for the four-year term of the Agreement and
to perform such duties ‘‘faithfully, diligently and in a timely
manner.’’ These provisions are most naturally read to express
the parties’ intention that petitioners were required to per-
form substantial future services for UMLIC S-Corp. in
exchange for their stock.
The termination provisions of the employment agreement
and the RSA must be evaluated in the light of the parties’
expressed intention and the construction of the regulation
that we have adopted above. Applying these parameters, and
looking only within the four corners of the agreements, we
believe that termination for activity specified in section 7(A)
of the employment agreement—e.g., for ‘‘[d]ishonesty, fraud,
embezzlement, alcohol or substance abuse’’—is reasonably
characterized as a discharge ‘‘for cause’’ within the meaning
of section 1.83–3(c)(2). However, we agree with petitioners
that termination for activity specified in section 7(B) of the
employment agreement does not fall within the scope of dis-
charge ‘‘for cause or for committing a crime’’ for purposes of
this regulation.
Section 7(B) permits termination for ‘‘[f]ailure or refusal by
Employee, after 15 days written notice to Employee, to cure
by faithfully and diligently performing the usual and cus-
tomary duties of his employment.’’ The conditions stated in
this section are the conditions that commonly lead employers
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(551) AUSTIN v. COMMISSIONER 567
throughout our economy to terminate at-will employees—
namely, unsatisfactory job performance. This is not a
‘‘remote’’ category of event that is unlikely to occur.
More specifically, under the peculiar drafting of these
instruments, section 7(B) appears to constitute, in conjunc-
tion with RSA section 5(a), a classic ‘‘earnout restriction.’’
The employment agreement states that it can be terminated
only by UMLIC S-Corp. and only for reasons denominated
‘‘for cause.’’ Given proscriptions against involuntary ser-
vitude, there must be some way that petitioners could volun-
tarily cease working for that company. Section 7(B) seems to
be the mechanism that the drafters intended to cover this
situation.
If one of petitioners announced his intention to leave his
employment before January 1, 2004, section 7(B) con-
templates that UMLIC S-Corp. would issue him a ‘‘notice to
cure.’’ He would then have 15 days to cure ‘‘by faithfully and
diligently performing the usual and customary duties of his
employment and adhere to the provisions of this Agreement.’’
This language tracks section 1 of the employment agreement,
wherein each petitioner agreed, during the four-year term of
that Agreement, ‘‘to perform * * * [his] duties and respon-
sibilities faithfully, diligently and in a timely manner and to
abide by all * * * [UMLIC S-Corp.] policies relating to its
employees generally.’’ What petitioner would have to ‘‘cure,’’
in other words, was his refusal to continue performing the
duties specified in the employment agreement, which he had
pledged diligently to discharge for four years. If petitioner
did not cure this breach within 15 days, UMLIC S-Corp. was
entitled under section 7(B) to terminate the employment
agreement ‘‘for cause.’’ 7
In short, section 7(B) of the employment agreement
appears to be the linchpin of the mechanism by which peti-
tioners would receive less than full fair market value upon
forfeiture of their stock if they did not continue to perform
substantial services for UMLIC S-Corp. for the four-year ini-
tial term of that agreement. As a general rule, ‘‘[t]he rights
7 Technically speaking, by acting under section 7(B), UMLIC S-Corp.
would not be terminating the employee for cause, but rather would be ter-
minating the employment agreement for cause, with ‘‘cause’’ consisting of
the employee’s breach of that Agreement by refusing to work for the
agreed-upon four-year term.
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568 141 UNITED STATES TAX COURT REPORTS (551)
of a person in property are subject to a substantial risk of
forfeiture if such person’s rights to full enjoyment of such
property are conditioned upon the future performance of
substantial services by any individual.’’ Sec. 83(c)(1). The
regulations make clear that an earnout restriction creates ‘‘a
substantial risk of forfeiture’’ if there is a sufficient likelihood
that the restriction will actually be enforced. Compare sec.
1.83–3(c)(4), Example (1), Income Tax Regs., with sec. 1.83–
3(c)(3), Income Tax Regs.
We thus conclude that RSA section 5(a) in conjunction with
section 7(B) of the employment agreement—however
inartfully drafted—constitutes an earnout restriction that
may give rise to a ‘‘substantial risk of forfeiture’’ under sec-
tion 83. Notwithstanding section 7(B)’s appearance in a
contractual provision addressing termination ‘‘for cause,’’ the
employee activity specified in section 7(B) falls outside the
scope of discharge ‘‘for cause or for committing a crime’’
within the meaning of section 1.83–3(c)(2), Income Tax Regs.
That is so because an employee’s inability or disinclination to
work for the agreed-upon term of his employment contract is
not a ‘‘remote’’ event that is unlikely to occur. Even more
clearly, that is so because a conclusion that section 1.83–
3(c)(2) precludes an earnout restriction from creating a
‘‘substantial risk of forfeiture’’ would make that subpara-
graph of the regulation inconsistent with the statute. See sec.
83(c)(1); Phillips Petroleum Co. v. Commissioner, 97 T.C. at
35.
Conclusion
For these reasons, we will deny respondent’s motion for
partial summary judgment, which is based solely on the
theory that section 1.83–3(c)(2), Income Tax Regs., caused
petitioners’ UMLIC S-Corp. stock to be ‘‘substantially vested’’
at the time it was issued to them. Respondent has advanced
a number of other theories, addressed both to the overall
structure that petitioners implemented and to the specific
question of whether their stock was ‘‘substantially vested
‘‘upon issuance. For example, as an alternative to his theory
based on section 1.83–3(c)(2), respondent contends that peti-
tioners’ stock was ‘‘substantially vested’’ on the theory that
petitioners’ status as the sole directors of UMLIC S-Corp.
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(551) AUSTIN v. COMMISSIONER 569
enabled them to remove at will any ownership restrictions to
which their stock was subject, so that the forfeiture condi-
tions were unlikely to be enforced. See sec. 1.83–3(c)(3),
Income Tax Regs. This theory, like respondent’s other theo-
ries, remains for trial on the merits. Because petitioners’
cross-motion seeks summary judgment on one or more of
these other IRS theories, which involve material issues of
disputed fact, petitioners’ cross-motion will be denied.
An appropriate order will be issued.
f
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