United States: Appeals Court Rules Stock Acquired By An Employee Is Vested For Purposes Of Section 83

In QinetiQ US Holdings, Inc. v. Commissioner, No. 15-2193 (4th Cir. 2017), the Fourth Circuit Court of Appeals affirmed the Tax Court's earlier ruling that stock acquired by an employee was not subject to a substantial risk of forfeiture within the meaning of Section 83; as a result, the employer was not entitled to a tax deduction when the stock vested.

In 2002, an individual, Thomas Hume, formed Dominion Technology Resources, Inc. (DTRI), an S corporation that later converted to a C corporation. That same year, another individual, Julian Chin, joined DTRI by becoming an employee, signing an employment agreement and purchasing voting and nonvoting shares of stock. Hume also executed an employment agreement, and both Hume and Chin executed shareholder agreements with DTRI. Those agreements provided that DTRI would have the option to repurchase the shares at an agreement value upon death, disability or termination of employment without cause. In the event of voluntary resignation by the employee, DTRI had the right to purchase the shares at 5% of the agreement value for every year of the departing employee's employment up to a maximum of 100% after 20 years of employment. In the event an employee voluntarily terminated employment and competed with DTRI, or if the employee was terminated for cause, DTRI had the option to purchase the shares at 5 % of the agreement value for every year of employment up to 25% of the agreement value.

In 2008, QinetiQ US Holdings, Inc. (QinetiQ), entered into negotiations to purchase DTRI. Immediately before the transaction closed, Hume and Chin executed an agreement waiving DTRI's rights to purchase the partially vested stock. QinetiQ included in both Hume and Chin's wages, subject to income tax and FICA tax withholding, the 2008 transaction date fair market value of the shares issued in 2002, and QinetiQ claimed a deduction under Section 83(h) for the fair market value of the shares. Hume and Chin filed personal income tax returns for the 2008 tax year claiming as wages the 2008 value of their respective shares issued in 2002.

The Tax Court held that the shares issued in 2002 were not "transferred in connection with the performance of services" within the meaning of Section 83, and the shares were not subject to a substantial risk of forfeiture from 2002 through the transaction date in 2008. The Fourth Circuit did not address whether the shares issued to Hume and Chin in 2002 were transferred in connection with the performance of services. Instead, the appeals court focused on whether the shares were subject to a substantial risk of forfeiture. To the extent they were not, the tax deduction, if any, under Section 83 would have been allowed to DTRI in 2002, which is closed under the statute of limitations.

Property is not subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of the property to the employee upon the return of the property under Treas. Reg. Sec. 1.83-3(c)(1). In addition, property is not subject to a substantial risk of forfeiture if "at the time of the transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced," under Treas. Reg. § 1.83-3(c)(1). The Fourth Circuit also said that "conditions imposed at the time of transfer that require the return of property  'if the employee accepts a job with a competing firm,' will not be sufficient to constitute a substantial risk of forfeiture," citing Treas. Reg. Sec. 1.83-3(c)(2).

The Fourth Circuit dismissed any notion that the noncompete provision in the shareholder agreement resulted in a substantial risk of forfeiture. In addition, the Fourth Circuit agreed with the Tax Court that the likelihood of forfeiture due to involuntary resignation did not amount to a substantial risk. According to the courts, Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event of Chin's voluntary departure. The courts reached this conclusion because of Chin's role as an initial investor in DTRI, Chin's very close working relationship with Hume and Chin's vital role within DTRI as the executive vice president, chief operating officer and a 49.75% shareholder in voting stock. As a result, the Fourth Circuit ruled that QinetiQ was not entitled to a tax deduction in 2008 related to the stock issued in 2002.

The Fourth Circuit did not directly address QinetiQ's tax deduction for the stock issued to Hume in 2002, but it is possible the same conclusion would apply to Hume's stock because he was the controlling shareholder of the DTRI. In addition, the Fourth Circuit did not address the compensation income recognized by Hume and Chin in 2008.

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