In U.S. v. Fort, 107 AFTR 2d ¶2011-739 (11th Cir. 4/19/2011) a three-judge panel of the Eleventh Circuit upheld a federal district court's (Northern District of Georgia) decision, granting the Department of Justice, Civil Tax Division, summary judgment on that issue that under the constructive receipt doctrine, a consulting partner's sale of an interest in Ernst & Young was a fully taxable in the year the interest was sold to Cap Gemini in exchange for the stock. The lower court rejected the taxpayer’s argument that since he was subject to a five year contractual restriction on selling the shares received in the exchange and was subject to a forfeiture provision for certain conditions based on the post-sale profitability of the consulting company operated by E&Y, such limitation and restrictions did not postpone the year in which a taxable realization occurred for federal income tax purposes. The government brought the action against the taxpayer, Danny C. Fort, to recover a tax refund of over $300,000 which it argued was erroneously refunded.
Constructive Receipt Doctrine In General
A fundamental principle of federal income taxation is that, in general, the receipt of property and/or cash for services rendered or to be rendered or as part of a sale or other disposition of property the amount includible in gross income is the year in which such property is received. §451(a). Where the taxpayer utilizes the cash method of accounting, income must be reported in the year in which the taxable receipts are "actually" or "constructively" received, whichever first occurs. Treas. Reg. §1.451-1(a). In addition, items of gross income are taxable in the year in which the taxpayer is in receipt of an "economic benefit" even if there is earlier no actual or constructive receipt. See also §409A (acceleration of year of gross income realization plus 20% surcharge for deferred compensation that violates the contract requirements contained in the regulations).
As to the constructive receipt doctrine, the courts have determined that the following conditions are required to cause income realization: (1) the amount must be due; (2) the amount must be appropriated on the books of the obligor; (3) the obligor must be willing to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have knowledge of the foregoing facts. Moreover the constructive receipt doctrine requires that an amount be credited to an individual's account and be subject to unqualified demand. Robinson v. Commissioner, 44 T.C. 20 (1965); Basila v. Commissioner, 36 T.C. 111 (1961) acq., 1962-1 C.B. 3; Oates v. Commissioner, 18 T.C. 570 (1952), aff'd, 207 F.2d 711 (7th Cir. 1953). See Treas. Reg. § 1.446-1(c)(1)(I).
In early 2000, Ernst & Young ("E&Y") prepared to spin off and sell its information-technology consulting business to Cap Gemini, S.A. ("Cap Gemini"), a French corporation. At this time, Fort was a partner in that consulting business. On February 28, 2000, E&Y and Cap Gemini executed a Master Agreement that detailed the terms of the transaction. Under the Master Agreement, the proceeds of the sale were divided among E&Y's partners. For consulting partners who qualified as accredited investors under SEC rules, such as Fort, the consulting partner agreed to terminate his or her interest in E&Y, and in exchange, received a distribution of Cap Gemini shares. Additionally, these partners would begin working at a new entity, Cap Gemini Ernst & Young ("CGE&Y"), under employment agreements containing noncompete clauses. There were limitations imposed on the receipt of Cap Gemini. Cap Gemini shares would not be distributed outright to each partner. Instead, 25% of each partner's shares would be sold immediately to cover that partner's income taxes incurred as a result of this transaction, and the other 75% of the shares (the "Restricted Shares") were placed into an individual account in the partner's name at Merrill Lynch. There were limitations placed on the Restricted Shares. They could not be withdrawn from the partner's account at Merrill Lynch immediately, and therefore, the Merrill Lynch accounts were like escrow accounts. For four years and 300 days following the closing, partners could only sell portions of the Restricted Shares at scheduled times. After the four-year, 300-day period, the partners could withdraw all remaining Restricted Shares from the Merrill Lynch account. The former tax director of E&Y's consulting practice, who helped structure this transaction, stated that the reason for these restrictions was to prevent all of the partners from selling too many Cap Gemini shares at once, thereby diminishing the value of the shares.
The Restricted Shares were also subject to forfeiture as "liquidated damages" if a partner (1) breached his employment agreement; (2) voluntarily left his employment; or (3) was terminated. The amount of forfeitable shares decreased with each anniversary of the closing date that the partner remained at CGE&Y, so, generally, the longer a partner worked for CGE&Y, the fewer shares he or she would forfeit if the forfeiture provision were triggered. In addition, the termination forfeiture requirement applied to only two types of termination, and the number of Restricted Shares forfeited upon termination depended on under which type a partner was terminated. If a partner was terminated "for cause," the partner forfeited the full amount of the forfeitable Restricted Shares. However, if a partner was terminated for "poor performance," the partner forfeited at least 50% of the forfeitable Restricted Shares, but could keep a percentage of the remaining 50%, as determined by a review committee.
Partners also would have dividend and voting rights in the Restricted Shares. The dividends paid on the Restricted Shares were not subject to forfeiture, and partners could withdraw these dividends shortly after they were declared. As for voting, Merrill Lynch's French affiliate would vote a partner's shares "as instructed by [the partner] as beneficial owner." Because of the restrictions placed upon the Restricted Shares, the Master Agreement stated that, for tax purposes, the Restricted Shares would be valued at 95% of the closing price of Cap Gemini stock on the closing date. Fort subsequently signed the Partner Agreement, making him a party to the Master Agreement.
The transaction closed on May 23, 2000. Twenty-five percent of Fort's shares were sold at closing and the proceeds turned over to Fort, to cover taxes due based on receipt of the full value of all the stock in 2000. The remaining 75%, the Restricted Shares, were deposited into Fort's Merrill Lynch account.
Fort reported gross proceeds of $1,759,097 from this transaction on his 2000 income tax return. At this time, the Cap Gemini stock was worth approximately $156 per share. In other words, the entire value of the Cap Gemini stock received was included in the amount realized on the sale in 2000. Fort’s basis in his interest in E&Y would then be reduced from the amount realized in arriving at taxable income. The characterization of the gain would be determinate in accordance with §§741 and 751.
In September 2003, Fort was terminated as part of a downsizing. At this time, the value of the Cap Gemini shares had declined substantially
The District Court Grants the Government's Motion for Summary Judgment
The district court granted the government's motion for summary judgment and awarded it the disputed amount. 105 AFTR 2d 2010-2559, (N.D. Ga. 5/10/2010) at 3 (N.D. Ga. May 20, 2010). The court stated that taxable income during a given taxable year includes all income from whatever source derived that is "actually" or "constructively" received during that year. While the court assumed that Fort did not actually receive the Restricted Shares, it concluded that he constructively received them, because: he alone stood to gain or lose money based on the stock's performance. He received the benefit of the dividends paid on the shares, and he had the right to direct how the shares would be voted. Moreover, he knowingly agreed to the sale restriction and the forfeiture provision. He also agreed to the amount of the discount.The district court also rejected Fort's argument that the forfeiture provision prevented him from constructively receiving the Restricted Shares in 2000. The court explained that "the fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place."Id.
Fort Appeals to the Eleventh Circuit
In review of the district court’s grant of summary judgment de novo, i.e., viewing the moving party’s evidence and all factual inferences arising from it in the light most favorable to such party, there is nevertheless, no genuine issue of any material fact and the moving party is entitled to judgment as a matter of law. Fort has appealed the grant of summary judgment in the government's favor, arguing that he did not "receive" the escrowed shares of stock in the year 2000 for tax purposes, and, therefore, was not taxable for their value in that year.
Government’s Danielson Rule Argument Rejected.
The government used the Danielson doctrine or rule in challenging that Fort’s ability to amend his 2000 return is limited because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income in 2000. See Comm’r v. Danielson, 378 F.2d 771 (3rd Cir. 1967). The government argues, citing to Danielson, that Fort's ability to challenge his 2000 tax return is limited, because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income received in 2000. Fort responds that the Danielson rule is inapplicable to this case. The Court agreed. The taxpayer argued that the agreed upon form of the transaction had particular tax consequences and since the form of the transaction was not in dispute, the Danielson doctrine did not apply. See, e.g., United States v. Fletcher, 562 F.3d 839, 842–43 (7th Cir. 2009) (in a case dealing with this same transaction and materially identical facts as the one at bar, the Seventh Circuit rejected reliance on the Danielson rule, writing that "because [the former E&Y partner] does not try to recharacterize the transaction, doctrines that limit or foreclose taxpayers' ability to take such a step are beside the point"); United States v. Nackel, 686 F. Supp. 2d 1008, 1019 [105 AFTR 2d 2010-474] (C.D. Cal. 2009) (in another case involving this same transaction, the District Court for the Central District of California wrote: "The government impermissibly conflates case law concerning a party's effort to look through and re-characterize the form of a transaction with that which addresses what the parties intended would be the tax consequences of a transaction. The former is subject to the heightened scrutiny sought now by the government, the latter is not."). The Eleventh Circuit panel of judges agreed that the Danielson rule was inapplicable in resolving the case.
The district court below had held that in the year 2000 Fort did not actually receive the income from the Restricted Shares but was in constructive receipt of the Restricted Shares and therefore the value of such stock should be includible in gross income to the extent of the agreed value of such Shares in 2000.
The Eleventh Circuit observed that in general,, when assets are placed in escrow as security or otherwise and the taxpayer receivesno right to control or otherwise enjoy those assets, the courts and the Service have held that income is not realized until such time as the contingency is satisfied and the funds are paid over to the taxpayer. On the other hand, the courts and the Service have generally held ... that income is presently realized notwithstanding that the taxpayer lacks an absolute right to possess the escrowed assets. Consistent with the IRS's position, courts have held that a taxpayer presently realizes income when he or she possesses sufficient indicia of control over the assets held within an escrow account or escrow-type arrangement.
In a case involving the legendary comedian and actor, Charles Chaplin v. Commissioner, a company delivered shares of stock to Charlie Chaplin in 1928, who then was required to place the shares in escrow, only to be released when he delivered photoplays to the company in later years. 136 F.2d at 300. The Ninth Circuit held that the shares were income to Chaplin at the time of the initial delivery in 1928, not later, when Chaplin delivered the photoplays and the shares were released. Id. The Ninth Circuit emphasized that Chaplin possessed the following indicia of control over the shares in escrow: (1) the contract at issue vested ownership immediately in Chaplin and the shares were issued in his name; (2) Chaplin had voting rights in the shares; (3) dividends on the shares were declared and paid to an escrow agent who held them for Chaplin's benefit; and (4) Chaplin was considered the owner of the shares.
In Bonham v. Commissioner, also cited above, a taxpayer and a company agreed that the taxpayer would receive title in 750 shares of stock, but the shares would be deposited with the company "as a guarantee for [his] performance." The Eighth Circuit held that the taxpayer realized immediate income when he initially received the 750 shares, not when the shares were later withdrawn.
In the case at bar the Eleventh Circuit was impressed with the fact that it could look at other courts which addressed the same issue arising from the same transaction.. In each of these cases, the courts held that the receipt of the Restricted Shares constituted income in the year 2000.United States v. Bergbauer , 602 F.3d 569, 581] (4th Cir. 2010), cert. denied, 131 S. Ct. 297 (2010);Fletcher , 562 F.3d at 845; Nackel, 686 F. Supp. 2d at 1026; United States v. Berry, 2008 WL 4526178 [102 AFTR 2d 2008-6447], at 7 (D.N.H. Oct. 2, 2008);United States v. Culp , 2006 WL 4061881 [99 AFTR 2d 2007-618], at 1 (M.D. Tenn. Dec. 29, 2006).
Of those related decisions, the lower court placed emphasis on the Fletcher decision out of the Seventh Circuit. In Fletcher the court stated that "a taxpayer's willingness to defer consumption does not defer taxation." 562 F.3d at 843. The court concluded that the CGE&Y agreement was merely a deferral of consumption, not income, for three reasons: (i) the partners bore the market risk that the Restricted Shares would appreciate or depreciate from the date of the closing, because the market price of the Restricted Shares could rise or fall while the shares were in the Merrill Lynch account; (ii) Cap Gemini had already paid the Restricted Shares into the partners' Merrill Lynch accounts, the partners merely agreed to postpone unrestricted access to the stock, rather than to allow Cap Gemini to pay them later; and (iii) the partners agreed to value the Restricted Shares at a discount—95% of the market price of the underlying shares on the closing date—which reflects "not only illiquidity but also the risk that [Cap Gemini] would use its power over the account in an unauthorized way, or that Merrill Lynch might fail in its duty as a custodian." The Eleventh Circuit concurred with the lower court that the Fletcher Court’s decision and supporting analysis was persuasive and that the case involved a mere "delay in consumption" and not a "delay of income".
After weaving through the various restrictions and limitations under the master purchase agreement, the Eleventh Circuit held that the lower court’s grant of summary judgement was affirmed. In sum, Fort constructively received the Restricted Shares in 2000. The fact that Fort could not access the shares immediately was merely a postponement of consumption, not income: CGE&Y paid the full consideration of the shares into Fort's Merrill Lynch account on the closing date, and therefore, Fort bore the market risk of share appreciation or depreciation beginning on the closing date. This conclusion is buttressed by the fact that Fort possessed indicia of control over the shares: he had dividend and voting rights in the shares, and the shares were held in an individual account in Fort's name. Additionally, constructive receipt was not impossible simply because Fort was required to forfeit the shares upon the occurrence of certain conditions, because Fort had sufficient control over whether those conditions would occur. Therefore, Fort realized income at the time the Restricted Shares were transferred into his Merrill Lynch account in 2000.
Constructive Receipt Doctrine . Cap Gemini did not require Fort to forfeit any of his Restricted Shares. Shortly after his termination, Fort learned that several former E&Y consulting partners had filed amended year 2000 tax returns, claiming that they did not realize income from the Restricted Shares in that year. Fort followed suit, filing his own year 2000 amended return, asserting that he did not realize income in 2000 from the then-value of the Restricted Shares. The IRS initially accepted Fort's amended return and granted him a refund for his 2000 tax return. Subsequently, however, the IRS determined that the refund to Fort was in error, and the government filed this suit to recover the refund.