Monday, I blogged on the final regulations on Code Section 83 and the definition of a “substantial risk of forfeiture,” which IRS and Treasury released last week. Well, the IRS’ attempt to clarify the meaning of a substantial risk of forfeiture under Section 83 with these new final regulations already may be undermined by a Tax Court decision in December 2013. In Austin v. Commissioner, 141 T.C. No. 18 (December 16, 2013), the U.S. Tax Court found that a “discharge for cause” provision in an employment agreement creates a substantial risk of forfeiture under Section 83, despite IRS regulations suggesting the opposite.

The Austin opinion focused on regulations section 1.83-3(c)(2), providing 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.”

The employee/taxpayer had entered into an Employment Agreement and Restricted Stock Agreement with the corporation. Under these agreements, the employee/taxpayer would forfeit a substantial amount of the value of his stock upon the occurrence of various events, enumerated in a paragraph that addressed termination “for cause.” The agreements defined “cause” to “include, without limitation,” the following three categories of employee action:

  1. 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.
  2. 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.
  3. 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 * * * [the corporation] may establish from time to time.

The Court looked beyond the wording of the regulations, at the history of section 1.83-3(c)(2), which in the Court’s view “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 IRS, in a post-hearing memorandum, had essentially agreed with this construction:

"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 considered 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 termination, but that is very unlikely to occur."

Thus, the Court found 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. In the circumstance of this case, the employee/taxpayer could forfeit his stock awards for the “[f]ailure or refusal..., after 15 days written notice..., to cure by faithfully and diligently performing the usual and customary duties of his employment and adhere to the provisions of this Agreement.”  This event was not as remote as the commission of a crime. The Court concluded that the provisions of the restricted stock agreement and the employment agreement “however inartfully drafted” constitute an earn-out restriction that may give rise to a “substantial risk of forfeiture” under section 83.

So what does all this mean?  Most employment, severance, and award agreements define “for cause” narrowly to include very bad acts, along the lines of how the Austin Court interpreted section 1.83-3(c)(2). However, many agreements use a broader definition.  This decision suggests that the definition of “substantial risk of forfeiture” may be broader than most of us had believed – and broader than the recently publish final regulations suggest.