In Austin v. Commissioner, the taxpayers formed an S corporation into which they transferred their ownership interests in certain entities in exchange for S corporation shares. The taxpayers, employees of the S corporation, executed related Restricted Stock Agreements and Employment Agreements requiring them to perform future services in order to secure full rights in their S corporation stock. The Employment Agreement provided that taxpayers would forfeit a substantial amount of the value of their stock upon a termination for cause prior to a certain date, which included the taxpayers’ refusal to perform their customary duties of employment.
The Treasury regulations under Code Section 83 provide 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 taxpayers argued that their S corporation stock was subject to a substantial risk of forfeiture, and therefore, absent a Section 83(b) election, there is no income until the stock vests (i.e., ceases to be subject to the substantial risk of forfeiture).
The Tax Court noted that prior proposed Section 83 Treasury regulations provided that a substantial risk of forfeiture would not have occurred if the employee were required to forfeit stock because the employee committed a crime. The phrase “discharged for cause” was added to the final Section 83 Treasury regulations and is not defined by statute, regulation or legislative history. The Tax Court determined that “discharged for cause” does not necessarily have the same scope or meaning that parties to a particular contract may have given to it in their negotiations. Discharged for cause, the Tax Court stated, refers to a termination for serious misconduct that is roughly comparable – in its severity and in the unlikelihood of its occurrence – to criminal misconduct. Further, the ability of the S corporation to terminate the taxpayers for unsatisfactory job performance is not a remote event that is unlikely to occur.
The Tax Court ultimately determined that the taxpayers’ potential to forfeit a substantial amount of the value of their stock upon a termination of employment for failure to perform their customary duties of employment prior to a certain date essentially amounted to an earn-out restriction that gave rise to a substantial risk of forfeiture. Even though the taxpayers’ failures to perform their customary duties of employment were grounds for termination for cause, the Court determined that such activity is outside the scope of the meaning of discharged for cause or for committing a crime under the Section 83 Treasury regulations. As a result, the taxpayer was immediately taxable on the receipt of the stock.
In sum, although forfeiture of property received for services on termination for cause or for commission of a crime generally is not considered to be substantial, the facts in this case indicated that any voluntary termination of employment by the employee would necessarily come under the definition of termination for cause as defined in the applicable agreement (which included the employee’s failure or refusal to perform customary duties of employment) such that the risk of forfeiture in that case was determined by the Court to be substantial.