Close Corporations and Compensatory Grants of Equity
It should come as no surprise to readers of this blog that I am not enamored with the notion of issuing equity to employees of a closely-held business. It’s not that these individuals should not be rewarded for their efforts and contributions to the growth, success and stability of the business. Far from it. It’s just that the employer-corporation and the existing shareholders need to fully appreciate the consequences of granting equity, including the fact that state law bestows many rights upon the minority shareholder and imposes many duties upon the majority; moreover, there are other, less compromising, vehicles by which a key employee may be rewarded.
But what if the key employee is already a shareholder of the employee-corporation? Indeed, what if he is a co-founder of the corporation’s business? Does it even make sense that the corporation would make a compensatory grant of stock to such an individual? The answer, of course, depends upon the facts and circumstances.
A recent decision from the U.S. Tax Court described a complex set of transactions involving the grant of stock to the two founders (the “Taxpayers”) of the employer-corporation’s business. The transactions gave rise to several issues, some of which were resolved in favor of the Taxpayers. Unfortunately for the Taxpayers, these proved to be pyrrhic victories, as the IRS ultimately prevailed.
Substantial Risk of Forfeiture
The issue on which we will focus – and on which the Court held for the Taxpayers – was whether the stock issued to the Taxpayers was subject to a substantial risk of forfeiture at the time of issuance.
In general, when stock in the employer-corporation is granted to an employee in consideration of the employee’s services, the employee must include in his gross income the fair market value of such stock.
However, if the stock is subject to substantial risk of forfeiture, the employee does not have to include the stock’s FMV in gross income until the risk of forfeiture lapses (“restricted stock”). Thus, the employee is allowed to defer recognition of income until his rights in the stock become “substantially vested.”
Stock is subject to a substantial risk of forfeiture if the employee’s rights to the stock are conditioned upon the future performance of substantial services by the employee or upon the occurrence of a condition related to the purpose of the transfer; for example, the employee is required to provide a stated number of years of continuous service beginning on the date of grant, or the employee’s division must attain a specified degree of productivity within a stated period of time beginning on such date. Where the employee fails to satisfy the conditions related to the grant, he will be required to return the stock to the employer, usually for no consideration.
Likelihood of Enforcement
An employee will not be required to include the FMV of the stock in his gross income if the possibility of forfeiture is substantial. However, stock is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.
In determining whether the possibility of forfeiture is substantial in the case of stock transferred to an employee of a corporation who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation, there will be taken into account (i) the employee’s relationship to other stockholders and the extent of their control, potential control, and possible loss of control of the corporation, (ii) the position of the employee in the corporation and the extent to which he is subordinate to other employees, (iii) the employee’s relationship to the officers and directors of the corporation, (iv) the person or persons who must approve the employee’s discharge, and (v) past actions of the employer in enforcing the restrictions.
For example, if an employee would be considered as having received rights in property subject to a substantial risk of forfeiture, but for the fact that the employee owns 20 percent of the single class of stock in the employer-corporation, and if the remaining 80 percent of the stock is owned by unrelated individuals so that the possibility of the corporation enforcing a restriction on such rights is substantial, then such rights are subject to a substantial risk of forfeiture. On the other hand, if 4 percent of the voting power of all the stock of a corporation is owned by the president of such corporation and the remaining stock is so widely held that the president, in effect, controls the corporation, then the possibility of the corporation enforcing a restriction on rights in property transferred to the president is not substantial, and such rights are not subject to a substantial risk of forfeiture.
The “Earnout” (?)
In the case considered by the Tax Court, the Taxpayers worked together for many years in the Business. Before Year One, they were the original shareholders and members of a group of related corporations and LLCs (the “Entities”).
Toward the end of Year One, the Taxpayers organized, and elected S-corporation status for, a holding company (“Holding Corp.”) to which they contributed their ownership interests in the Entities in exchange for all of the shares of Holding Corp.’s common stock.
As part of this exchange, each Taxpayer executed a “Restricted Stock Agreement” (“RSA”) and an “Employment Agreement” with Holding Corp. A principal purpose of these agreements was to require the Taxpayers to perform future services for Holding Corp. in order to acquire full rights in their stock. Read together, these agreements specified a five-year “earnout” period and provided that either Taxpayer would forfeit 50% of the value of his shares if he voluntarily terminated his employment with Holding Corp. before Year Six. Removing or waiving this restriction required consent of the holders of 100% of the shares entitled to vote.
The Taxpayers were the sole directors of Holding Corp. throughout the tax years at issue. Taxpayer A was the company’s president and was responsible for its “front-end” operations. Taxpayer B was its senior executive vice president and was responsible for its “back-end” operations.
Allocation of S Corp. Income
Because the Taxpayers received their Holding Corp. shares in a “tax-free” exchange, they were relieved of any obligation to recognize gain upon receipt of the shares or upon transfer of the ownership interests in the Entities to Holding Corp.
The chief relevance of determining whether the shares were “substantially vested” upon receipt was that this determination controlled whether the Taxpayers’ shares were treated as outstanding stock of the S-corporation for purposes of allocating Holding Corp.’s income to the Taxpayers.
Late in Year One, with the avowed goal of encouraging long-term job retention, the Taxpayers caused Holding Corp. to form an ESOP for its employees, including the Taxpayers.
The company funded the ESOP with a loan, which was used to purchase shares of Holding Corp.’s common stock. Thus, as of the end of Year One, each Taxpayer owned 47.5% of Holding Corp.’s common stock and the ESOP owned the remaining 5%.
The Taxpayers discharged their obligations under the RSA and the employment agreements through the end of Year Five and, in Year Six, the restrictions on their stock lapsed accordingly.
The Taxpayers did not report any income from Holding Corp. on their federal income tax returns for Year One, taking the position that their stock was subject to a “substantial risk of forfeiture” and relying on the rule that, for purposes of subchapter S, “stock that is issued in connection with the performance of services * * * and that is substantially nonvested * * * 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.”
Under this reasoning, because the shares owned by the Taxpayers were not deemed to be outstanding, Holding Corp. allocated 100% of its income, losses, deductions, and other tax items to the ESOP.
The IRS determined that the Taxpayers’ stock in Holding Corp. was “substantially vested” upon receipt in Year One; that their stock was thereafter “outstanding”; and that they were accordingly required to report their pro rata shares of the company’s income for each year.
The Taxpayers timely petitioned the Tax Court.
The Court’s Analysis
The Court began by stating that a taxpayer’s rights to stock are subject to substantial risk of forfeiture if his rights to full enjoyment of the stock are conditioned upon his future performance of substantial services. The risk of forfeiture analysis, it continued, required the Court to determine whether the property interests transferred by the employer were “capable of being lost.”
The Taxpayers contended that their stock in Holding Corp. was subject to a substantial risk of forfeiture when they received it in Year One and remained subject to a substantial risk of forfeiture until Year Six, when the five-year earnout restriction lapsed.
The IRS contended that the Taxpayers’ stock was substantially vested when they received it in Year One; that their stock was thus “outstanding” for subchapter S purposes throughout the tax years at issue; and that the Taxpayers consequently were required to report their pro rata shares of the company’s income on their tax returns for those years.
After observing that, in prior cases, it had held that an earnout restriction created a “substantial risk or forfeiture,” provided there was a sufficient likelihood that the restriction would actually be enforced, the Court turned to the question of whether the restriction at issue was likely to be enforced.
Each Taxpayer owned 47.5% of Holding Corp.’s voting common stock, with the ESOP owning the remaining 5%. The Court explained that in situations where nominally restricted property was transferred to an employee “who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation,” one must consider several factors in determining whether the possibility of forfeiture was substantial.
The Court emphasized the importance, not just of percentage stock ownership, but of de facto power to control. Under such circumstances, “the possibility of the corporation enforcing a restriction on rights in property transferred to [an employee] is not substantial, and such rights are not subject to a substantial risk of forfeiture.”
The Court stated that if either Taxpayer had quit his job before the end of the five-year earnout period, Holding Corp. would likely have enforced the restriction requiring that he forfeit 50% of the value of his shares.
While both Taxpayers had experience in the Business, the Court reasoned, their skill sets were quite distinct; Taxpayer A performed the front-end work, while Taxpayer B had back-end and back-office responsibilities. According to the Court, the Taxpayers recognized that the success of the Business depended on their both remaining with the company. To incentivize this, they executed reciprocal agreements whereby each would lose 50% of the value of his stock if he left the company within five years. The Taxpayers thus “tied each other to the mast,” the Court said, for a five-year period.
Moreover, removal or waiver of this forfeiture provision required the consent of the holders of 100% of the company’s shares. As a holder of a 47.5% interest facing the holder of another 47.5% interest, neither Taxpayer had power to control the company. Neither Taxpayer could act unilaterally to remove the forfeiture restriction affecting his stock.
If either Taxpayer threatened to leave during the five-year earnout period, the other had a strong incentive, the Court observed, to insist that the forfeiture restriction be enforced as written. First, given the complementary nature of their responsibilities and skill sets, it was in each Taxpayer’s economic interest to have the other remain with the company. Second, if the departing Taxpayer forfeited 50% of the value of his stock, the value of the remaining Taxpayer’s stock (and that of the ESOP) would be increased accordingly. There was no family or other relationship between the Taxpayers, the Court continued, that would have caused either of them to act against his economic interest.
Conceivably, the Court stated, both Taxpayers might have decided independently that they wished to retire early instead of serving out their promised five-year terms. But despite their status as the sole directors of the company, they would have needed the consent of the ESOP to remove the forfeiture provisions. The ESOP, however, would have had a strong economic incentive to refuse such consent. If the Taxpayers left the company, the company might well have folded, and the ESOP beneficiaries would then have lost their jobs.
The IRS nevertheless urged that the Taxpayers could control the ESOP because they served as two of its initial three trustees and the third trustee was subordinate to them. In response, the Court pointed out that the IRS ignored the fiduciary duties that all three owed the ESOP. As trustees, the Taxpayers were personally liable for any breaches of their fiduciary duty.
In sum, the Court concluded that the Taxpayers’ stock was subject to a substantial risk of forfeiture when issued to them in Year One and remained subject to that risk until the restrictions lapsed in January of Year Six. Neither Taxpayer held a controlling position in Holding. If either failed to perform his duties or left the company before the earnout restriction ended, the other would have had every incentive to insist on enforcement of the forfeiture provision according to its terms. The ESOP had even stronger economic incentives to do this.
Because “the possibility of forfeiture * * * [was] substantial,” the Court ruled that the stock held by the Taxpayers did not become “substantially vested” until they completed their promised service through the end of the five-year earnout period.
What Does It Mean?
Granted, the situation presented in the decision described above was somewhat unusual. Moreover, that the Court did not regard as significant the fact that the stock at issue was granted to the Taxpayers in exchange for their capital contributions to Holding Corp. is somewhat surprising, especially in the case of an S-corporation where the issuance of “restricted” stock to certain shareholders would seem to raise the possibility of shifting income or losses among shareholders in violation of the principles underlying the “second-class-of-stock” rule.
Nevertheless, the Court’s opinion should provide some comfort to an employer-corporation that wants to grant restricted stock to individuals who are already shareholders. Provided the stock is issued for a bona fide business reason that is related to the risk of forfeiture, the employer-corporation, the employee-shareholder, and the other shareholders of the corporation should be able to structure the grant so as to ensure that the likelihood of enforcement of a forfeiture condition is substantial, and to thereby avoid the immediate taxation of the stock issued.