UNITED STATES TAX COURT



      LARRY E. AUSTIN AND BELINDA AUSTIN, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent

ESTATE OF ARTHUR E. KECHIJIAN, DECEASED, SUSAN P. KECHIJIAN
 AND SCOTT E. HOEHN, CO-EXECUTORS, AND SUSAN P. KECHIJIAN,
  Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent


   Docket Nos. 8966-10, 8967-10.           Filed December 16, 2013.



          Ps exchanged property for ostensibly restricted stock of a
   newly formed S corporation (S). The governing agreements provided
   that Ps, upon termination of employment, would receive less than the
   full fair market value of their S shares only if they were terminated
   “for cause” during the initial term of the employment agreement.
   Section 7(B) of the employment agreement defined termination “for
   cause” to include termination upon “[f]ailure or refusal by Employee
   * * * to cure by faithfully and diligently performing the usual and
   customary duties of his employment.” Section 1.83-3(c)(2), Income
   Tax Regs., provides 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.”
                                         -2-

             1. Held: The term “discharged for cause,” as used in section
      1.83-3(c)(2), does not necessarily have the same meaning the parties
      have given that term in their private agreements but refers to
      termination for serious misconduct which, like criminal misconduct,
      is highly unlikely to occur.

             2. Held, further, the risk that Ps would receive less than full
      fair market value upon forfeiture of their stock if they failed faithfully
      and diligently to perform the usual and customary duties of their
      employment during the prescribed period constituted an earnout
      restriction that could create a “substantial risk of forfeiture” if there
      existed a sufficient likelihood that the restriction would actually be
      enforced.



      Lynn Forrest Chandler, Jonathan P. Heyl, and Tanya N. Oesterreich, for

petitioners.

      Patricia Pierce Davis, Nina E. Choi, and Mark L. Hulse, for respondent.



                                     OPINION


      LAUBER, Judge: These consolidated cases are before this Court on

respondent’s motion for partial summary judgment and petitioner’s motion for

summary judgment both filed under Rule 121.1 The sole issue for decision is


      1
        Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code) in effect for the tax years 2000, 2001, 2002, 2003 and 2004,
and all Rule references are to the Tax Court Rules of Practice and Procedure.
                                         -3-

whether stock petitioners received in December 1998, which was labeled

“restricted stock,” was subject to a substantial risk of forfeiture when issued to

them or rather was “substantially vested” within the meaning of section 83 and

section 1.83-1(a)(1), Income Tax Regs. Under the governing employment

agreements, petitioners would forfeit a substantial amount of the value of their

stock upon the occurrence of various events, enumerated in a paragraph that

addressed termination “for cause.” Under section 1.83-3(c)(2), Income Tax Regs.,

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.” Disposition of the pending motions requires us to determine the scope

of the phrase “for cause” as used in section 1.83-3(c)(2), Income Tax Regs., and

the proper application of that regulation to the agreements involved here.

                                    Background

      The following facts are not in dispute. Larry Austin and Arthur Kechijian

(petitioners) resided in North Carolina when they filed petitions.2 Belinda Austin

and Susan Kechijian are parties to these cases solely by virtue of having filed joint

Federal income tax returns with their husbands for the tax years at issue.

      2
       Petitioner Arthur E. Kechijian died while the summary judgment motions
were pending. On October 24, 2013, we substituted his estate as a party petitioner.
His estate is being probated in North Carolina.
                                        -4-

      Petitioners worked together for more than 15 years in the “distressed debt

loan portfolio business.” Before 1998 petitioners were the original shareholders

and members of a group of related companies called “the UMLIC Entities.” In

December 1998 petitioners formed, and elected subchapter S status for, UMLIC

Consolidated, Inc., a North Carolina corporation (UMLIC S-Corp.). In a section

351 transaction, each petitioner transferred his unrestricted ownership interest in

the UMLIC Entities to UMLIC S-Corp. in exchange for 47,500 shares of its

common stock. Concurrently, UMLIC S-Corp. issued 5,000 shares of its common

stock, in exchange for a note, to an employee stock ownership plan (ESOP) for its

employees, including petitioners. Thus, as of December 7, 1998, each petitioner

owned 47.5% of UMLIC S-Corp., and the ESOP owned 5%. At all relevant times,

petitioners were the only directors on the UMLIC S-Corp. board of directors.

Petitioners, along with the company’s assistant controller, were the initial trustees

of the ESOP.

      Petitioner Kechijian was employed as the president of UMLIC S-Corp. He

had responsibility for general operations and for servicing loan portfolios, includ-

ing workout strategies, loan sales, foreclosures, and loan modifications. Petitioner

Austin was employed as senior executive vice president of UMLIC S-Corp. He

had responsibility for loan portfolio acquisitions, including due diligence involved
                                         -5-

in the evaluation of loan portfolios, foreclosure gain/loss analysis, expected

cashflows, bidding strategies, and investor relationships.

      As part of the section 351 exchange, each petitioner executed with UMLIC

S-Corp. substantially identical agreements denominated “Restricted Stock Agree-

ment” (RSA) and “Employment Agreement.” These agreements were explicitly

linked. Section 12 of the employment agreement stated that the employee’s

ownership of UMLIC S-Corp. shares “shall be governed by * * * [the RSA]

entered into simultaneously * * * [and] incorporated herein by reference.”

      The stated purpose of these agreements was to incentivize petitioners to

exchange their UMLIC interests for UMLIC S-Corp. stock and require them to

perform future services in order to secure full rights in this stock. The RSA stated

the company’s intention “to induce * * * [each petitioner’s] continued

employment on behalf of * * * [UMLIC S-Corp.] * * * by providing certain

financial incentives under this Agreement.” Conversely, each petitioner agreed

that, in consideration of UMLIC S-Corp.’s issuance of shares to him, he was

“willing to perform future services on behalf of * * * [UMLIC S-Corp.] under the

terms of the Employment Agreement.”

      The shares issued to petitioners bore the following legend: “The shares

represented by this certificate, and the transfer hereof, are subject to the terms of
                                        -6-

* * * [the RSA].” The RSA permitted limited transfer of the shares to or for the

benefit of family members. However, transfer was permitted only if the transferee

agreed to be bound by the RSA and hence by any restrictions on full enjoyment of

the stock to which the RSA subjected petitioners.

      Section 4 of the employment agreement provided that “[t]he initial term of

this Agreement shall commence on December 7, 1998 * * * and shall continue

until January 1, 2004.” Section 1 of the Agreement, captioned “Employment,”

provided:

      During the term of this Agreement * * * [employee] will devote all of
      his efforts to the performance of his duties as * * * [an officer of
      UMLIC S-Corp.] and any other duties and responsibilities the Board
      of Directors * * * may assign to him from time to time. Employee
      agrees to perform such duties and responsibilities faithfully, diligently
      and in a timely manner and to abide by all * * * [UMLIC S-Corp.]
      policies relating to its employees generally.

      Section 7 of the employment agreement, captioned “Termination,” provided

that “[t]his Agreement may be terminated by * * * [UMLIC S-Corp.] at any time

for cause.” The Agreement makes no provision for termination by the employee,

and it makes no provision for termination by the employer on grounds other than

“for cause.” For purposes of the Agreement, “cause” was defined to “include,

without limitation,” the following three categories of employee action:
                                       -7-

             A. 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.

             B. 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.

            C. 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 * * *
      [UMLIC S-Corp.] may establish from time to time.

      Section 4 of the RSA, captioned “Termination of Employment,” governed

the consequences “[i]n the event of termination, voluntary or otherwise,” of the

employee’s employment with UMLIC S-Corp. Section 4 addressed two types of

termination: “termination without cause” and “termination with cause.” If the

employee’s employment was terminated “without cause, as defined in Section 7 of

the Employment Agreement,”3 he would be deemed by RSA section 4(b) to have

offered to sell all of his stock to the company pursuant to RSA section 5(b). The

latter provided that, if employment terminated after December 31, 2003--that is,

following the end of the initial term of the employment agreement--and the

employee was not in material breach of either agreement, he would receive 100%

      3
      In fact, section 7 of the employment agreement does not define termination
“without cause,” and those words do not appear in that section.
                                        -8-

of the fair market value of his stock, as determined by formula. Regardless of his

actual termination date, in other words, an employee discharged “without cause”

would be treated as if he had terminated employment after December 31, 2003,

and he would receive the full value of his shares.

      If the employee’s employment was terminated by UMLIC S-Corp. “with

cause, as defined in Section 7 of the Employment Agreement,” the employee

would likewise be deemed to have offered to sell all of his stock to the company

under RSA sec. 4(a). However, the purchase price would then depend on the date

of the termination. If the employee was terminated for cause after December 31,

2003, he would receive 100% of the fair market value of his stock under RSA

section 5(b). If the employee was terminated for cause before January 1, 2004, the

purchase price would be governed by RSA section 5(a). It provided that, if

employment terminated before January 1, 2004--that is, during the initial term of

the employment agreement--the employee would receive at most 50% of the fair

market value of his stock, with the possibility of receiving nothing, as determined

by formula.

      For purposes of filing their individual income tax returns for 2000-2003,

petitioners took the position that their UMLIC S-Corp. stock was subject to a

“substantial risk of forfeiture” and was thus “substantially nonvested” within the
                                        -9-

meaning of section 1.83-3(b), Income Tax Regs. Section 1.1361-1(b)(3), Income

Tax Regs., generally provides that, for purposes of subchapter S, “stock that is

issued in connection with the performance of services * * * and that is

substantially nonvested (within the meaning of § 1.83-3(b)) 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.”4 Petitioners thus took the

position that 100% of the outstanding stock of UMLIC S-Corp. was owned by the

ESOP during 2000-2003 and that 100% of the company’s income was allocable to

it. Accordingly, neither petitioner reported any income or other flowthrough items

from UMLIC S-Corp. on his individual income tax return for 2000-2003. And

because the ESOP was a tax-exempt entity, it likewise reported no taxable income

from UMLIC S-Corp. during 2000-2003.

      The Internal Revenue Service (IRS or respondent) issued to petitioners

timely notices of deficiency that challenged, on a variety of grounds, the tax

structure that petitioners and UMLIC S-Corp. had implemented. In this Opinion,

we address only one of the theories the IRS has advanced--namely, that peti-




      4
       A holder of restricted S corporation stock may elect to be treated as a
shareholder, sec. 1.1361-1(b)(3), Income Tax Regs., but neither petitioner made
such an election.
                                       - 10 -

tioners’ stock when issued to them was “substantially vested” by virtue of section

1.83-3(c)(2), Income Tax Regs.

                                     Discussion

I.    Summary Judgment Standard

      Summary judgment is intended to expedite litigation and avoid unnecessary

and expensive trials. See FPL Grp., Inc. & Subs. v. Commissioner, 

,

74 (2001). Either party may move for summary judgment upon all or any part of

the legal issues in controversy. Rule 121(a). A motion for summary judgment or

partial summary judgment will be granted only if it is shown that there is no

genuine dispute as to any material fact and that a decision may be rendered as a

matter of law. See Rule 121(b); Elec. Arts, Inc. v. Commissioner, 

,

238 (2002). The moving party bears the burden of proving that there is no

genuine dispute as to any material fact, and the Court views all factual materials

and inferences in the light most favorable to the nonmoving party. Dahlstrom v.

Commissioner, 

, 821 (1985).

      The parties agree that there are no disputes of material fact affecting the

question addressed in this Opinion--namely, whether section 1.83-3(c)(2), Income

Tax Regs., precludes the agreements at issue from giving rise to a “substantial risk

of forfeiture.” Our disposition of this question turns entirely on legal determina-
                                        - 11 -

tions and the interpretation of the governing agreements. We accordingly

conclude that we may decide this question summarily.

II.   Status of Petitioners’ Stock Under Section 83

      The RSA provides that each petitioner, upon termination of employment,

will be deemed to have offered to sell his stock to UMLIC S-Corp. at the “pur-

chase price” specified in section 5. Section 5(b), wherever it applies, specifies that

the employee will receive 100% of the fair market value of his stock, determined

by formula. Section 1.83-3(c)(1), Income Tax Regs., states that “[p]roperty is not

transferred subject to a substantial risk of forfeiture to the extent that the employer

is required to pay the fair market value * * * to the employee upon the return of

such property.” The parties accordingly agree that section 5(b) cannot create a

substantial risk of forfeiture.

      That being so, the only provision of the RSA that could create a substantial

risk of forfeiture is section 5(a), under which the employee will receive at most

50% of the fair market value of his stock. Section 5(a) comes into play upon “ter-

mination of * * * employment.” This subject is governed, apparently compre-

hensively, by section 4 of the RSA, captioned “Termination of Employment,”

which applies “[i]n the event of termination, voluntary or otherwise.” The only

situation in which section 4 triggers the 50% discount mandated by section 5(a) is
                                         - 12 -

a termination “with cause” occurring before January 1, 2004. Under the regula-

tions, a requirement that stock be forfeited “if the employee is discharged for

cause * * * will not be considered to result in a substantial risk of forfeiture.” Sec.

1.83-3(c)(2), Income Tax Regs. Respondent accordingly concludes that no

provision of the RSA gives rise to a substantial risk of forfeiture.

      Petitioners contend that the scope of “for cause,” as used in section 1.83-

3(c)(2), is not necessarily identical to the scope the parties have given that phrase

in their agreements. Section 7 of the employment agreement broadly defines three

categories of employee action justifying “termination with cause.” Petitioners

agree that discharge for activity specified in section 7(A)--e.g., for “[d]ishonesty,

fraud, embezzlement, alcohol or substance abuse”--is reasonably characterized as

a “discharge for cause” within the meaning of the regulation. On the other hand,

petitioners contend that termination for activity specified in section 7(B)--i.e., for

refusal to perform faithfully “the usual and customary duties of [the employee’s]

employment”--should not be deemed a “discharge for cause” under section 1.83-

3(c)(2). Rather, according to petitioners, section 7(B) is the mechanism the parties

have adopted, clumsily perhaps, to enforce the central requirement of the RSA--

that petitioners continue their employment with UMLIC S-Corp. for the four-year

term of the employment agreement in order to secure the full value of their stock.
                                        - 13 -

Such a requirement, petitioners contend, necessarily creates a “substantial risk of

forfeiture” under the statute and its implementing regulations.

      A.     The Statute and the Regulations

      Section 83(a) applies where, as concededly occurred here, property is

transferred to a taxpayer “in connection with the performance of services.” Upon

such a transfer, the excess of the fair market value of the property over the amount

(if any) paid for the property shall be included in the taxpayer’s gross income in

the first taxable year in which the taxpayer’s rights in the property “are not subject

to a substantial risk of forfeiture.” Sec. 83(a). The statute thus permits a taxpayer

to defer recognition of any gain until his rights in the restricted property become

“substantially vested.” Sec. 1.83-1(a)(1), Income Tax Regs.; see Storm v. United

States, 

, 1056 (9th Cir. 2011).5

      Section 83(c) provides that “[t]he rights of a person in property are subject

to a substantial risk of forfeiture if such person’s rights to full enjoyment of such




      5
        Because petitioners received their UMLIC-S Corp. shares in a section 351
exchange, they were relieved of any obligation to recognize gain upon receipt of
the shares. The relevance of determining whether the shares were “substantially
vested” upon receipt is that this determination controls whether petitioners’ shares
are treated during 2000-2003 as “outstanding stock of the corporation,” sec.
1.1361.1(b)(3), Income Tax Regs., for purposes of allocating UMLIC-S Corp.
income to petitioners.
                                        - 14 -

property are conditioned upon the future performance of substantial services by

any individual.” The regulations echo the statutory definition:

      For purposes of section 83 and the regulations thereunder, whether a
      risk of forfeiture is substantial or not depends upon the facts and
      circumstances. A substantial risk of forfeiture exists where rights in
      property that are transferred are conditioned, directly or indirectly,
      upon the future performance (or refraining from performance) of
      substantial services by any person * * *

Sec. 1.83-3(c)(1), Income Tax Regs.

      The requirement that an employee perform future services as a condition of

obtaining full enjoyment of restricted property is sometimes called an “earnout”

restriction. See Campbell v. Commissioner, T.C. Memo. 1990-162, 59 T.C.M.

(CCH) 236, 251, aff’d in part, rev’d in part, 

(8th Cir. 1991).

Because of the real possibility that this condition may not be fulfilled, an earnout

restriction will normally create a “substantial risk of forfeiture” that postpones

taxation until the restriction lapses. The regulations provide a clear example of an

earnout restriction:

      On November 1, 1971, corporation X transfers in connection with the
      performance of services to E, an employee, 100 shares of corporation
      X stock for $90 per share. Under the terms of the transfer, E will be
      subject to a binding commitment to resell the stock to corporation X
      at $90 per share if he leaves the employment of corporation X for any
      reason prior to the expiration of a 2-year period from the date of such
      transfer. Since E must perform substantial services for corporation X
      and will not be paid more than $90 for the stock, regardless of its
                                         - 15 -

      value, if he fails to perform such services during such 2-year period,
      E’s rights in the stock are subject to a substantial risk of forfeiture
      during such period.

Sec. 1.83-3(c)(4), Example (1), Income Tax Regs.

      Section 1.83-3(c)(2) of the regulations, the focus of the present con-

troversy, provides several illustrations of substantial risks of forfeiture. It

provides in pertinent part:

      Where an employee receives property from an employer subject to a
      requirement that it be returned if the total earnings of the employer do
      not increase, such property is subject to a substantial risk of
      forfeiture. On the other hand, requirements that the property be
      returned to the employer if the employee is discharged for cause or
      for committing a crime will not be considered to result in a substantial
      risk of forfeiture. * * *

      Read in isolation, the term “for cause” is susceptible to a broad construc-

tion. In the employment law context, “for cause” expresses “a common standard

governing the removal of a civil servant or an employee under contract.” Black’s

Law Dictionary 717 (9th ed. 2009). Generally, “[a]n employer has cause for early

termination of an agreement for a definite term of employment if the employee has

engaged in misconduct, other malfeasance, or other material breach of the

agreement, such as persistent neglect of duties, gross negligence, or failure to

perform the duties of the position due to a permanent disability.” Restatement,

Employment 3d, Tentative Draft No. 2, sec. 2.04 (2009). According to the
                                        - 16 -

Restatement, the parties to an employment agreement are free to define the term

“for cause” as they believe appropriate to the particular employment setting. 

law definition of “for cause” can thus cover termination for a

wide range of reasons.

      The history of a regulation may be helpful in resolving ambiguities in it.

See Wallace v. Commissioner, 

(2007); Anderson v. Commissioner,

, 233 (2004), aff’d, 137 Fed. Appx. 373 (1st Cir. 2005). The

Department of the Treasury issued proposed regulations under section 83 in 1971.

36 Fed. Reg. 10787 (June 3, 1971). Section 1.83-3(c), Proposed Income Tax

Regs., 36 Fed. Reg. 10790 (June 3, 1971), did not contain the phrase “discharged

for cause.” Rather, the proposed regulation read in pertinent part: “On the other

hand, a requirement that the property be returned to the employer if the employee

commits a crime will not be considered to result in a substantial risk of forfeiture.”

Sec. 1.83-3(c)(1), Proposed Income Tax 

.

      When issuing these regulations in proposed form, the Secretary stated that

“[p]rior to the final adoption of such regulations, consideration will be given to

any comments or suggestions pertaining thereto.” 36 Fed. Reg. 10787. The IRS

received 374 pages of public comments, several of which bear on the question

here. Comments submitted by the New York State Bar Association, received by
                                        - 17 -

the IRS on January 10, 1972, suggested that “the Regulations should not attempt

to create presumptions or draw lines, except in the clearest situations (such as

forfeiture conditioned only on committing a crime), because to do so is to make a

rule of law where none was authorized by Congress.” Comments submitted by

Cravath, Swaine & Moore, received by the IRS on July 8, 1971, suggested that the

exception for “committing a crime” was sound because “the risk of forfeiture rests

upon a single possibility which is very unlikely to happen.”

      After the public comments were received, but before any final regulations

were issued, this Court decided two cases that addressed the meaning of

“substantial risk of forfeiture” under section 83. In Ludden v. Commissioner, 

(1977), aff’d, 

(9th Cir. 1980), we were required to

determine the tax consequences when a corporation contributed funds to trusts that

failed to qualify under section 401(a). As a collateral matter, we had to determine

whether property was subject to a substantial risk of forfeiture under section 83.

See 

The terms of both trusts provided that “[i]f a participating

employee has been discharged by the Company for cause, such as any intentional

act of proven dishonesty or any other intentional act which would injure the

Company,” the employee would forfeit the entire amount allocated to him. 

We held that “the probability that either of the petitioners would be
                                         - 18 -

discharged for cause from their wholly owned corporation, thereby forfeiting

benefits * * *, is too remote to constitute a substantial risk of forfeiture.” 

Commissioner, 

(1977), we determined that a

corporation’s pension plan did not qualify under section 401(a) and again had to

decide whether the employer’s contributions to that plan were includable in the

employee’s gross income under section 83. The plan provided that the property

would be forfeited if the employee was “discharged for theft of company property

or embezzlement.” 

403. We held that the property was not subject to a

substantial risk of forfeiture because the possibility that an employee would be

discharged for theft or embezzlement “is too remote to present any substantial risk

that the amounts contributed on his behalf will be forfeited.” 

We noted

that the Department of the Treasury had issued proposed regulations under section

83 and stated our belief that our holding was consistent with those regulations. 

1.83-3(c)(1), Proposed Income Tax 

).

      The following year, the Department of the Treasury issued the section 83

regulations in final form. T.D. 7554, 1978-2 C.B. 71. The final regulations added

the phrase “discharged for cause” to what is now section 1.83-3(c)(2), Income Tax

Regs., modifying the sentence in question to read as it currently does: “On the

other hand, requirements that the property be returned to the employer if the
                                        - 19 -

employee is discharged for cause or for committing a crime will not be considered

to result in a substantial risk of forfeiture.” T.D. 7554, 1978-2 C.B. at 78.

      When issuing the final regulations, the Department of the Treasury

explained the principal changes it had made to the proposed regulations. T.D.

7554, 1978-2 C.B. at 72-73. The insertion of “discharged for cause” into section

1.83-3(c)(2), Income Tax Regs., was not among the changes so discussed. “In

addition to the changes already mentioned,” the Secretary stated: “[S]everal

changes of less significance were made in response to public comments.” T.D.

7554, 1978-2 C.B. at 73. The insertion of “discharged for cause” into section

1.83-3(c)(2) was evidently regarded as one of these “less significant” changes.

      B.     Discharge “for Cause or for Committing a Crime”

      Because the term “for cause” as used in section 1.83-3(c)(2) is not defined

in the statute, the regulations, or the legislative history, we employ the standard

tools of construction to discern its scope. Regulations are interpreted in the same

manner as statutes. See Black & Decker Corp. v. Commissioner, 

, 65

(4th Cir. 1993), aff’g T.C. Memo. 1991-557. The starting point is the language

itself. Greyhound Corp. v. Mt. Hood Stages, Inc., 

, 330 (1978). In

determining “the plain meaning of the statute, the court must look to the particular

statutory language at issue, as well as the language and design of the statute as a
                                        - 20 -

whole.” K Mart Corp. v. Cartier, Inc., 

, 291 (1988); Norfolk Energy,

Inc. v. Hodel, 

, 1442 (9th Cir. 1990). When a statute is ambiguous,

the court must find the interpretation that “can most fairly be said to be embedded

in the statute, in the sense of being most harmonious with its scheme and with the

general purposes that Congress manifested.” NLRB v. Lion Oil Co., 

, 297 (1957). “We interpret * * * regulations in toto rather than phrase by

phrase.” Microsoft Corp. v. Commissioner, 

, 248-249 (2000) (citing

Norfolk Energy, 

). In the end, a regulation will be

interpreted to avoid conflict with a statute. See Phillips Petroleum Co. v.

Commissioner, 

, 35 (1991), aff’d without published opinion, 

(10th Cir. 1995).

      The text and evolution of section 1.83-3(c)(2) indicate that the term “dis-

charged for cause,” as used therein, does not necessarily have the same scope that

parties to a particular contract may have given this term in their negotiations.

Rather, as used in the regulation, “discharged for cause” refers to termination for

serious misconduct that is roughly comparable--in its severity and in the

unlikelihood of its occurrence--to criminal misconduct. The 1971 proposed

regulations mentioned discharge “for committing a crime” as the only illustration

of an employment-related contingency that failed, as a matter of law, to create a
                                        - 21 -

“substantial risk of forfeiture.” Whether a risk of forfeiture is “substantial” gene-

rally “depends upon the facts and circumstances.” Sec. 1.83-3(c)(1), Income Tax

Regs. Despite this general rule, commenters on the proposed regulations agreed

that the proposed exception for “committing a crime” was reasonable, since this

limited per se rule comprised a narrow, well-defined category of event that was

very unlikely to occur.

      We may never know for certain what prompted the Department of the

Treasury, in the 1978 final regulations, to revise this exception to read “discharged

for cause or for committing a crime.” However, a fair inference is that this

revision was implemented to codify the results in Ludden and Burnetta, both of

which were decided the previous year. In Ludden, we held that a “substantial risk

of forfeiture” did not exist where the employment-related contingency was

“discharge[] * * * for cause, such as any intentional act of proven dishonesty or

any other intentional act which would injure the Company.” 

. In

Burnetta, we held that a “substantial risk of forfeiture” did not exist where the

employment-related contingency was “discharge[] for theft of company property

or embezzlement.” In both cases, we viewed the contingency in question as “too

remote” to create a “substantial risk of forfeiture.” Ludden, 

;

Burnetta, 

.
                                        - 22 -

      This history of section 1.83-3(c)(2), Income Tax Regs., 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 fact that the Department of the Treasury did

not view the insertion of “discharged for cause” into the final regulations as a

change of significance supports this interpretation. And respondent in his

posthearing memorandum agrees 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. Respon-
      dent further contends that the addition of the “for cause” provision
      was intended to clarify that contingencies resulting in an involun-
      tary 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.

In short, it seems clear 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.6

      6
       The canon of construction “noscitur a sociis”--a Latin phrase meaning “it is
known by its associates”--supports the construction set forth in the text. This
canon of construction “hold[s] that the meaning of an unclear word or phrase
should be determined by the words immediately surrounding it.” Black’s Law
                                                         (continued...)
                                       - 23 -

      C.    Application of the Regulation to the Agreements

      Section 14 of the employment agreement provides that it “shall be construed

in accordance with and governed by the internal law * * * of the State of North

Carolina.” In interpreting a contract under North Carolina law, the intention of the

parties generally controls. Jones v. Palace Realty Co., 

, 907 (N.C.


      6
       (...continued)
Dictionary 1160-1161 (9th ed. 2009). While this canon does not set forth an
inescapable rule, it is often wisely applied to avoid giving unintended breadth to a
word susceptible to multiple meanings. See James v. United States, 

,
222 (2007) (“[The] various possible meanings a word should be given must be
determined in a manner that makes it ‘fit’ with the words with which it is closely
associated.”); Jarecki v. G.D. Searle & Co., 

, 307 (1961) (“noscitur a
sociis” is a commonsense cannon); Wallace v. Commissioner, 

, 141
(2007) (“[T]he meaning of an unclear word or phrase should be determined by the
words immediately surrounding it.”). For example, in G.D. Searle & Co., the
Court interpreted the word “discovery” as used in section 456(a)(2)(B) of the
Internal Revenue Code of 1939, which imposed tax on “income resulting from
exploration, discovery, or prospecting.” Whereas “discovery” is a broad term that
in other contexts can include geographical and scientific discoveries, the Court
held that its association with “exploration” and “prospecting” suggested that the
term, as used in this statute, had the narrower meaning of “discovery of mineral
resources.” 

While “noscitur a sociis” is most commonly applied to lists
of three or more terms, it may apply “when two or more words are grouped
together.” 2A Norman J. Singer & J.D. Shambie Singer, Sutherland Statutory
Construction, sec. 47:16, at 347 (7th ed. 2007). Here, the term “for cause” is
susceptible to a wide variety of meanings under private contracts. Applying the
“noscitur a sociis” canon, we can surmise that the Department of the Treasury, by
associating the phrase “for cause” with “for committing a crime,” intended
“discharge for cause” in section 1.83-3(c)(2), Income Tax Regs., to have a
narrower meaning and to denote termination for serious misconduct that is roughly
comparable to criminal misconduct.
                                         - 24 -

1946) (“The heart of a contract is the intention of the parties.”); Bueltel v. Lumber

Mut. Ins. Co., 

, 209 (N.C. Ct. App. 1999) (“The court is to interpret

a contract according to the intent of the parties to the contract, unless such intent is

contrary to law.”). The intention of the parties “is to be gathered from the entire

instrument, viewing it from its four corners.” 

.

      We review the employment agreement and the RSA as an integrated whole.

Petitioners were the key contributors to their distressed debt loan portfolio business

before the UMLIC Entities were consolidated into UMLIC S-Corp. The stated

purpose of these agreements was to “provid[e] certain financial incentives” to

induce petitioners to continue their employment with the consolidated company for

an initial term of four years. As a condition of receiving the UMLIC S-Corp. stock,

petitioners affirmed that they were “willing to perform future services” on behalf of

the company. Section 1 of the employment agreement required each petitioner to

“devote all of his efforts to the performance of his duties” for UMLIC S-Corp. for

the four-year term of the Agreement and to perform such duties “faithfully,

diligently and in a timely manner.” These provisions are most naturally read to

express the parties’ intention that petitioners were required to perform substantial

future services for UMLIC S-Corp. in exchange for their stock.
                                        - 25 -

       The termination provisions of the employment agreement and the RSA must

be evaluated in the light of the parties’ expressed intention and the construction of

the regulation that we have adopted above. Applying these parameters, and

looking only within the four corners of the agreements, we believe that termination

for activity specified in section 7(A) of the employment agreement--e.g., for

“[d]ishonesty, fraud, embezzlement, alcohol or substance abuse”--is reasonably

characterized as a discharge “for cause” within the meaning of section 1.83-3(c)(2).

However, we agree with petitioners that termination for activity specified in section

7(B) of the employment agreement does not fall within the scope of discharge “for

cause or for committing a crime” for purposes of this regulation.

      Section 7(B) permits termination for “[f]ailure 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.” The conditions stated in this

section are the conditions that commonly lead employers throughout our economy

to terminate at-will employees--namely, unsatisfactory job performance. This is

not a “remote” category of event that is unlikely to occur.

      More specifically, under the peculiar drafting of these instruments, section

7(B) appears to constitute, in conjunction with RSA section 5(a), a classic “earnout

restriction.” The employment agreement states that it can be terminated only by
                                        - 26 -

UMLIC S-Corp. and only for reasons denominated “for cause.” Given proscrip-

tions against involuntary servitude, there must be some way that petitioners could

voluntarily cease working for that company. Section 7(B) seems to be the

mechanism that the drafters intended to cover this situation.

      If one of petitioners announced his intention to leave his employment before

January 1, 2004, section 7(B) contemplates that UMLIC S-Corp. would issue him a

“notice to cure.” He would then have 15 days to cure “by faithfully and diligently

performing the usual and customary duties of his employment and adhere to the

provisions of this Agreement.” This language tracks section 1 of the employment

agreement, wherein each petitioner agreed, during the four-year term of that

Agreement, “to perform * * *[his] duties and responsibilities faithfully, diligently

and in a timely manner and to abide by all * * * [UMLIC S-Corp.] policies relating

to its employees generally.” What petitioner would have to “cure,” in other words,

was his refusal to continue performing the duties specified in the employment

agreement, which he had pledged diligently to discharge for four years. If

petitioner did not cure this breach within 15 days, UMLIC S-Corp. was entitled

under section 7(B) to terminate the employment agreement “for cause.”7

      7
       Technically speaking, by acting under section 7(B), UMLIC S-Corp. would
not be terminating the employee for cause, but rather would be terminating the
                                                                      (continued...)
                                          - 27 -

      In short, section 7(B) of the employment agreement appears to be the

linchpin of the mechanism by which petitioners would receive less than full fair

market value upon forfeiture of their stock if they did not continue to perform

substantial services for UMLIC S-Corp. for the four-year initial term of that

agreement. As a general rule, “[t]he rights of a person in property are subject to a

substantial risk of forfeiture if such person’s rights to full enjoyment of such

property are conditioned upon the future performance of substantial services by any

individual.” Sec. 83(c)(1). The regulations make clear that an earnout restriction

creates “a substantial risk of forfeiture” if there is a sufficient likelihood that the

restriction will actually be enforced. Compare sec. 1.83-3(c)(4), Example (1),

Income Tax Regs., with sec. 1.83-3(c)(3), Income Tax Regs.

      We thus conclude that RSA section 5(a) in conjunction with section 7(B) of

the employment agreement--however inartfully drafted--constitutes an earnout

restriction that may give rise to a “substantial risk of forfeiture” under section 83.

Notwithstanding section 7(B)’s appearance in a contractual provision addressing

termination “for cause,” the employee activity specified in section 7(B) falls

outside the scope of discharge “for cause or for committing a crime” within the

      7
       (...continued)
employment agreement for cause, with “cause” consisting of the employee’s
breach of that Agreement by refusing to work for the agreed-upon four-year term.
                                        - 28 -

meaning of section 1.83-3(c)(2), Income Tax Regs. That is so because an

employee’s inability or disinclination to work for the agreed-upon term of his

employment contract is not a “remote” event that is unlikely to occur. Even more

clearly, that is so because a conclusion that section 1.83-3(c)(2) precludes an

earnout restriction from creating a “substantial risk of forfeiture” would make that

subparagraph of the regulation inconsistent with the statute. See sec. 83(c)(1);

Phillips Petroleum Co. v. Commissioner, 

.

                                     Conclusion

      For these reasons, we will deny respondent’s motion for partial summary

judgment, which is based solely on the theory that section 1.83-3(c)(2), Income Tax

Regs., caused petitioners’ UMLIC S-Corp. stock to be “substantially vested” at the

time it was issued to them. Respondent has advanced a number of other theories,

addressed both to the overall structure that petitioners implemented and to the

specific question of whether their stock was “substantially vested “ upon issuance.

For example, as an alternative to his theory based on section 1.83-3(c)(2), respon-

dent contends that petitioners’ stock was “substantially vested” on the theory that

petitioners’ status as the sole directors of UMLIC S-Corp. enabled them to remove

at will any ownership restrictions to which their stock was subject, so that the

forfeiture conditions were unlikely to be enforced. See sec. 1.83-3(c)(3), Income
                                        - 29 -

Tax Regs. This theory, like respondent’s other theories, remains for trial on the

merits. Because petitioners’ cross-motion seeks summary judgment on one or more

of these other IRS theories, which involve material issues of disputed fact,

petitioners’ cross-motion will be denied.


                                                 An appropriate order will

                                       be issued.