Austin v. Commissioner

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

551

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552 141 UNITED STATES TAX COURT REPORTS (551)

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.’’

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 cus-

tomary 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 like-

lihood 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 whether stock

petitioners received in December 1998, which was labeled

‘‘restricted stock,’’ was subject to a substantial risk of for-

feiture 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

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.

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(551) AUSTIN v. COMMISSIONER 553

events, enumerated in a paragraph that addressed termi-

nation ‘‘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.’’ Dis-

position 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 regula-

tion 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.

Petitioners worked together for more than 15 years in the

‘‘distressed debt loan portfolio business.’’ Before 1998 peti-

tioners 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 cor-

poration (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, including workout strate-

2 Petitioner Arthur E. Kechijian died while the summary judgment mo-

tions were pending. On October 24, 2013, we substituted his estate as a

party petitioner. His estate is being probated in North Carolina.

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554 141 UNITED STATES TAX COURT REPORTS (551)

gies, loan sales, foreclosures, and loan modifications. Peti-

tioner Austin was employed as senior executive vice presi-

dent of UMLIC S-Corp. He had responsibility for loan port-

folio acquisitions, including due diligence involved in the

evaluation of loan portfolios, foreclosure gain/loss analysis,

expected cashflows, bidding strategies, and investor relation-

ships.

As part of the section 351 exchange, each petitioner

executed with UMLIC S-Corp. substantially identical agree-

ments denominated ‘‘Restricted Stock Agreement’’ (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 Agree-

ment.’’

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 * * * [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:

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(551) AUSTIN v. COMMISSIONER 555

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 ‘‘Termi-

nation,’’ provided that ‘‘[t]his Agreement may be terminated

by * * * [UMLIC S-Corp.] at any time for cause.’’ The Agree-

ment 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 Agree-

ment, ‘‘cause’’ was defined to ‘‘include, without limitation,’’

the following three categories of employee action:

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 Employ-

ment,’’ governed the consequences ‘‘[i]n the event of termi-

nation, voluntary or otherwise,’’ of the employee’s employ-

ment 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,

3 In fact, section 7 of the employment agreement does not define termi-

nation ‘‘without cause,’’ and those words do not appear in that section.

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556 141 UNITED STATES TAX COURT REPORTS (551)

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

as determined by formula. Regardless of his actual termi-

nation 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 Employ-

ment 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

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 substan-

tially 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 posi-

tion 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, nei-

ther petitioner reported any income or other flowthrough

items from UMLIC S-Corp. on his individual income tax

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.

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(551) AUSTIN v. COMMISSIONER 557

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 petitioners’ 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, 116 T.C. 73, 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 sum-

mary 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. Commis-

sioner, 118 T.C. 226, 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, 85 T.C. 812, 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., pre-

cludes the agreements at issue from giving rise to a

‘‘substantial risk of forfeiture.’’ Our disposition of this ques-

tion turns entirely on legal determinations 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 ‘‘purchase price’’ specified in sec-

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558 141 UNITED STATES TAX COURT REPORTS (551)

tion 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 substan-

tial 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

‘‘termination of * * * employment.’’ This subject is governed,

apparently comprehensively, by section 4 of the RSA, cap-

tioned ‘‘Termination of Employment,’’ which applies ‘‘[i]n the

event of termination, voluntary or otherwise.’’ The only situa-

tion in which section 4 triggers the 50% discount mandated

by section 5(a) is a termination ‘‘with cause’’ occurring before

January 1, 2004. Under the regulations, 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

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(551) AUSTIN v. COMMISSIONER 559

UMLIC S-Corp. for the four-year term of the employment

agreement in order to secure the full value of their stock.

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, 641

F.3d 1051, 1056 (9th Cir. 2011). 5

Section 83(c) provides that ‘‘[t]he rights of a person in prop-

erty are subject to a substantial risk of forfeiture if such per-

son’s rights to full enjoyment of such property are condi-

tioned upon the future performance of substantial services by

any individual.’’ The regulations echo the statutory defini-

tion:

For purposes of section 83 and the regulations thereunder, whether a

risk of forfeiture is substantial or not depends upon the facts and cir-

cumstances. A substantial risk of forfeiture exists where rights in prop-

erty that are transferred are conditioned, directly or indirectly, upon the

future performance (or refraining from performance) of substantial serv-

ices 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 prop-

erty is sometimes called an ‘‘earnout’’ restriction. See

Campbell v. Commissioner, T.C. Memo. 1990–162, 59 T.C.M.

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 pur-

poses of allocating UMLIC–S Corp. income to petitioners.

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560 141 UNITED STATES TAX COURT REPORTS (551)

(CCH) 236, 251, aff ’d in part, rev’d in part, 943 F.2d 815 (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 tax-

ation 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 sub-

ject 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 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 controversy, provides several illustrations of substan-

tial 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 construction. 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 defi-

nite term of employment if the employee has engaged in mis-

conduct, other malfeasance, or other material breach of the

agreement, such as persistent neglect of duties, gross neg-

ligence, 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

Restatement, the parties to an employment agreement are

free to define the term ‘‘for cause’’ as they believe appropriate

to the particular employment setting. Id. The employment

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(551) AUSTIN v. COMMISSIONER 561

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, 128 T.C. 132

(2007); Anderson v. Commissioner, 123 T.C. 219, 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 Regs., supra.

When issuing these regulations in proposed form, the Sec-

retary stated that ‘‘[p]rior to the final adoption of such regu-

lations, 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 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, 68 T.C. 826

(1977), aff ’d, 620 F.2d 700 (9th Cir. 1980), we were required

to determine the tax consequences when a corporation

contributed funds to trusts that failed to qualify under sec-

tion 401(a). As a collateral matter, we had to determine

whether property was subject to a substantial risk of for-

feiture under section 83. See id. at 835. The terms of both

trusts provided that ‘‘[i]f a participating employee has been

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562 141 UNITED STATES TAX COURT REPORTS (551)

discharged by the Company for cause, such as any inten-

tional act of proven dishonesty or any other intentional act

which would injure the Company,’’ the employee would for-

feit the entire amount allocated to him. Id. at 836. We held

that ‘‘the probability that either of the petitioners would be

discharged for cause from their wholly owned corporation,

thereby forfeiting benefits * * *, is too remote to constitute

a substantial risk of forfeiture.’’ Ibid.

In Burnetta v. Commissioner, 68 T.C. 387 (1977), we deter-

mined 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 ‘‘dis-

charged for theft of company property or embezzlement.’’ Id.

at 390, 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.’’ Id. at 405. We

noted that the Department of the Treasury had issued pro-

posed regulations under section 83 and stated our belief that

our holding was consistent with those regulations. Id. (citing

sec. 1.83–3(c)(1), Proposed Income Tax Regs., supra).

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 cur-

rently does: ‘‘On the other hand, requirements that the prop-

erty be returned to the employer if the employee is dis-

charged 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 Sec-

retary stated: ‘‘[S]everal changes of less significance were

made in response to public comments.’’ T.D. 7554, 1978–2

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(551) AUSTIN v. COMMISSIONER 563

C.B. at 73. The insertion of ‘‘discharged for cause’’ into sec-

tion 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 legisla-

tive 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. Commis-

sioner, 986 F.2d 60, 65 (4th Cir. 1993), aff ’g T.C. Memo.

1991–557. The starting point is the language itself. Grey-

hound Corp. v. Mt. Hood Stages, Inc., 437 U.S. 322, 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

whole.’’ K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291

(1988); Norfolk Energy, Inc. v. Hodel, 898 F.2d 1435, 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 harmo-

nious with its scheme and with the general purposes that

Congress manifested.’’ NLRB v. Lion Oil Co., 352 U.S. 282,

297 (1957). ‘‘We interpret * * * regulations in toto rather

than phrase by phrase.’’ Microsoft Corp. v. Commissioner,

115 T.C. 228, 248–249 (2000) (citing Norfolk Energy, Inc.,

898 F.2d at 1442). In the end, a regulation will be inter-

preted to avoid conflict with a statute. See Phillips Petroleum

Co. v. Commissioner, 97 T.C. 30, 35 (1991), aff ’d without

published opinion, 70 F.3d 1282 (10th Cir. 1995).

The text and evolution of section 1.83–3(c)(2) indicate that

the term ‘‘discharged 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 regu-

lations 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 ‘‘substantial risk of for-

feiture.’’ Whether a risk of forfeiture is ‘‘substantial’’ gen-

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564 141 UNITED STATES TAX COURT REPORTS (551)

erally ‘‘depends upon the facts and circumstances.’’ Sec. 1.83–

3(c)(1), Income Tax Regs. Despite this general rule, com-

menters on the proposed regulations agreed that the pro-

posed 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 Depart-

ment 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.’’

68 T.C. at 836. 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, 68 T.C. at 836; Burnetta, 68 T.C. at 405.

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 construc-

tion:

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 consid-

ered 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 termi-

nation, but that is very unlikely to occur.

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(551) AUSTIN v. COMMISSIONER 565

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

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 inter-

preting a contract under North Carolina law, the intention of

the parties generally controls. Jones v. Palace Realty Co., 37

S.E.2d 906, 907 (N.C. 1946) (‘‘The heart of a contract is the

intention of the parties.’’); Bueltel v. Lumber Mut. Ins. Co.,

518 S.E.2d 205, 209 (N.C. Ct. App. 1999) (‘‘The court is to

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 sur-

rounding it.’’ Black’s Law 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 mean-

ings. See James v. United States, 550 U.S. 192, 222 (2007) (‘‘[The] various

possible meanings a word should be given must be determined in a man-

ner that makes it ‘fit’ with the words with which it is closely associated.’’);

Jarecki v. G.D. Searle & Co., 367 U.S. 303, 307 (1961) (‘‘noscitur a sociis’’

is a commonsense cannon); Wallace v. Commissioner, 128 T.C. 132, 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 ‘‘explo-

ration’’ and ‘‘prospecting’’ suggested that the term, as used in this statute,

had the narrower meaning of ‘‘discovery of mineral resources.’’ Id. at 307.

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 Construc-

tion, sec. 47:16, at 347 (7th ed. 2007). Here, the term ‘‘for cause’’ is suscep-

tible 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.

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566 141 UNITED STATES TAX COURT REPORTS (551)

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.’’ Jones, 37

S.E.2d at 907.

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 per-

form substantial future services for UMLIC S-Corp. in

exchange for their stock.

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 dis-

charge ‘‘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 cus-

tomary duties of his employment.’’ The conditions stated in

this section are the conditions that commonly lead employers

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(551) AUSTIN v. COMMISSIONER 567

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 conjunc-

tion with RSA section 5(a), a classic ‘‘earnout restriction.’’

The employment agreement states that it can be terminated

only by UMLIC S-Corp. and only for reasons denominated

‘‘for cause.’’ Given proscriptions against involuntary ser-

vitude, there must be some way that petitioners could volun-

tarily 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) con-

templates 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 respon-

sibilities 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

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

appears to be the linchpin of the mechanism by which peti-

tioners 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 ini-

tial term of that agreement. As a general rule, ‘‘[t]he rights

7 Technically speaking, by acting under section 7(B), UMLIC S-Corp.

would not be terminating the employee for cause, but rather would be ter-

minating the 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.

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568 141 UNITED STATES TAX COURT REPORTS (551)

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 sec-

tion 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 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 subpara-

graph of the regulation inconsistent with the statute. See sec.

83(c)(1); Phillips Petroleum Co. v. Commissioner, 97 T.C. at

35.

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), respondent contends that peti-

tioners’ stock was ‘‘substantially vested’’ on the theory that

petitioners’ status as the sole directors of UMLIC S-Corp.

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(551) AUSTIN v. COMMISSIONER 569

enabled them to remove at will any ownership restrictions to

which their stock was subject, so that the forfeiture condi-

tions were unlikely to be enforced. See sec. 1.83–3(c)(3),

Income Tax Regs. This theory, like respondent’s other theo-

ries, 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.

f

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