In Austin v. Commissioner
, T.C. Memo. 2017-69 (April 24, 2017), the Tax Court held in favor of the IRS when it determined that certain steps in a transaction, in which stock held by shareholders of an S corporation was surrendered and repurchased, lacked economic substance.
In a simplified version of the facts of Austin
, two individuals (Petitioners) contributed assets to UMLIC Consolidated, Inc. (UMLIC) – a newly formed holding company that elected S corporation status – in December 1998 in a Section 351 exchange. Upon the exchange, Petitioners each executed a restricted stock agreement (RSA) and an employment agreement with UMLIC. The RSA provided for a five year “earn-out” period, after which Petitioners’ stock would fully vest. In addition, Petitioners caused UMLIC to form an employee stock ownership plan (ESOP), which is a tax-exempt entity, for its employees, including Petitioners.
After the initial formation of UMLIC and the ESOP, Petitioners each owned approximately 47.5% (together, 95%), and the ESOP owned approximately 5%, of UMLIC. However, for purposes of subchapter S, restricted stock that meets the requirements provided under Treas. Reg. Sec. 1.1361-1(b)(3) 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 unless an election under Section 83(b) is made. Petitioners took the position that the stock they received, which was subject to the RSA, met the requirements of Treas. Reg. Sec. 1.1361-1(b)(3). Accordingly, the ESOP was treated by Petitioners as the sole shareholder of UMLIC for U.S. federal income tax purposes until the restrictions under the RSA lapsed, and therefore, all items of income and deduction were allocated to the tax-exempt ESOP until that time.
In 2003, Petitioners formed a new limited liability company, Holdings, LLC (Holdings). Petitioners then caused UMLIC to sell its assets to Holdings in exchange for a promissory note. UMLIC elected out of installment sale treatment under Section 453, and the significant gain realized by UMLIC was allocated 100% to the ESOP. As discussed above, the ESOP owned only approximately 5% of UMLIC, but all of the income was allocated to the ESOP because the Petitioners’ 95% interest consisted of restricted stock.
On Jan. 1, 2004, the restrictions on Petitioners’ restricted stock lapsed and the stock became fully vested. Generally, if a taxpayer’s restricted stock fully vests – and an election under Section 83(b) was not previously made with respect to that stock – the taxpayer must recognize compensation income equal to the difference between the basis in the stock and its fair market value (FMV) on the date it fully vests. To avoid having to report compensation income equal to this amount, each Petitioner executed a series of transactions whereby they putatively surrendered their vested UMLIC stock with a respective FMV of $46 million, and purchased replacement shares in exchange for a $41.5 million promissory note. As a result, each Petitioner reported as compensation income only the difference between the $46 million FMV of their respective UMILC stock and the $41.5 million promissory note, or $4.5 million.
The IRS challenged Petitioners’ treatment of the transactions on several fronts under the economic substance doctrine. The Petitioners’ facts pre-dated the 2010 codification of the economic substance doctrine under Section 7701(o). In its opinion, the Tax Court applied the judicial two-part test provided by Rice’s Toyota World, Inc.,
752 F.2d 89 (4th Cir. 1985) to analyze each of the IRS’s challenges. To disregard a transaction, Rice’s Toyota World
provides that a court must find: (1) that the taxpayer was motivated by no business purpose other than obtaining tax benefits and (2) that the transaction had no economic substance because it offered no reasonable possibility of profit. A transaction must fail both of these prongs for a court to disregard the transaction.
The Tax Court evaluated four separate instances where the IRS challenged the Petitioners’ transactions using the economic substance doctrine. Under the two-part test, the Tax Court found that the stock surrender and repurchase transactions lacked economic substance. The only business purpose for these transactions suggested by Petitioners was to avoid paying employment taxes, which “in itself is a tax avoidance purpose.” By admitting that they sought to avoid payment of employment taxes, Petitioners admitted that they sought to avoid income taxes because “the former would not be payable unless the latter were also payable.”
With respect to the second part of the test, the Tax Court found that the Petitioners could not have envisioned a reasonable possibility of realizing profit by surrendering valuable stock and incurring indebtedness to acquire stock that was already owned free and clear. As a result of these findings, the Tax Court held that on the date the restricted stock fully vested, Petitioners were required to include in income the difference between the FMV of the restricted stock and its basis (approximately $143,000 for each Petitioner).
The IRS was unsuccessful, however, in its attempt to use the economic substance doctrine to recast or unwind three other transactions the Petitioners engaged in. The Tax Court rejected the IRS’s challenge of Petitioners’ Section 351 transactions where the Petitioners contributed various assets to a newly formed S corporation. In addition, the Tax Court rejected the IRS’s challenge of UMLIC’s sale of its assets to Holdings using the economic substance doctrine.
Finally, the IRS challenged the economic substance of the formation and operation of the ESOP “because it was a mere ‘accommodation party’ that enabled [P]etitioners to defer receipt of income from [UMLIC].” The Tax Court found that the ESOP, which was properly formed and operated under the laws at the time, provided meaningful benefits to the employees, and therefore did not lack economic substance (the ESOP at issue pre-dated the adoption of Section 409(p)). Quoting the Sixth Circuit Court of Appeals in the recently decided Summa Holdings, Inc. v. Commissioner
, 848 F3d 779 (6th Cir. 2017), the Tax Court said “[t]he Commissioner cannot fault taxpayers for making the most of the tax-minimizing opportunities Congress created.” The decision in Summa Holdings
stands for the proposition that judicially created doctrines cannot be used to change the plain meaning of the Internal Revenue Code.
It is notable that the Tax Court in Austin
cited favorably Summa Holdings
– a case that appears to limit the government’s ability to recast a taxpayer’s chosen form – in light of the fact that the Fourth Circuit, rather than the Sixth Circuit, would be the appellate court to review Austin
and the fact that the Sixth Circuit had overruled the Tax Court in Summa Holdings
. Practitioners have questioned whether Summa Holdings
would have far-reaching implications and be cited by other courts. It is still unclear, however, what impact Summa Holdings
will have on other cases and whether courts will be hesitant to recast transactions when challenged by the IRS.
Partner, Washington National Tax Office
T +1 202 521 1502
Managing Director, Washington National Tax Office
T +1 202 861 4116
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