Analysis of and reflections on recent cases and rulings.

Date01 April 2022
AuthorBeavers, James A.

Gross Income

Illegal tax shelter seller finds no shelter in stock forfeiture provision

A taxpayer's stock in an S corporation was not subject to a substantial risk of forfeiture due to a forfeiture provision in a restricted stock agreement because it was unlikely the forfeiture provision would ever be enforced.

Background

John M. Larson, a CPA and a senior manager at a large accounting firm, and John Pfaff, a CPA and partner with the same firm, left their firm in 1997 and formed Presidio Advisors LLC. Another employee of the accounting firm, Kerry Bratton, joined them. David Makov, a stockbroker, also joined these three at Presidio Advisors a short time later.

On Aug. 10, 1999, Larson incorporated Morley, an S corporation for federal income tax purposes during the years relevant to this case. On the same day, Larson, Pfaff, and Makov, through Morley, formed Presidio Advisory Services LLC (Presidio). They also later formed Presidio Growth LLC (Presidio Growth). Through Presidio and Presidio Growth, the three men began to market a tax shelter using the bond linked issue premium structure (BLIPS) strategy.

In a BLIPS tax shelter, investors would buy an interest in a strategic investment fund set up and partially owned by an entity of the shelter promoter (here Presidio Growth) and make a premium loan consisting of a principal amount and a substantial additional premium with an above-market interest rate. The promoter would use the loan proceeds to place a short position, speculating that certain foreign currencies would lose value.

The investor in the BLIPS investment would treat the obligation to repay the premium portion of the loan as contingent and not as a liability for outside basis purposes. This ostensibly would allow the investor to claim a highly inflated basis in assets distributed to the investor from the strategic investment fund, which was created as part of each BLIPS investment, and claim large losses on the sale of those assets. Larson, Pfaff, and Makov sold over 100 BLIPS investments in 1999 and 2000.

On Aug. 10, 1999, Morley formed an employee stock ownership plan (ESOP) and a related trust for its employees, with Larson, Pfaff, Makov, and Bratton as trustees. The IRS recognized the ESOP in May 2000. Larson, as president of Presidio, adopted the Morley ESOP on behalf of Presidio as a "participating employer." As of Dec. 31, 1999, and Dec. 31, 2000, there were nine participating employees vested in the Morley ESOP, including Larson, Pfaff, and Makov. Except for these three, the participants were employed by Presidio, not Morley.

When Morley was formed, Larson, Pfaff, and Makov each signed an employment agreement with Morley that included a section titled "restricted stock agreement." This section stated that each man's respective grantor trust would receive shares of common stock of Morley and ownership of that stock would be governed by restricted stock agreements.

Each restricted stock agreement provided that the shareholder of Morley stock could not assign, transfer, mortgage, pledge, encumber, hypothecate, or otherwise dispose of any of the Morley shares without consent of 100% of the Morley shareholders. If the employee shareholder was terminated with or without cause before Aug. 10, 2002, he was deemed to have offered to sell all of his shares of Morley stock. The shareholders could end the agreement by written consent to termination by 100% of the shareholders of outstanding voting common stock. If Morley received a written notice of consent to termination, it was required to promptly deliver copies of the written notice to all its shareholders.

The alleged purpose of the agreements was to retain Makov, who had a history of job-hopping. Makov did not want to be singled out in this respect, so Larson and Pfaff also signed agreements. However, Larson was aware that if the stock forfeiture provisions in the restricted stock agreements were respected, he, Pfaff, and Makov would be able to defer receiving the income that would otherwise be passed through to them by Morley.

The good times for Presidio, unfortunately, did not last long. In Notice 2000-44, the IRS advised that purported losses from tax shelters such as BLIPS were not bona fide and did not reflect actual economic consequences and that penalties might be imposed on the promoters of these transactions. After that, Larson, Pfaff, and Makov ceased selling BLIPS transactions, wrapped up existing deals, and began laying off employees.

As a result of the notice, Makov's work for Presidio slowed to such an extent that Larson believed there was no reason to provide an incentive for Makov to stay. On Jan. 2, 2001, Larson, Pfaff, and Makov released the forfeiture restrictions on their shares of Morley stock. They did not release the restrictions as trustees of the Morley ESOP, nor did they resign their positions as trustees of the Morley ESOP before terminating their stock restrictions.

The provisions regarding the written consent to the termination of the Morley stock forfeiture restrictions in the restricted stock agreements were not followed. Presidio employees were unaware that Larson had released the stock forfeiture restrictions, and they did not vote to release those restrictions. Larson did not retain outside counsel for the ESOP to protect its interest. At trial, Larson testified that he did not know he had fiduciary obligations as an ESOP trustee to the Morley ESOP and its...

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