Earnout restriction causes substantial risk of forfeiture.

• Author: Beavers, James A.

The Tax Court held that sections of a restricted stock agreement and an employment agreement read together constituted an earnout restriction that might create a substantial risk of forfeiture for stock transferred to an employee.

Background

Larry Austin and Arthur Kechijian (the taxpayers) worked together for more than 15 years in the "distressed debt loan portfolio business." Before 1998. they were the original shareholders and members of a group of related companies called the UMLIC Entities. In December 1998, they formed, and elected subchapter S status for, UMLIC! Consolidated Inc., a North Carolina corporation (UMLIC! S Corp.). In a Sec. 351 transaction, each 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 the taxpayers. Thus, as of Dec. 7, 1998, the taxpayers each owned 47.5% of UMLIC S Corp., and the ESOP owned 5%.

At the same time, as part of the Sec. 351 exchange, each taxpayer executed with UMLIC! S Corp. a restricted stock agreement (RSA) and an employment agreement. The stated purpose of the agreements was to induce the taxpayers to exchange their UMLIC interests for UMLIC! S Corp. stock and to require them to work for the company for a certain amount of time to obtain full rights to the stock. Under the initial term of the employment agreement, which lasted until Jan. I, 2004, each taxpayer was required to devote all his efforts to his duties and responsibilities as an officer of the company. The agreement provided that UMLIC S Corp. could terminate the taxpayers' employment at any time for cause. In Section 7 of the employment agreement, cause was defined to include:

A: Dishonesty, fraud, embezzlement, alcohol or substance abuse, gross negligence or other similar conduct. ... 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 IS days written notice to Employee, to cure by complying with the reasonable policies, standards and regulations applicable to employees [of the company]. Section 4 of the RSA governed the consequences of the voluntary or involuntary termination of the...