Federal Taxation - Robert Beard
| Publication year | 2012 |
Federal Taxation
by Robert Beard*
I. Introduction
In the year 2011,1 the courts addressed interesting issues in the areas of constructive receipt, taxpayer standing to pursue non-monetary damages, and lender liability for unpaid payroll taxes. This Article surveys these decisions.
II. United States v. Fort
In United States v. Fort,2 the United States Court of Appeals for the Eleventh Circuit dealt with the important issue of when assets held in escrow should be treated as income by the beneficiary of the escrow.3 Though the decision in Fort rests on questionable reasoning, courts in several circuits have reached similar decisions, so it represents a significant trend.4
Fort was one of a number of tax cases that arose from Ernst & Young's (E&Y) 2000 sale of its consulting business to Cap Gemini.5 In the sale, a number of E&Y partners involved in the consulting business exchanged their interest in E&Y for shares of Cap Gemini and began working for Cap Gemini.6 Seventy-five percent of the shares received by each partner were restricted and held in an escrow account. A
* Associate in the firm of King & Spalding, Atlanta, Georgia. Yale University (B.A., 2004); Georgetown University (J.D., 2007); University of Florida, Frederic G. Levin College of Law (L.L.M., 2011). Member, State Bar of Ohio.
1. For an analysis of federal tax cases decided during the prior survey period, see Augustus N. Makris, Federal Taxation, Eleventh Circuit Survey, 62 Mercer L. Rev. 1187 (2010).
2. 638 F.3d 1334 (11th Cir. 2011).
3. Id. at 1337.
4. See, e.g., United States v. Fletcher, 562 F.3d 839 (7th Cir. 2009).
5. Fort, 638 F.3d at 1335; see Fletcher, 562 F.3d at 840; United States v. Nackel, 686
F. Supp. 2d 1008, 1010 (C.D. Cal. 2009).
6. Fort, 638 F.3d at 1335.
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portion of the shares could be sold at specified periods, and all shares left escrow just under five years after the closing date. A portion of the shares were forfeited ifthe partner resigned or was terminated for cause or for poor performance. As a result of these restrictions, the affected shares were valued at a discount in the sale agreement.7
In disclosure documents distributed before the transaction, E&Y partners were informed that the sale would be a taxable transaction and that parties had agreed to consistently treat it as such. The taxpayer, Fort, reported gain from the transaction on this basis on his 2000 tax return.8
In 2003, the taxpayer was terminated from his position with Cap Gemini, but because the termination was not for cause or for poor performance, none of his shares were forfeited. After his termination, Fort filed an amended return for 2000, in which he took the position that the restricted receipt of the Cap Gemini shares did not give rise to income in 2000. The Internal Revenue Service (the Service) initially granted the refund but later sued to recover it.9
Two important issues were raised in Fort. The first issue was whether the taxpayer, pursuant to the rule set forth in Commissioner v. Danielson,10 was barred from attempting to recharacterize the transac-tion.11 The second was whether, on the merits, the taxpayer had income in 2000 from the Cap Gemini transaction.12
A. Commissioner v. Danielson
Substance over form is frequently an issue in tax,13 and Commissioner v. Danielson14 recognized a significant asymmetry in the doctrine.15 As noted in Danielson, the Service is free to assert that the substance of a transaction is different from its form.16 Thus, the Service can treat a putative lease as a secured loan or a sale if the facts justify. The taxpayer, on the other hand, is almost always bound by the form of a transaction.17
7. Id. at 1335-36.
8. Id. at 1336.
9. Id. at 1336-37.
10. 378 F.2d 771 (3d Cir. 1967).
11. Fort, 638 F.3d at 1337.
12. Id. at 1338.
13. See generally 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of
Income, Estates and Gifts 1 4.3.3 (3d ed. 2003 & Supp. 3 2011).
14. 378 F.2d 771 (3d Cir. 1967).
15. Id. at 774-75.
16. Id.
17. Id.
2012] FEDERAL TAXATION 1269
In Danielson, the parties to a stock sale agreed to apportion the consideration between the stock (which was a capital asset) and the shareholders' covenant not to compete (which produced ordinary income).18 However, in their returns, the shareholders took the position that none ofthe consideration was allocable to the covenants not to compete.19 The United States Court of Appeals for the Second Circuit held that the taxpayer was not permitted to challenge the form of his own transaction absent a showing of fraud, duress, or undue influ-ence.20 The court noted that permitting such challenges would severely burden tax enforcement because the Service would be unable to rely on the form of taxpayer transactions and would instead have to factually investigate every relevant transaction.21
In Fort, the government argued that the taxpayer's agreement to the transaction, described in the disclosure documents, which included an agreement that the transaction would be treated as a taxable sale, estopped the taxpayer from later asserting that the transaction was not taxable in 2000. The United States Court of Appeals for the Eleventh Circuit disagreed.22 The court held that Danielson only forbids the taxpayer from challenging the agreed form of a transaction, not its tax consequences.23 The Danielson rule did not apply because Fort accepted that the transaction was a sale; he only disputed its tax
24
consequences.
B. Constructive Receipt
The second issue in Fort was whether the taxpayer had constructive receipt of the Cap Gemini shares when they were deposited in escrow in 2000.25 A cash-method taxpayer generally recognizes income when money or property is actually or constructively received.26 The court based its decision on constructive receipt.27 Treasury Regulation section 1.451-2(a)28 provides that a taxpayer has constructive receipt of property if it is "credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time," but property
18. Id. at 772-73.
19. Id. at 773-74.
20. Id. at 778-79.
21. Id. at 775.
22. Fort, 638 F.3d at 1337.
23. Id. at 1337-38.
24. Id. at 1338.
25. Id.
26. Treas. Reg. § 1.451-1(a) (2011).
27. Fort, 638 F.3d at 1338.
28. Treas. Reg. § 1.451-2(a) (2011).
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is not constructively received if it is subject to "substantial limitations or restrictions."29
The Eleventh Circuit ruled that Fort did have constructive receipt of the escrow shares because he had sufficient control over the shares and the conditions of forfeiture were largely under his control.30 The court identified three specific factors that established Fort's control over the shares: (1) the shares were deposited in an escrow account for Fort's benefit; (2) Fort had dividend and voting rights; and (3) the shares were used as a guarantee for Fort's performance of future services.31 The court also noted the fact that only about ten percent of the E&Y partners had forfeited their shares and that avoiding termination for cause or for poor performance was largely within Fort's control.32
The Eleventh Circuit's reliance on a constructive receipt theory was misplaced. The regulations and case law provide that an item is not constructively received if there are substantial limitations on the taxpayer's ability to take possession of the item.33 Thus, to hold that Fort was in constructive receipt of the Cap Gemini shares, the court was forced to come to the implausible conclusion that performance of nearly five years of service (without termination for cause or poor performance) is not a substantial restriction. Another district court considering the same transaction made the same observation as follows:
Here, however, the restrictions involved concern matters exclusively within the ex-consulting partner's hands to control. The only person standing in the way of [the taxpayer] actually exercising dominion over the shares themselves was himself. So long as he did not engage in conduct amounting to cause to fire him, or did not quit his position at the firm, or did not breach non-disclosure provisions, the shares in the restricted escrow account were his.34
The proposition that a restriction is not substantial merely because it is within the taxpayer's capability to fulfill is unprecedented and unsupported. Indeed, performance of future services is the epitome of a substantial restriction in other contexts. For example, in determining whether property received for services is subject to a "substantial risk of forfeiture" under section 83 of the Internal Revenue Code (I.R.C.),35 the
29. Id.
30. Fort, 638 F.3d at 1340.
31. Id. at 1340-41.
32. Id. at 1341.
33. Id. at 1339.
34. Nackel, 686 F. Supp. 2d at 1021.
35. I.R.C. § 83 (2006).
2012] FEDERAL TAXATION 1271
regulations provide that a requirement to provide substantial future services is always such a risk.36
Counterintuitively, the proper approach to the case would have been to consider whether Fort had actual receipt of the shares. Though the district court rejected this theory and the Service did not dispute the finding,37 an actual receipt theory fits the facts far better than a constructive receipt analysis. The shares were titled to a brokerage account in Fort's name.38 Fort had dividend and voting rights over the shares, and he was subject to the rise and fall ofthe value ofthe shares. Fort's employment agreement stated that the shares would be forfeited as damages in certain circumstances, which indicates that he was using the...
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