New developments: S corps, restricted stock, ESOPs and 'portability'.

• Author: Josephs, Stuart R.
• Position: FedTax

In 1998 two ececutives formed an S corp. and each received 47,500 shares of its common stock. The S corp simultaneously issued 5,000 shares to its employee stock ownership plan (ESOP), of which these executives were among the beneficiaries. The executives concurrently signed a restricted stock agreeiment and an employment agreement, which were explicitly linked to each other.

The S corp stock would lose more than hall its value if the executives were terminated " for cause." Under Regs. Sec. 1.83-3(c)(2), "...requirements that the property be returned to the employee is discharged for cause or for committing a crime will [not] be considered to result in a substantial risk of forfeiture..."

However, in Austin el al v. Commissioncr,141 TC No. 18. 12/16/13. The Tax Court held that this stock was restricted for purposes of this regulation since it was subject to a substantial risk of forfeiture (SRF).

The meaning of "for cause" as used by the executives in their agreements was broader than that used in the regulation. It included what is commonly referred to as unsatisfactriry job performance, which is not a remote category of event that is unlikely to occur--in contrast in criminal activity. Therefor, since this stock was subject to an SRF, it was not vested.

[Regs. Sec. 1 .1361- 1(b)(3) provides that, for purposes of Subchapter S. stock issued in connection with the perfermance of services--and that is substantially nonvested--is not treated as outstanding stock of the corporation and the holder of thai stock is not treated as a sharcliolder. solely by rcason of holding such stock (unless the holder makes an IRC Sec. 83(b) clection).

Consequently, all of the S corp's income was allocated to the taxation under Sec. 501(a).

Sec. 1361(c)(6) allows qualified retirement plans. such as an ESOP, to be an S corp shareholder. Under Sec. 512(e)(1), if an organization described in S. 1361(c)(6) holes S corp stock, such interest shall be treated as an interest in an unrelated trade or business and all items of income, loss or deduction taken into account under Sec. 1366(a) shall he taken into account in computing the organization's unrelated business taxable income.

But. Sec. 512(c)(3) provides that Sec. 512(e)(1), does not apply to employer securities hold by an ESOP described in Sec. 4975(e)(7). Thus. none of the S corp's income would be subjected to federal income tax.

Caution

The court denied the IRS' motion for partial summary, judgment, which was...