Several years ago, the consulting partners of Ernst & Young received shares in Capgemini, S.A., in exchange for their partnership interests. The shares received in the transaction were restricted for almost five years: If a partner quit, was fired for cause, or went into competition with Capgemini, some or all of the shares could be forfeited.
E&Y, Capgemini and the consulting partners of E&Y agreed by contract that they would report the transaction as a partnership for shares swap in 2000, that was fully taxable in that year. Approximately 25 percent of the shares were sold in 2000; the remainder were held by Merrill Lynch until such time as the restrictions lapsed.
One of the consulting partners, Cynthia Fletcher, received 16,500 shares of Capgemini stock, and as a result Capgemini sent Fletcher a Form 1099-B reporting that she had received $2,478,655 in stock “taxable at ordinary income rates.” Fletcher later filed an amended tax return for 2000 in which she reported that only $653,756 was income for 2000, and that the rest of the income was not received until 2003, the year in which she left Capgemini’s employ. The Internal Revenue Service disagreed with Fletcher’s conception of the transaction.
The principal argument being put forth by the IRS is that Fletcher and the other consulting partners are bound by their own characterization of the transaction as one in which all shares were received in 2000. In making that determination, the IRS relies on two court cases: Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967) and Comdisco, Inc. v. United States, 756 F.2d 569 (7th Cir. 1985). In those cases, the court said that, in general, a taxpayer may not disavow the form of a deal.
In other words, taxpayers cannot look through the forms they chose themselves to improve their tax treatment with the benefit of hindsight. The District Court found for the IRS, and the Court of Appeals for the Seventh Circuit also upheld the government’s determination, but for reasons quite different from those the District Court cited. (See United States v. Fletcher, _F.3d_ (7th Cir. 2009).
The court observed that Fletcher does not want to proceed as if the deal had different terms. Instead, she argues that the deal’s actual terms have tax consequences different from those that her contracts with E&Y and Capgemini required her to report in 2000. Therefore, because Fletcher does not try to recharacterize the transaction, those doctrines (like the “Danielson rule”) that limit a taxpayer’s ability to do so “are beside the point,” noted the court.
So the issue is really is: What are the tax consequences of the parties’ chosen form? Here, Capgemini deposited all the shares into individual accounts in 2000, but the accounts were restricted — that is, the stock could be reached only as time passed.
Nevertheless, from the moment of the deposit in 2000 the consulting partners bore the economic risk. Indeed, bearing that economic risk makes the consulting partners the “beneficial owners” as of 2000, contends the IRS. By contrast, Fletcher maintains that until she could do with the stock “as she pleased” it did not count as income. In the court’s view, the IRS had the better of the argument.