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.
To be sure, in this situation, Fletcher agreed by contract that 75 percent of the consideration would be held in a restricted account for up to five years. But her willingness to accept restrictions, in the court’s view, does not eliminate constructive receipt in 2000.
Here, Fletcher and the other consulting partners stood to receive the entire market gain, and bear all loss, from the moment the transaction closed in 2000. This shows that the stock was in her “constructive possession” in 2000.
The court noted that if Capgemini had doled out the stock in installments (say 50 percent in 2000 and 50 percent if the partner remained on the payroll in 2005) only 50 percent would be taxable in 2000. However, 100 percent of the stock was transferred to Merrill Lynch in 2000, and Merrill was to hold the stock until certain conditions had been satisfied. In light of the fact that the partners received the entire economic gain and loss from changes in the price of the securities from 2000 forward, the transaction “looks more like income in 2000 rather than like a stream of payments over time,” the court concluded.
Further, the judge noted that several courts have held that when stock is transferred under a sales agreement, and held in escrow to guarantee a party’s performance under the agreement, the party receives the stock when it is placed in escrow rather than when it is released. What’s more, the court asserted that the escrow-related principle applies to the Fletcher case.
Finally, the court observed that the more likely it is that the conditions (imposed on one’s unfettered receipt of stock) will be satisfied and the restrictions lifted, the more sensible it is to treat all of the stock as constructively received when it is deposited in the account. In the instant case, Fletcher’s acknowledgement that the risk of forfeiture of the stock was “small” shows that the conditions of constructive receipt in 2000 had been satisfied. Accordingly, Fletcher was taxable in 2000 with respect to all of the stock transferred by Capgemini, including the shares that were diverted to the restricted accounts maintained by Merrill Lynch.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com