QinetiQ U.S. Holdings, Inc. v. Commissioner
This text of 2015 T.C. Memo. 123 (QinetiQ U.S. Holdings, Inc. v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
Decision will be entered for respondent.
GOEKE,
*125 The issue presented for our decision is whether petitioner is entitled to a deduction,*134 pursuant to
Petitioner timely filed a petition with this Court for redetermination of the deficiency for TYE March 31, 2009. The parties simultaneously filed a Joint Submission of Case Without Trial pursuant to
On March 13, 2002, Hume incorporated Thomas G. Hume, Inc. (TGH), under the laws of the Commonwealth of Virginia to provide Government *126 contracting services. Hume and Karyn Hume, Hume's wife, served as the initial directors of TGH.
At the time of incorporation, TGH was authorized to issue 5,000 shares of common stock with a par value of 10 cents*135 per share. Although authorized to do so, TGH did not issue certificates for shares of stock nor offer to sell or issue shares of stock at the time of its incorporation. On March 26, 2002, on Form 2553, Election by a Small Business Corporation, Hume elected for TGH to be treated as an S corporation under
In November 2002 Hume and Chin engaged in discussions regarding Chin's joining the business enterprise. The law firm that represented Hume sent him a memorandum on November 27, 2002, listing certain action items, including: amending the name of the corporation, amending the articles of incorporation, and authorizing new shares of stock. On December 6, 2002, Hume and Karyn Hume, as directors of TGH, filed articles of amendment with the Commonwealth of Virginia changing the name of TGH to DTRI. The articles of amendment also authorized an increase in the common stock of DTRI from 5,000 to 20,000 shares and divided the shares into two classes: 15,000 shares of class A voting and 5,000 *127 shares of class B nonvoting stock.5 On December 7, 2002, Karyn Hume*136 resigned from DTRI's board of directors, leaving Hume as the sole director. Hume was also employed as the president and chief executive officer of DTRI while Chin was employed as its executive vice president and chief operating officer.
On December 9, 2002, DTRI deposited $1,000 into a bank account at Cardinal Bank, N.A. Hume provided $450 as par value consideration for 4,500 shares of DTRI class A common voting stock.
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Decision will be entered for respondent.
GOEKE,
*125 The issue presented for our decision is whether petitioner is entitled to a deduction,*134 pursuant to
Petitioner timely filed a petition with this Court for redetermination of the deficiency for TYE March 31, 2009. The parties simultaneously filed a Joint Submission of Case Without Trial pursuant to
On March 13, 2002, Hume incorporated Thomas G. Hume, Inc. (TGH), under the laws of the Commonwealth of Virginia to provide Government *126 contracting services. Hume and Karyn Hume, Hume's wife, served as the initial directors of TGH.
At the time of incorporation, TGH was authorized to issue 5,000 shares of common stock with a par value of 10 cents*135 per share. Although authorized to do so, TGH did not issue certificates for shares of stock nor offer to sell or issue shares of stock at the time of its incorporation. On March 26, 2002, on Form 2553, Election by a Small Business Corporation, Hume elected for TGH to be treated as an S corporation under
In November 2002 Hume and Chin engaged in discussions regarding Chin's joining the business enterprise. The law firm that represented Hume sent him a memorandum on November 27, 2002, listing certain action items, including: amending the name of the corporation, amending the articles of incorporation, and authorizing new shares of stock. On December 6, 2002, Hume and Karyn Hume, as directors of TGH, filed articles of amendment with the Commonwealth of Virginia changing the name of TGH to DTRI. The articles of amendment also authorized an increase in the common stock of DTRI from 5,000 to 20,000 shares and divided the shares into two classes: 15,000 shares of class A voting and 5,000 *127 shares of class B nonvoting stock.5 On December 7, 2002, Karyn Hume*136 resigned from DTRI's board of directors, leaving Hume as the sole director. Hume was also employed as the president and chief executive officer of DTRI while Chin was employed as its executive vice president and chief operating officer.
On December 9, 2002, DTRI deposited $1,000 into a bank account at Cardinal Bank, N.A. Hume provided $450 as par value consideration for 4,500 shares of DTRI class A common voting stock. Chin provided $450 as par value consideration for 4,455 shares of DTRI class A common voting stock and 45 shares of DTRI class B common nonvoting stock.
On December 12, 2002, Hume, in his capacity as director of DTRI, executed a "Consent in Lieu of the Organizational Meeting of the Board of Directors of DTRI" (consent), which stated that the board wished to offer for sale and issue shares of class A and class B common stock of DTRI. Attached to the consent were copies of letters signed by Hume and Chin acknowledging that they were *128 willing to subscribe to the number of shares*137 of common stock for which they had paid on December 9, 2002, and representing that the stock was purchased for "investment and not for the purpose of distribution or resale." The consent authorized DTRI to enter into both an employment agreement and a shareholders agreement with each of Hume and Chin in the future. The consent also authorized DTRI to enter into an employment agreement and a restrictive stock agreement with each of Thomas E. Bove, Richard L. White, and Gordon G. Hastings at a later date. The consent did not specify a time for entering into either an employment agreement or a shareholders agreement. Nor did the consent contain any provisions regarding forfeiture of the previously issued stock in the event that either Hume or Chin failed to enter into either an employment agreement or a shareholders agreement.
Hume and Chin each entered into a shareholders agreement with DTRI on December 18, 2002. The shareholders agreement stated that "the Corporation has nine thousand (9,000) shares of common stock issued and outstanding." The shareholders agreement also stated that "Hume and Chin each own the number of shares of common stock of the Corporation,*138 all stock being fully paid and non-assessable, as is set out beside their names". The shareholders agreement defined *129 "stock" as "all of the interest of each of the Shareholders in all of the issued and outstanding common stock of the Corporation." The shareholders agreement contained provisions with respect to Hume's and Chin's ability to voluntarily transfer the class A and class B shares of stock either as gifts or for value with prior notice and consent of DTRI and the other shareholders.
The shareholders agreement stated that Hume and Chin believe that it is in their mutual best interest to make provisions for the future disposition of all of the shares of common stock of the Corporation to the end that continuity of harmonious management is assured, and a fair process is established by which said shares of common stock may be transferred, conveyed, assigned or sold. 7.1 Voluntary Termination of Employment without Competition: In the event that a Shareholder voluntarily terminates his employment and does not engage in Competition, then the Agreement Price shall *130 be determined by reducing the Agreement Value by five percent (5%) for every full year of service by the Terminating Shareholder as an employee of the Corporation less than twenty (20) years. For example, if the Terminating Shareholder voluntarily terminates his employment after seventeen full years of service and does not engage in Competition, the Agreement Price will be eighty five percent (85%) [100% minus 15%] of the Agreement Value. 7.2 Voluntary Termination of Employment with Competition; Termination of Employment With Cause By the Corporation: In the event that a Shareholder voluntarily terminates his employment and engages in Competition or is terminated by the Corporation for cause, the Agreement Price shall be*140 (i) The Agreement Price calculated as set forth in paragraph 7.1; or (ii) twenty five percent (25%) of the Agreement Value, whichever is less. 7.3 Disability; Termination of Employment Without Cause By the Corporation: In the event of the Disability of a Shareholder or the termination of the employment of a Shareholder by the Corporation without cause, the Agreement price shall be one hundred percent (100%) the Agreement Value.
On December 18, 2002, Hume and Chin separately entered into employment agreements with DTRI. The employment agreements stated: This Agreement contains the entire understanding of the parties with respect to the subject matter hereof. All prior promises, understandings or agreements are merged herein. It may not be changed orally, but only by an agreement in writing, signed by the *131 party against whom enforcement of any waiver, change, modification or discharge is sought.
Between December 2002 and January 2004, DTRI entered into employment agreements and restrictive stock agreements with White, Hastings, Bove, Edouard Granstedt, and Wesley E. McDonald, Jr. In consideration of the covenants and undertakings of the employees as stated in their respective employment agreements, and subject to their execution of restrictive stock agreements, DTRI granted shares of Class B common stock to each employee. Each employment agreement explicitly stated the number of shares of class B common stock granted to the employee in consideration of his employment. Each of the stock*142 grants *132 vested annually over five years beginning one year after the grant date. The restrictive stock agreements set forth various terms and conditions relating to the ownership of stock, including: the requirement that shareholders give DTRI written notice of any intention to transfer the class B common stock for value; DTRI's rights of first refusal; and DTRI's right to repurchase stock at a predetermined purchase price upon the occurrence of certain triggering events.
Between December 2005 and December 2007, DTRI granted shares of restricted class B common stock to certain key employees at no cost to the employees. Each of the restricted stock grants vested annually over five years beginning one year after the grant date. The restricted stock was subject to restrictions imposed pursuant to a restrictive stock agreement between DTRI and the employee receiving the class B common stock. On December 31, 2007, DTRI granted each of Hume and Chin 275,000 shares of DTRI's class B common stock, subject to terms and restrictions set forth in restricted stock grants. Chin's restricted stock grant explicitly stated that "[t]he shares of Granted Stock acquired by you under this restricted stock grant*143 will vest so long as you remain an employee of DTRI." Chin's restricted stock grant also included the following restrictions: *133 (i) Prior to Vesting. Prior to the vesting of the Granted Stock * * * you will have no rights as a shareholder of DTRI. All shares of Granted Stock that have not yet vested shall be held by DTRI in the form of non-certificated shares until they are fully vested or, in the event that your employment terminates prior to vesting, such Granted Stock shall be cancelled on the books of DTRI. (ii) After Vesting. Subject to the provisions hereof and to the provisions of the Restrictive Stock Agreement, after vesting of the Granted Stock * * * you will have all of the rights of a stockholder of Class B stock with respect to all of the Granted Stock, including the right to receive a certificate reflecting your ownership of the shares and all dividends or other distributions with respect to such Granted Stock. In connection with the payment of such dividends or other distributions, DTRI will be entitled to deduct any taxes or other amounts required by any governmental authority to be withheld and paid over to such authority for your account. As soon as practicable after*144 the vesting of the Granted Stock * * * DTRI will release the certificate(s) representing such Granted Stock to you subject to the terms of the Restrictive Stock Agreement.
The bylaws of DTRI provided that "certificates representing shares of the corporation shall be issued to every shareholder for the fully paid shares owned by him in such form as the Board of Directors shall determine." The bylaws also provided that "[t]he shareholders may restrict the transfer of stock between themselves through written agreement." Finally, the bylaws state that shareholders cannot dispose of their shares in the corporation otherwise than by gift, bequest, or intestacy or to a trust for the benefit of the *134 shareholder, or spouse or lineal descendants, without first giving the corporation and all other shareholders written notice of their intention to make such disposition, and further providing DTRI and its shareholders with a right of first refusal.
DTRI filed Forms 1120S, U.S. Income Tax Return for an S Corporation, that allocated income and losses to Hume, Chin, and other shareholders according to DTRI stock ownership for TYE December 31, 2002 through 2006. DTRI*145 also issued yearly Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., that reported the distributable share of income and losses to DTRI shareholders, including Hume and Chin, according to their percentages of DTRI stock ownership for TYE December 31, 2002 through 2006.
Respondent did not assess Federal income tax against DTRI for TYE December 31, 2002 through 2006, because DTRI elected to be treated as a pass-through entity. However, respondent timely assessed Federal income tax against each of DTRI's shareholders individually, including Hume and Chin, for TYE December 31, 2002 through 2006. DTRI did not report the value of any portion of the stock at issue as wages for Federal employment tax purposes during TYE December 31, 2002 through 2007, and paid no employment taxes thereon.
By letter dated December 8, 2006, DTRI revoked its S corporation election effective January 1, 2007. On or about March 14, 2008, DTRI filed its Form 1120 for TYE December 31, 2007. On June 19, 2008, DTRI filed with respondent a request for a private letter ruling, seeking relief from an inadvertent termination of its S corporation status*146 under
By letter dated January 3, 2008, petitioner proposed to DTRI the terms of a nonbinding agreement for the sale of DTRI to petitioner for a purchase price in the range of $70 million to $80 million. Petitioner increased its proposal to a purchase price in the range of $85 million to $100 million, followed by an aggregate purchase price of $115 million. On August 4, 2008, petitioner, Project Black Acquisition Corp., DTRI, Hume, and Chin entered into a final agreement and plan of merger wherein petitioner paid $123 million as merger consideration. The *136 merger transaction closed on October 17, 2008, with petitioner acquiring all of the outstanding shares of DTRI.
On September 3, 2008, Hume, in his capacity as both Director and shareholder of DTRI, Chin as shareholder, and*147 Brian D. Hume as trustee for the Thomas G. Hume Irrevocable Trust as shareholder, executed a "Consent in Lieu of a Special Meeting of the Voting Shareholders of DTRI" (September 3 consent). The September 3 consent stated that certain shares of DTRI stock held by employees were subject to the shareholders agreement or restrictive stock agreements that provide for a redemption option or obligation with respect to such stock on the part of DTRI at a price that was less than the fair market value of the stock in the event that the employee's employment with DTRI terminated in certain instances. The September 3 consent also stated that the redemption option or obligation constituted a substantial risk of forfeiture within the meaning of
On October 17, 2008, Hume, as director of DTRI, executed a "Consent in Lieu of a Special Meeting of the Board of Directors of DTRI" (first October 17 consent) that stated that DTRI had entered into an agreement and plan of merger with petitioner and Project Black Acquisition Corp. for the exchange of all issued and outstanding shares of class A and class B common stock of DTRI for cash. *137 The first October 17 consent waived all of DTRI's rights with respect*148 to the stock transfer restrictions effective immediately before the closing of the transaction.
Also on October 17, 2008, all of the shareholders of class A common stock of DTRI executed a "Consent in Lieu of the Organizational Meeting of the Board of Directors of DTRI" (second October 17 consent). The second October 17 consent authorized the waiver of the class A shareholders' rights with respect to the stock transfer restrictions effective immediately before the closing of the transaction.
A third "Consent in Lieu of the Organizational Meeting of the Board of Directors of DTRI" was executed on October 17, 2008 (third October 17 consent). The third October 17 consent stated that certain employees of DTRI had been granted class B restricted common stock that remained only partially vested. It further stated that those shares were to be vested immediately before the closing of the transaction.
Hume and Chin filed Federal income tax returns for TYE December 31, 2002 through 2006, reporting allocations and distributions of profits and losses. For TYE December 31, 2008, Hume and Chin reported as ordinary income on *138 their Federal income tax returns*149 their respective shares of the $117,777,501 of wage income at issue consistent with petitioner's reported wage and compensation deduction. By letter dated January 19, 2012, Hume and Chin filed protective refund claims for the 2008 taxable year as a result of respondent's proposed disallowance of petitioner's claimed salary and wage deduction at issue. The protective refund claims assert that the $117,777,501 received by Hume and Chin was long-term capital gain rather than ordinary income from wages. The protective refund claims, if allowed, would result in overpayments of Federal income tax for Hume and Chin of $11,011,381 and $11,259,241, respectively.
The parties stipulated the following: [i]f called to testify, Hume and Chin would testify that, during the period beginning in December 2002 until the merger of DTRI with petitioner in August 2008 ("the pre-merger period"), their ownership interests in the Class A and Class B stock of DTRI subscribed to in December 2002, is consistent with representations made by DTRI, Hume and Chin of outstanding ownership in such stock on all Federal tax filings made by DTRI, Hume and Chin during the pre-merger period.
Petitioner claimed a salary*150 and wage deduction of $117,777,501 under
According to the general rule, petitioner bears the burden of proving, by a preponderance of the evidence, that respondent's determinations are incorrect.
Therefore,*152 in order for
The determination of whether the Chin stock was transferred "in connection with the performance of services" is essentially a question of fact.
(1) whether the property right is granted at the time the employee or independent*153 contractor signs his employment contract;
(2) whether the property restrictions are linked explicitly to the employee's or independent contractor's tenure with the employing company;
*142 (3) whether the consideration furnished by the employee or independent contractor in exchange for the transferred property is services; and
(4) the employer's intent in transferring the property.
Petitioner asserts that the Chin stock was transferred in connection with the performance of services because: (1) the Chin stock was granted when Chin began his employment at DTRI; (2) the Chin stock was restricted in a manner that linked the stock to Chin's continued performance of services; (3) Chin's services served as the consideration for the stock; and (4) DTRI intended to limit the transfer of stock exclusively to employees as compensation for services.
The first and second factors appear to be met. It is evident that the Chin stock was transferred near the time when DTRI entered into the shareholders agreement and the employment agreement with Chin. The consent authorizing the issuance of the shares is dated December 12, 2002. The stock certificates, shareholders agreement,*154 and employment agreements are all dated December 18, 2002. In consideration of the second factor, petitioner points to the shareholders *143 agreement and argues that the Chin stock was restricted and conditioned on Chin's continued employment with DTRI. Petitioner also contends that if Chin's employment had ended, he would have been required to relinquish the shares of DTRI at a discounted price based on the duration of his employment at DTRI. It is evident that the shareholders agreement contains terms that protect against ownership by nonemployees of DTRI. However, the question of whether those terms provide a substantial risk of forfeiture in regard to the Chin stock remains, as discussed
Whether petitioner has met the third factor is less evident. Petitioner argues that Chin's services served as the consideration furnished in exchange for the Chin stock. Petitioner believes that the $450 that Chin deposited into the bank account was a nominal amount that would correspond to the par value of the shares subsequently issued and was less than the intrinsic value of the services that he had devoted to the enterprise by that time. However, petitioner did not provide evidence*155 to support this contention. Petitioner has failed to show that Chin's $450 deposit should not be considered an entrepreneurial investment, thereby representing the true consideration for the issuance of the Chin stock.
Whether petitioner has met the fourth factor is also less evident. Petitioner had no ownership interest in DTRI until October 2008 and was not a party to *144 either the shareholders agreement or the employment agreements upon which it relies to establish intent. Neither was petitioner a party to discussions between DTRI, Hume, and Chin in 2002 in connection with the organization of DTRI and the issuance of DTRI's capital stock. Therefore, petitioner cannot speak with certainty to DTRI's intent.
However, Hume and Chin were parties to both the shareholders agreement and the employment agreements. Both Hume and Chin participated in discussions regarding the issuance of DTRI's capital stock and had personal knowledge regarding the transfer of the Chin stock. Hume, as director of DTRI, executed the consent and participated in discussions regarding both the organization of DTRI and the issuance of DTRI's capital stock. From 2002 through 2008, DTRI, Hume, and Chin made representations*156 that Chin had outright unrestricted ownership of the Chin stock.
From 2002 through 2006 DTRI also distributed income and losses to Chin as if he was the owner of the Chin stock as fully vested and outstanding stock. Chin, in turn, received his share of the profits of DTRI and reported those distributions on his individual income tax returns. DTRI, Hume, and Chin also consistently treated the Chin stock as outstanding stock of DTRI for corporate purposes as evidenced by the DTRI bylaws and other corporate documents. *145 Article 2 of DTRI's bylaws (Capital Stock) provides: The authorized number of shares, the classes, and the par value of stock of the corporation shall be established by the Articles of Incorporation and amendments thereto; that each outstanding share having voting rights shall be entitled to one vote on each matter submitted to a vote at the meeting of the shareholders; and that certificates representing shares of the corporation shall be issued to every shareholder for the fully paid shares owned by him in such form as the Board of Directors shall determine.
In all*157 other situations where DTRI transferred stock to employees in connection with the performance of services, the restrictive stock agreements specifically state that the stock grants were made "in consideration of the employment." The respective employment agreements also explicitly tie the stock grants to the performance of services. In contrast, neither the shareholders agreement nor Chin's employment agreement explicitly ties the granting of the Chin stock to the performance of services.
We acknowledge there are cases suggesting that a broad reading of the applicability of
Petitioner contends that the initial issuance of the Chin stock was subject to a substantial risk of forfeiture under
*147
Petitioner contends that the first three factors leave little doubt that Chin did not have sufficient control over DTRI to modify, cancel, or waive the restrictions on the Chin stock. Petitioner argues that the Chin stock was subject to a substantial risk of forfeiture because the shareholders agreement contains provisions that: (1) could not be waived unilaterally by Chin; (2) require Chin to sell his stock back to DTRI at a price below fair market value if he terminated employment within 20 years of execution of the shareholders agreement; and (3) *148 preclude Chin from transferring or selling his stock without first offering it to DTRI. Petitioner contends that Chin was subordinate to Hume because Hume owned 50.25% of the voting shares and served as DTRI's president, CEO, and sole director. Petitioner argues that Chin's*160 risk of forfeiture is governed by the first example in
Alternatively, respondent argues that the shareholders agreement does not contain substantial risk of forfeiture provisions for purposes of
We believe that petitioner failed to show that the Chin stock was subject to a substantial risk of forfeiture. The facts and circumstances support this position. Hume and Chin had a very close work relationship. They were DTRI's initial investors, and together they built the company from its early stages of incorporation. Along with Hume, Chin voted on all company matters and helped determine the company's overall direction. Since Chin held such a vital role within DTRI as the executive vice president, COO, and a 49.75% shareholder in voting stock, it is unlikely that Hume would have taken any actions to terminate his employment.
Additionally, the parties stipulated the following: If called to testify, Hume and Chin would testify that,*162 during the period beginning in December 2002 until the merger of DTRI with petitioner in August 2008 ("the pre-merger period"), their ownership *150 interests in the Class A and Class B stock of DTRI subscribed to in December 2002, is consistent with representations made by DTRI, Hume and Chin of outstanding ownership in such stock on all Federal tax filings made by DTRI, Hume and Chin during the pre-merger period.
*151 Chin's actions make it evident that the risk of forfeiture was not significant. Chin treated the Chin stock as if he had full ownership rights and control from the initial issuance in 2002. The Chin stock was issued subject to the shareholders agreement. From 2002 through 2006 Chin reported all allocations and distributions of profits and losses arising from his ownership of the Chin stock on his Federal income tax returns. In contrast, the subsequent issuances of class B common nonvoting stock were issued subject to restricted stock grants. These grants explicitly provide guidelines for the treatment of such stock both before and after vesting. Chin's restricted stock grant on the class B common nonvoting stock issued on December 31, 2007, specifies that [p]rior to vesting of the Granted Stock * * * you will have no rights as a shareholder of DTRI. All shares of Granted Stock that*164 have not yet vested shall be held by DTRI in the form of non-certificated shares until they are fully vested or, in the event that your employment terminates prior to vesting, such Granted Stock shall be cancelled on the books of DTRI.
*152 This Court has previously determined that "[t]he regulations make clear that an earnout restriction creates 'a substantial risk of forfeiture' if there is a sufficient likelihood that the restriction will actually be enforced."
In reaching our holding herein, we have considered all arguments the parties made, and to the extent we did not mention them above, we conclude they are moot, irrelevant, or without merit.
To reflect the foregoing,
Footnotes
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. In addition to disallowing the $117,777,501 deduction petitioner claimed for salaries and wages under
sec. 83 , the notice of deficiency determined the following: (1) petitioner is not entitled to a deduction in regard to Apogen restricted stock; (2) the deduction petitioner claimed for amortization expenses is reduced by $111,498; (3) because of other adjustments in the notice, the amount applied to M-3 undersec. 163(j) is recomputed; and (4) the amount petitioner can deduct undersec. 199 is increased by $2,007,202. Petitioner does not dispute the Apogen restricted stock adjustment or the amortization adjustment. However, petitioner disputes that it is not entitled to thesec. 163(j) applied M-3 adjustment and thesec. 199 adjustment. These issues are correlative and depend upon whether respondent's disallowance of petitioner's claimedsec. 83↩ deduction is sustained in part or in full. Therefore, these issues are not before this Court.3. Petitioner also filed protective claims to carry back a portion of net operating losses to Forms 1120, U.S. Corporation Income Tax Return, filed by DTRI for TYE December 31, 2007 and 2008. However, these claims are not before this Court.↩
4. As a result of this holding, we do not address respondent's duty of consistency affirmative defense.↩
5. The class A stock was subject to a 100-for-1 stock split effective January 15, 2004, and a 5-for-1 stock split effective December 22, 2005.↩
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2015 T.C. Memo. 123, 110 T.C.M. 17, 2015 Tax Ct. Memo LEXIS 132, Counsel Stack Legal Research, https://law.counselstack.com/opinion/qinetiq-us-holdings-inc-v-commissioner-tax-2015.