Taxpayer Not Allowed to Defer Income on Sale of Partnership Interest

A partner in a consulting partnership who received restricted stock in the sale of her interest in the partnership to a corporation and agreed by contract to report the full value of the stock in income in the year the stock was transferred could not defer including part of the value of the stock in income until the year the restrictions on the stock were lifted.

Background

In 2000, the public accounting firm Ernst & Young sold its information-technology consulting group to a French corporation, Cap Gemini. In exchange for their partnership interests in Ernst & Young, the consulting partners in the group (the expartners) received shares in Cap Gemini. The ex-partners agreed to take the shares of Cap Gemini stock subject to restrictions that lasted for almost five years in order to ensure their loyalty to Cap Gemini. Under these restrictions, if an ex-partner quit, was fired for cause, or went into competition with Cap Gemini, some or all of the shares the ex-partner received could be forfeited.

Ernst & Young, Cap Gemini, and the consulting partners agreed by contract to report the transaction as a partnershipfor- shares swap in 2000, fully taxable in that year. This agreement, which the IRS accepted, ensured consistent tax treatment of all the parties. Approximately 25% of the shares were sold in 2000 to generate cash that was distributed to the partners to pay their taxes on the transaction. Merrill Lynch held the remainder of the shares in separate accounts for each ex-partner subject to instructions from Cap Gemini until the restrictions lapsed.

Cynthia Fletcher, one of the ex-partners, voted for the transaction, signed the contract, and went to work for Cap Gemini. She and her husband reported the value of all the shares she received in the transaction as income in 2000, as required by the contract. Fletcher quit cap Gemini in 2003. Although she left before the five years required by the contract to avoid forfeiture of her Cap Gemini shares, the company waived its rights and directed Merrill Lynch to lift all restrictions on the stock in her account. At this point, the price of the stock had fallen dramatically, which in hindsight made Fletcher’s agreement to be subject to tax on the transfer of all the shares in 2000 a very costly decision.

To avoid the results of this decision, in 2003 Fletcher filed an amended tax return for 2000, taking the position that only the value of the shares that were sold in 2000 was includible in income in 2000. She claimed that the value of the rest of the shares that Cap Gemini deposited with Merrill Lynch should not be included in income until the restrictions on the shares were lifted in 2003. Because the value of the shares when the restrictions were lifted was much lower than in 2000, Fletcher’s overall tax on the transfer of the shares would be much lower under this scenario. Without bothering to determine if Fletcher was entitled to the refund she claimed on the amended return, the IRS issued her the refund. Subsequently, the Service sued Fletcher to force her to return the refund.

The Parties’ Arguments

The IRS argued (citing Danielson, 378 F.2d 771 (3d Cir. 1967)) that a taxpayer could not avoid the tax consequences of a contract except in cases of fraud, duress, or undue influence. According to the Service, having agreed to the form of the transaction with the goal of minimizing taxes, Fletcher and the other ex-partners must adhere to it even though market movements had later made it disadvantageous.

Fletcher argued that, as several circuit courts have held, a taxpayer is allowed to disregard the form of a transaction where the taxpayer can show “strong proof” that the economic reality of the transaction was different than what was set out in the agreement. She also contended, in response to the IRS’s assertion of the Danielson standard, that she did not “really” agree to the structure that Ernst & Young and Cap Gemini (and most of her partners) wanted in 2000. She stated that she signed the transaction agreement under undue influence or duress because if she had voted no and refused to sign, she would have been excluded from the economic benefits of the sale and might have been fired.

The District Court’s Decision

The district court held that Fletcher should include the value of all the shares transferred in the sale of her partnership interest in income in 2000 (Fletcher, No. 06 C 6056 (N.D. Ill. 1/15/08)). According to the court, the intent of the contract itself was ambiguous because, while it provided for reporting the gain on the transaction in 2000, it also provided that a portion of the stock would be held in escrow until later years, indicating that the parties did not actually intend that the entire gain be taxable in 2000. However, the court found that whether it applied the Danielson standard or the strong proof standard, Fletcher must include the value of all the shares in income in 2000 because there was no proof in the record outside the contract that the parties to the transaction intended that the ex-partners were to treat the income as being received over time rather than in the year of the transaction.

The court also rejected Fletcher’s arguments that she had been forced to sign the agreement under undue influence or duress, finding that it was unclear that the concept of undue influence even applied in a contract case and, in any event, Fletcher had failed to prove that she had signed the contract under undue influence or duress.

The Seventh Circuit’s Decision

The Seventh Circuit affirmed the district court. It found that while the transaction agreement may have been extremely complex and the decision to sign it may have been difficult, Fletcher’s arguments were frivolous and that the only thing that mattered was “the tax consequences of the contracts she signed.”

The court focused on the doctrine of constructive receipt, holding that Fletcher must include the value of all the stock received in the sale in income in 2000 because she constructively received the stock in that year. The court pointed to three facts that indicated constructive receipt in 2000: (1) Fletcher, not Cap Gemini, bore all gain and loss on the shares from the moment of the transaction in 2000; (2) Fletcher had the authority to direct the disposition of the stock and did so by signing the contract that restricted her access to part of the stock; and (3) the value of the stock was discounted from fair market value in the contract to take account of the restrictions.

With respect to the forfeiture contingencies in the contract, the court held that they did not disturb its finding of constructive receipt because a forfeiture was not likely to occur. The court stated that a finding of constructive receipt was appropriate if it was highly likely that Fletcher would meet the conditions and the chance that she would forfeit her stock was remote. Because the contingencies were in Fletcher’s control, she had agreed to only a small (5%) valuation discount on the stock, and she had acknowledged in testimony that the risk of forfeiture was small, the court found that the risk of forfeiture was small enough that the forfeiture contingencies did not prevent the conditions of constructive receipt from being satisfied in 2000.

Reflections

The Cap Gemini transaction has already generated several judicial decisions (see, e.g., Culp, No. 3:05-cv-0522 (M.D. Tenn. 12/29/06); Bergbauer, No. RDB-05- 2132 (D. Md. 8/18/08); and Berry, No. 06-CV-211-JD (D.N.H. 10/2/08)), and reportedly “scores” of other cases have been filed but not yet decided (Willens, “Taxation Without Receipt?” BNA Daily Tax Report J-1 (February 12, 2008)).

This case illustrates a lesson that many taxpayers learned the hard way in the early 2000s: The IRS and the courts will generally not ignore or rewrite tax law to aid taxpayers who are the victims of their own poor financial or tax decisions. Therefore, when advising a client on any transaction that is motivated in whole or in part by tax considerations, it is critical that a practitioner clearly inform the client of any potential downsides to the transaction, whether these downsides are or should be obvious (for example, that a fall in stock prices may eliminate the tax benefits of a transaction or make it impossible for a taxpayer to raise the money needed to pay the tax caused by the transaction) and whether the chance of these downsides occurring seemed remote at the time of the transaction. Thoroughly discussing the worst-case scenario for a transaction may save a client from making a decision he or she later regrets and may also prevent the client from claiming that the practitioner gave incomplete or inadequate advice if the results of the transaction are not favorable.

Fletcher, No. 08-2173 (7th Cir. 4/10/09)