Illegal tax shelter seller finds no shelter in stock forfeiture provision

By James A. Beavers, CPA, CGMA, J.D., LL.M.

A taxpayer's stock in an S corporation was not subject to a substantial risk of forfeiture due to a forfeiture provision in a restricted stock agreement because it was unlikely the forfeiture provision would ever be enforced.

Background

John M. Larson, a CPA and a senior manager at a large accounting firm, and John Pfaff, a CPA and partner with the same firm, left their firm in 1997 and formed Presidio Advisors LLC. Another employee of the accounting firm, Kerry Bratton, joined them. David Makov, a stockbroker, also joined these three at Presidio Advisors a short time later.

On Aug. 10, 1999, Larson incorporated Morley, an S corporation for federal income tax purposes during the years relevant to this case. On the same day, Larson, Pfaff, and Makov, through Morley, formed Presidio Advisory Services LLC (Presidio). They also later formed Presidio Growth LLC (Presidio Growth). Through Presidio and Presidio Growth, the three men began to market a tax shelter using the bond linked issue premium structure (BLIPS) strategy.

In a BLIPS tax shelter, investors would buy an interest in a strategic investment fund set up and partially owned by an entity of the shelter promoter (here Presidio Growth) and make a premium loan consisting of a principal amount and a substantial additional premium with an above-market interest rate. The promoter would use the loan proceeds to place a short position, speculating that certain foreign currencies would lose value.

The investor in the BLIPS investment would treat the obligation to repay the premium portion of the loan as contingent and not as a liability for outside basis purposes. This ostensibly would allow the investor to claim a highly inflated basis in assets distributed to the investor from the strategic investment fund, which was created as part of each BLIPS investment, and claim large losses on the sale of those assets. Larson, Pfaff, and Makov sold over 100 BLIPS investments in 1999 and 2000.

On Aug. 10, 1999, Morley formed an employee stock ownership plan (ESOP) and a related trust for its employees, with Larson, Pfaff, Makov, and Bratton as trustees. The IRS recognized the ESOP in May 2000. Larson, as president of Presidio, adopted the Morley ESOP on behalf of Presidio as a "participating employer." As of Dec. 31, 1999, and Dec. 31, 2000, there were nine participating employees vested in the Morley ESOP, including Larson, Pfaff, and Makov. Except for these three, the participants were employed by Presidio, not Morley.

When Morley was formed, Larson, Pfaff, and Makov each signed an employment agreement with Morley that included a section titled "restricted stock agreement." This section stated that each man's respective grantor trust would receive shares of common stock of Morley and ownership of that stock would be governed by restricted stock agreements.

Each restricted stock agreement provided that the shareholder of Morley stock could not assign, transfer, mortgage, pledge, encumber, hypothecate, or otherwise dispose of any of the Morley shares without consent of 100% of the Morley shareholders. If the employee shareholder was terminated with or without cause before Aug. 10, 2002, he was deemed to have offered to sell all of his shares of Morley stock. The shareholders could end the agreement by written consent to termination by 100% of the shareholders of outstanding voting common stock. If Morley received a written notice of consent to termination, it was required to promptly deliver copies of the written notice to all its shareholders.

The alleged purpose of the agreements was to retain Makov, who had a history of job-hopping. Makov did not want to be singled out in this respect, so Larson and Pfaff also signed agreements. However, Larson was aware that if the stock forfeiture provisions in the restricted stock agreements were respected, he, Pfaff, and Makov would be able to defer receiving the income that would otherwise be passed through to them by Morley.

The good times for Presidio, unfortunately, did not last long. In Notice 2000-44, the IRS advised that purported losses from tax shelters such as BLIPS were not bona fide and did not reflect actual economic consequences and that penalties might be imposed on the promoters of these transactions. After that, Larson, Pfaff, and Makov ceased selling BLIPS transactions, wrapped up existing deals, and began laying off employees.

As a result of the notice, Makov's work for Presidio slowed to such an extent that Larson believed there was no reason to provide an incentive for Makov to stay. On Jan. 2, 2001, Larson, Pfaff, and Makov released the forfeiture restrictions on their shares of Morley stock. They did not release the restrictions as trustees of the Morley ESOP, nor did they resign their positions as trustees of the Morley ESOP before terminating their stock restrictions.

The provisions regarding the written consent to the termination of the Morley stock forfeiture restrictions in the restricted stock agreements were not followed. Presidio employees were unaware that Larson had released the stock forfeiture restrictions, and they did not vote to release those restrictions. Larson did not retain outside counsel for the ESOP to protect its interest. At trial, Larson testified that he did not know he had fiduciary obligations as an ESOP trustee to the Morley ESOP and its participants and he was unaware that fiduciaries should not engage in self-dealing.

On its Forms 1120-S, U.S. Income Tax Return for an S Corporation, for the 1999, 2000, and 2001 tax years, Morley reported income and expenses of Presidio because it was a disregarded entity. Morley's income consisted of BLIPS fees paid to Presidio, and its expenses included the salary expenses of the six Presidio employees.

The returns for 1999 and 2000 reported that the Morley ESOP owned 100% of Morley and that all Morley income for the 1999 and 2000 tax years was allocated to the Morley ESOP. Morley took the position that although Larson, Pfaff, and Makov held 95% of the shares of Morley, the Morley ESOP was properly treated as the sole owner of Morley under Regs. Sec. 1.1361-1(b)(3), which provides that "stock that is issued in connection with the performance of services ... and that is substantially nonvested ... is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock." Because the stock of Larson, Pfaff, and Makov was subject to a substantial risk of forfeiture, it was nonvested and therefore should not be treated as outstanding stock of Morley. This left the Morley ESOP as Morley's sole shareholder.

Larson also took this position on his individual tax returns for 1999 and 2000. He did not report any pro rata share of Morley's 1999 or 2000 passthrough income on his income tax returns. The IRS, however, did not agree that Larson was not taxable on any of Morley's earnings.

After examining Larson's returns for 1999 through 2001, the IRS issued a notice of deficiency to Larson for those years. In it, the IRS determined that Larson was required to include his distributive share of Morley's income in his gross income and that he had deficiencies of $6.9 million for 1999, $2.4 million for 2000, and $1.3 million for 2001.

Larson challenged the IRS determinations in Tax Court, where he argued that the Morley stock he was issued was subject to a substantial risk of forfeiture under Sec. 83 because of the employment-related forfeiture restrictions in the restricted stock agreement. Therefore, the stock did not vest until those restrictions were cleared on Jan. 2, 2001. The IRS countered that Larson's Morley stock was vested when he received it because the forfeiture conditions in the restricted stock agreement were unlikely to be enforced. Alternatively, it argued that the restrictions lacked economic substance because there was no nontax business purpose for the restricted stock agreements or the employment agreements that Larson, Pfaff, and Makov entered into.

The Tax Court's decision

The Tax Court held that Larson's Morley stock was not subject to a substantial risk of forfeiture because, based on the facts and circumstances, the forfeiture conditions were unlikely to be enforced.

In situations where restricted property is transferred to an employee "who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation," Regs. Sec. 1.83-3(c)(3) provides several factors that should be considered in determining whether stock restrictions will be enforced. According to the Tax Court, the regulation emphasizes that both the stock ownership percentages of the shareholders and their de facto power to control the corporation are important in the analysis.

While Larson, Pfaff, and Makov did not individually own enough stock to control the corporation, the court found ample evidence that the three men did have control over Morley. The three men had formed Morley and promoted its BLIPS business together. Further, Larson had testified that they intended to act "as one, unanimously" when lifting the restrictions, and, when the restrictions ceased to be beneficial, they terminated the restrictions. The court concluded that Larson's relationship to the officers and directors of the corporation and their actions revealed an effort to collectively avoid enforcement of the restrictions.

Moreover, the court observed that the restricted stock agreement required that a removal or waiver of the forfeiture restrictions required the consent of 100% of Morley's shareholders. Because the Morley ESOP owned 5% of the Morley shares, its consent was required to lift the forfeiture restrictions. However, Larson did not make Morley obtain the ESOP's consent. In the court's view, this also showed that Larson, Pfaff, and Makov had complete control over Morley.

The Tax Court additionally found that another indicator that the three men had complete control of Morley was that the record in the case did not show a pattern of open and fair dealing with the Morley ESOP participants. According to the court, the Morley ESOP participants were woefully ill-informed of their rights and seemed oblivious to the existence of stock forfeiture restrictions, and thus it was unsurprising that they were unaware that Larson had released the restrictions or that they had the right to vote on such a release. The Morley ESOP participants would have had a strong economic incentive to enforce the forfeiture clauses, but Larson did not give them the opportunity to have them enforced.

The court further found that Larson's handling of his fiduciary duties to the plan were a "grotesque conflict of interest" in his dealing with the ESOP. Actions that the court cited as giving rise to a conflict of interest included Larson's failing to resign as a Morley ESOP trustee before voting on the stock forfeiture restrictions and his failing to retain outside counsel to protect the ESOP's interest in the vote to lift the stock forfeiture restrictions.

Taken together, the court concluded that evidence of Larson, Pfaff, and Makov's control over Morley, and Larson's clear conflict of interest in his dealings with the Morley ESOP proved that the stock forfeiture provisions in the restricted stock agreement would not be enforced. Therefore, the Morley stock that Larson held was not subject to a substantial risk of forfeiture.

Reflections

Larson and Pfaff also were charged criminally for their BLIPS activities and, in December 2008, they were convicted of 12 counts of tax evasion. In April 2009, Larson was given a mandatory sentence of 10 years and one month in prison, three years of supervised release, and a fine.

Larson, T.C. Memo. 2022-03

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