                              T.C. Memo. 2015-123



                        UNITED STATES TAX COURT



       QINETIQ U.S. HOLDINGS, INC. & SUBSIDIARIES, Petitioner v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 14122-13.                        Filed July 2, 2015.



      Gerald A. Kafka and Sean M. Akins, for petitioner.

      Linda P. Azmon and Marie E. Small, for respondent.



                          MEMORANDUM OPINION


      GOEKE, Judge: Respondent determined a deficiency in QinetiQ U.S.

Holdings, Inc. & Subsidiaries’ (petitioner) Federal income tax of $13,902,087 for

the taxable year ended (TYE) March 31, 2009, due to a disallowance of a portion

of petitioner’s claimed deduction for salary and wage compensation pursuant to
                                         -2-

[*2] section 83.1 The disallowance relates to class A and class B shares of stock

issued by Dominion Technology Resources, Inc. (DTRI), to Thomas G. Hume and

Julian Chin in 2002.2 However, petitioner conceded that the portion of the

adjustment attributable to the class A shares of stock of DTRI subscribed to by

Hume was not subject to a substantial risk of forfeiture within the meaning of

section 1.83-3(c)(3), Income Tax Regs. Accordingly, petitioner disputes only the

portion of the adjustment attributable to the class A and class B shares of stock of

DTRI subscribed to by Chin in 2002 (Chin stock).3


      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 under sec. 163(j) is recomputed; and (4) the amount petitioner can
deduct under sec. 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 the sec. 163(j) applied M-3 adjustment
and the sec. 199 adjustment. These issues are correlative and depend upon
whether respondent’s disallowance of petitioner’s claimed sec. 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
                                                                        (continued...)
                                          -3-

[*3] The issue presented for our decision is whether petitioner is entitled to a

deduction, pursuant to section 83, for salary and wage compensation paid in

connection with the Chin stock for petitioner’s TYE March 31, 2009. We hold

that petitioner is not entitled to the deduction under section 83.4

                                     Background

      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 Tax Court Rule 122. Certain facts

in evidence have been stipulated and are so found. The parties’ stipulations of

facts and the accompanying exhibits are incorporated herein by this reference.

When petitioner filed the petition, its principal place of business was in Reston,

Virginia. Petitioner is engaged in the defense, aerospace, and security business.

I.    Incorporation of DTRI

      On March 13, 2002, Hume incorporated Thomas G. Hume, Inc. (TGH),

under the laws of the Commonwealth of Virginia to provide Government




      3
       (...continued)
before this Court.
      4
       As a result of this holding, we do not address respondent’s duty of
consistency affirmative defense.
                                          -4-

[*4] 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 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 section 1362(a), indicating that he was the sole

shareholder of TGH. The Internal Revenue Service approved the S corporation

election on April 6, 2002.

      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
                                        -5-

[*5] shares of class B nonvoting stock.5 On December 7, 2002, Karyn Hume

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.

II.    Consents, Agreements, and Bylaws

       A.    December 12 Consent

       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


      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.
                                         -6-

[*6] willing to subscribe to the number of shares 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.

      B.     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, all stock being fully paid and non-

assessable, as is set out beside their names”. The shareholders agreement defined
                                          -7-

[*7] “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.

Additionally, the shareholders agreement stated that “[t]he parties desire to limit

the ownership of the Stock to Shareholders who are employees of the

Corporation” and further stated that a shareholder who “terminates his

employment with the Corporation with or without cause, or whose employment

with the Corporation is terminated by the Corporation with or without cause, shall

be deemed to have offered to sell all of his Stock to the Corporation for the

Agreement price”. The “Agreement price” to be paid to a deceased or terminating

shareholder was set forth in the shareholders agreement as follows:

      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
                                         -8-

      [*8] 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 (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.

The shareholders agreement also required that any “change, alteration, or

modification” be “in writing and signed by all of the parties hereto.”

      C.     Employment Agreements and Stock Agreements

      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
                                          -9-

      [*9] party against whom enforcement of any waiver, change,
      modification or discharge is sought.

The employment agreements did not contain a provision regarding the transfer of

any stock to Hume or Chin in connection with their performance of services for

DTRI or any other entity. Also on December 18, 2002, Hume and Chin executed

the original stock certificates. The original stock certificates bore a legend that

stated: “The sale and/or transfer of this stock is restricted in accordance with the

provisions of a Shareholders Agreement dated effective the ___ day of _____,

2002, a copy of which is filed in the corporate book.” DTRI did not enter into

restrictive stock agreements with Hume or Chin relating to the ownership of the

class A and class B shares of stock transferred on December 18, 2002.

      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 grants
                                         -10-

[*10] 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 will vest so long as you remain an

employee of DTRI.” Chin’s restricted stock grant also included the following

restrictions:
                                        -11-

      [*11] (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 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.

D.    Bylaws

      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
                                        -12-

       [*12] 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.

III.   DTRI’s Federal Tax Filings

       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 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.
                                         -13-

[*13] IV.    DTRI’s Revocation of S Corporation Election

      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 under section 1362(f). On December 15, 2008, respondent

issued a private letter ruling concluding that if the erroneous failure to treat the

class B Restricted stock as outstanding stock of DTRI caused its S election to

terminate, the termination was an inadvertent termination and DTRI would be

treated as continuing to be an S corporation from March 13, 2002, through January

1, 2007.

V.    2008 Execution of the Agreement and Plan of Merger

      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
                                        -14-

[*14] 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 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

section 83.

      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.
                                        -15-

[*15] The first October 17 consent waived all of DTRI’s rights with respect 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.

VI.   Hume’s and Chin’s Federal Tax Filings

      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
                                        -16-

[*16] their Federal income tax returns 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.

                                    Discussion

      Petitioner claimed a salary and wage deduction of $117,777,501 under

section 83 partly on the argument that the Chin stock was transferred to Chin in

2002 in connection with the performance of services and did not vest until
                                         -17-

[*17] petitioner’s TYE March 31, 2009. Respondent challenged the deduction,

arguing that the Chin stock was not transferred in connection with the

performance of services under section 83 but rather was considered fully vested

and outstanding capital stock of an S corporation immediately upon issuance in

2002. Additionally, respondent argued that treatment of the Chin stock as fully

vested and outstanding capital stock of DTRI is consistent with seven years of

multiple representations of outstanding stock ownership made by DTRI, Hume,

and Chin for Federal tax and other corporate purposes. Therefore, the principal

issue we must decide is whether section 83 applies to the Chin stock so as to

entitle petitioner to the claimed deduction.

      According to the general rule, petitioner bears the burden of proving, by a

preponderance of the evidence, that respondent’s determinations are incorrect.

See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover,

deductions are a matter of legislative grace, and petitioner bears the burden of

proving entitlement to any claimed deductions. See Rule 142(a)(1); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992). We conclude on the basis of the

record that petitioner has failed to carry this burden.

      Section 83(a) governs the tax treatment of property transferred “in

connection with the performance of services” and generally provides that the value
                                         -18-

[*18] of such property is taxable “in the first taxable year in which the rights of the

person having the beneficial interest in such property are transferable or are not

subject to a substantial risk of forfeiture”. “The rights of a person in property are

subject to a substantial risk of forfeiture if such person’s rights to full enjoyment

of such property are conditioned upon the future performance of substantial

services by any individual.” Sec. 83(c)(1). “The rights of a person in property are

transferable only if the rights in such property of any transferee are not subject to a

substantial risk of forfeiture.” Sec. 83(c)(2). Accordingly, section 83(h) allows a

deduction under section 162 to the person for whom such services were performed

in an amount equal to the amount included under section 83(a) in the gross income

of the person who performed such services. The statute permits a taxpayer to

defer recognition of any gain until his rights in the restricted property become

“substantially vested”. Sec. 1.83-1(a)(1), Income Tax Regs.; see Strom v. United

States, 641 F.3d 1051, 1056 (9th Cir. 2011).

      Therefore, in order for section 83 to apply in the manner that petitioner

asserts, petitioner must show that: (1) the Chin stock was transferred in

connection with the performance of services and (2) the Chin stock was subject to

a substantial risk of forfeiture until October 17, 2008. Petitioner believes the

stipulated facts and exhibits establish that DTRI issued the Chin stock to compel
                                        -19-

[*19] his continued employment with DTRI, and had that employment terminated,

Chin would have been required to sell the Chin stock back to DTRI at a below-

market rate. However, for the reasons stated below, we conclude that petitioner

failed to meet either requirement of section 83 and, therefore, section 83 does not

apply in this case.

A.    Transferred in Connection With the Performance of Services

      The determination of whether the Chin stock was transferred “in connection

with the performance of services” is essentially a question of fact. Centel

Commc’ns Co. v. Commissioner, 92 T.C. 612, 627 (1989) (citing Bagley v.

Commissioner, 85 T.C. 663, 669 (1985), aff’d, 806 F.2d 169 (8th Cir. 1986)),

aff’d, 920 F.2d 1335 (7th Cir. 1990). In order for section 83 to apply in this

matter, it must be shown that the stock was transferred in connection with the

performance of services by Chin. The following factors have been considered in

such an analysis:

      (1) whether the property right is granted at the time the employee or

independent 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;
                                        -20-

[*20] (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.

See Bagley v. Commissioner, 806 F.2d at 170-171; Alves v. Commissioner, 734

F.2d 478, 481-482 (9th Cir. 1984), aff’g 79 T.C. 864 (1982); Montelepre

Systemed, Inc. v. Commissioner, T.C. Memo. 1991-46 (citing Centel Commc’ns

Co. v. Commissioner, 92 T.C. 612), aff’d, 956 F.2d 496 (5th Cir. 1992).

      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, and employment agreements are all dated December 18,

2002. In consideration of the second factor, petitioner points to the shareholders
                                        -21-

[*21] 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 infra part B.

      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 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
                                         -22-

[*22] 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 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.
                                        -23-

[*23] 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.

Additionally, Chin voted and signed corporate documents as an outstanding owner

of class A stock in DTRI from 2002 through 2008.

      In all 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 section 83 is appropriate. See, e.g., Alves v. Commissioner, 79

T.C. at 876 (“Congress * * * has clearly expressed the intention that section 83 is

to have the broadest application”); Montelepre Systemed, Inc. v. Commissioner,
                                         -24-

[*24] T.C. Memo. 1991-46, 1991 Tax Ct. Memo LEXIS 65, at *19 (“[T]he statute

only envisions some sort of relationship between the services performed and the

property transferred.”). However, on the facts and circumstances of this case, we

conclude that petitioner has failed to prove the Chin stock was transferred in

connection with the performance of services pursuant to section 83. Nonetheless,

in this matter we believe the crux of our section 83 analysis is whether the Chin

stock was subject to a substantial risk of forfeiture.

      B.     Substantial Risk of Forfeiture

      Petitioner contends that the initial issuance of the Chin stock was subject to

a substantial risk of forfeiture under section 83 and, therefore, deductible as

compensation under section 162. Shares of stock are subject to a substantial risk

of forfeiture when the owner’s rights to their full enjoyment are conditioned upon

the future performance of substantial services by any individual. See sec. 1.83-

3(c)(1), Income Tax Regs.; see also Facq v. Commissioner, T.C. Memo. 2006-111.

Whether a risk of forfeiture is substantial depends on the facts and circumstances.

Sec. 1.83-3(c)(1), Income Tax Regs. Property is not transferred subject to a

substantial risk of forfeiture if at the time of transfer the facts and circumstances

demonstrate that the forfeiture condition is unlikely to be enforced. Id.
                                          -25-

[*25] Section 1.83-3(c)(3), Income Tax Regs., governs enforcement of forfeiture

provisions and provides five factors to consider “[i]n determining whether the

possibility of forfeiture is substantial in the case of rights in property transferred to

an employee of a corporation who owns a significant amount of the total combined

voting power or value of all classes of stock of the employer corporation.” Those

factors are: (i) the employee’s relationship to other stockholders and the extent of

their control, potential control and possible loss of control of the corporation; (ii)

the employee’s position in the corporation and the extent to which he is

subordinate to other employees; (iii) the employee’s relationship to the officers

and directors of the corporation; (iv) the person who must approve the employee’s

discharge; and (v) the employer’s prior actions in enforcing the provisions of the

restrictions. Id.

       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)
                                         -26-

[*26] 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 risk of forfeiture is governed by the

first example in section 1.83-3(c)(3), Income Tax Regs., which establishes that if a

majority of a corporation’s voting stock “is owned by an unrelated individual * * *

so that the possibility of the corporation enforcing a restriction on * * * [another

shareholder’s property] rights is substantial, then such rights are subject to a

substantial risk of forfeiture.”

      Alternatively, respondent argues that the shareholders agreement does not

contain substantial risk of forfeiture provisions for purposes of section 83.

Respondent contends that the record contains no evidence that: (1) DTRI

transferred class A common voting stock to any other employees in connection

with the performance of services; (2) any class A common voting stock was

subject to a substantial risk of forfeiture; and (3) any restrictions on class A stock

were ever actually enforced. Respondent argues that the shareholders agreement

provides an agreed-upon price for the repurchase by DTRI of the capital stock

owned by Hume and Chin based upon a formula contingent upon years of service.

Respondent further argues that because Chin was the executive vice president,
                                        -27-

[*27] COO, and a 49.75% shareholder in voting stock of DTRI, it is unlikely

Hume would have taken any actions to terminate Chin’s employment. Finally,

respondent states that petitioner failed to demonstrate the existence of any

enforcement history by DTRI of restrictions in connection with class A common

voting stock. Respondent contends that the stipulation of facts contains

information regarding the enforcement of forfeiture provisions only with respect to

employees owning small percentages of DTRI class B common nonvoting stock.

      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, during the
      period beginning in December 2002 until the merger of DTRI with
      petitioner in August 2008 (“the pre-merger period”), their ownership
                                         -28-

      [*28] 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 argues that the stipulation regarding Hume’s and Chin’s testimony

caused respondent to confuse legal ownership of outstanding shares with tax

ownership under section 83. Petitioner contends that the dispute involves whether

the legally owned shares were subject to restrictions that make clear they were

issued in connection with the performance of services and subject to a substantial

risk of forfeiture. Petitioner believes that the stipulation does not negate the

manner in which Hume, Chin, and DTRI structured and documented their

interactions. Petitioner submits that the DTRI documents are controlling and

establish its entitlement to the section 83 deduction. However, respondent

contends that the stipulation directly contradicts petitioner’s interpretation of the

agreements and the basis for the claimed deduction. We agree. In addition to

Hume, Chin, and DTRI’s representation and treatment of the Chin stock as

outstanding stock, we believe that Hume’s and Chin’s statement establish that the

intent of the parties in 2002 was to transfer the Chin stock as fully vested and

outstanding stock in DTRI.
                                        -29-

[*29] 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 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.

Petitioner failed to provide any evidence of the method of recourse intended to

recover any nonvested Chin stock in the event that Chin violated the terms of the

shareholders agreement. Moreover, petitioner failed to demonstrate that DTRI had

ever enforced any restrictions in connection with class A common voting stock.
                                          -30-

[*30] 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.” Austin v. Commissioner,

141 T.C. 551, 568 (2013) (quoting section 1.83-3(c)(4) and (3), Income Tax

Regs.). Petitioner has failed to show proof of the likelihood of enforcement of the

forfeiture provisions on the Chin stock. Therefore, we conclude that petitioner has

failed to carry its burden of proof with respect to this issue. Accordingly, we hold

that the Chin stock was not subject to a substantial risk of forfeiture under section

83. Consequently, petitioner is not entitled to a deduction, pursuant to section 83,

for salary and wage compensation with regard to the Chin stock.

      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,


                                                 Decision will be entered for

                                         respondent.
