DENIAL OF BUSINESS EXPENSE DEDUCTION FOR EXECUTIVE'S ACQUIRED SHARES AFFIRMED BY FOURTH CIRCUIT

For most of us, the days following the New Year were filled with introspection, one or two remaining holiday/New Year’s parties, and plenty of hunkering down as a cold front swept through the country.  The start of 2017 for QinetiQ U.S. Holdings, Inc. & Subsidiaries (“QinetiQ” or “Acquiring Co.”), a technology-based solutions and products company that offers support services to defense, security, and related markets, was, unfortunately, not so mundane.  QinetiQ was recently forced to deal with a January 6, 2017, Fourth Circuit decision affirming the Service’s denial of QinetiQ’s Internal Revenue Code (the “Code”) § 83(h) deduction, for stock issued to its officers (the “DTRI Stock”), as well as the $117,777,501 in additional taxable income that must be recognized (a natural consequence of the Fourth Circuit’s decision).

Section 83(a) of the Code generally treats [stock] transferred "in connection with the performance of services" as "gross income of the person who performed such services."  The person who receives such stock, in exchange for their services, generally recognizes the receipt of the stock as income in the year the stock is transferred.  Employer is then entitled to a deduction, in the amount that is recognized as income by the recipient, in the same year that recipient employee captures the receipt of stock as income.  This general rule, however, is greatly modified when the stock received by employee, in connection with employee’s services to employer, is subject to a substantial risk of forfeiture.  In such an instance, employee is allowed to delay the recognition of income until the year in which the substantial risks of forfeiture lapse.  Employer’s deduction under § 83(h), accordingly, must also be delayed until the substantial risks of forfeiture lapse.  This delay allows employer’s ordinary and necessary business expense deduction, under §§ 83(h) and 162, to occur in a year (potentially much) later than the year in which the stock was “transferred” and for an amount (potentially much) greater than the FMV at the time of the initial “transfer.”

In 2008, QinetiQ entered into negotiations to acquire Dominion Technology Resources, Inc. (“DTRI”) vis-a-vi a stock acquisition (“M&A Plan”).  As part of the M&A Plan, QinetiQ agreed to purchase all outstanding DTRI stock for $123,000,000 (the outstanding DTRI Stock was primarily owned by two DTRI executives).  Initially, pursuant to the M&A Plan, the two major DTRI shareholders executed consent agreements waiving DTRI's rights with regards to DTRI Stock transfer restrictions (“Consent Agreements”).  Such restrictions were put in place as part of the initial 2002 transfer of stock to the two executives.  The M&A Plan was eventually finalized and QinetiQ proceeded to deduct from its 2008 taxable income, pursuant to Code §§ 83(h) and 162, the fair market value of the DTRI Stock that was initially “transferred” to the two DTRI executives in 2002.  

QinetiQ’s rationale to make an ordinary and necessary business expense deduction for the DTRI Stock, in taxable year 2008, was based on its belief that there was a substantial risk of forfeiture attached to the executives’ DTRI Stock, from 2002 through 2008, but that such risk of forfeiture, after execution of the Consent Agreements, had lapsed.

The Service, however, concluded that the DTRI Stock was never subject to an actual substantial risk of forfeiture.  The Service determined that the DTRI Stock should have been previously included in the executives’ 2002 taxable income and, thus, tax year 2002 was when DTRI would have been allowed a deduction pursuant to § 83(h). The Fourth Circuit proceeded to examine the facts and circumstances surrounding the 2002 DTRI Stock transfer and ultimately upheld the denial of the deduction.  The Fourth Circuit found that the record showed: (i) that under the DTRI Stock transfer agreements, DTRI would have been required to pay the executives the fair market value of the stock if the stock was forfeited for almost any reason (such is not indicative of an actual substantial risk of forfeiture); and (ii) the sole event dictating actual forfeiture of DTRI Stock, for less than fair market value, would unlikely have been enforced by DTRI since the executives’ had majority control of DTRI and had a strong working relationship with one another.

We all remember the good old days of the fast-track IPOs (which would allow founders to continue to grow their companies and build their legacy within such company). An IPO, naturally, is much more attractive than exit through merger and acquisition. However, sometimes we must face reality. Startups will likely, eight-out-of-ten times, remain unprofitable private ventures, be acquired through an acquirer, or pivot and merge into a new business that is a far more profitable venture.  For these reasons, in order to have the most attractive opportunity possible when contemplating and planning an exit through merger and acquisition, entrepreneurs have to start paying more attention to § 83 of the Code and the necessary requirements that must be followed in order to take full advantage of Code § 83.