Gudmundsson v.United States

Citations: 634 F.3d 212; 107 A.F.T.R.2d (RIA) 852; 2011 U.S. App. LEXIS 2642; 2011 WL 482467Docket: 09-4869

Court: Court of Appeals for the Second Circuit; February 10, 2011; Federal Appellate Court

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The United States Court of Appeals for the Second Circuit affirmed the district court's judgment in Gudmundsson v. United States, which dismissed the plaintiffs-appellants' claim for a tax refund. Plaintiffs Olafur Gudmundsson and Sally Rudrud contended that they prematurely recognized and overvalued stock received as compensation, arguing this led to an incorrect income report on their 1999 federal tax return. The stock, which Gudmundsson received on July 1, 1999, was subject to contractual and legal restrictions limiting its marketability for one year, and its value had significantly decreased by that time.

Gudmundsson had reported approximately $1.3 million as income based on the stock's mean unrestricted trading price at the time of receipt, calculated under I.R.C. § 83, which governs taxation for property transferred as compensation for services. After exhausting administrative remedies, the plaintiffs filed suit in the Western District of New York. The district court granted summary judgment in favor of the government, leading to the appeal. The court found the plaintiffs' arguments unpersuasive and upheld the decision, confirming that the stock's restricted status and the timing of its valuation were correctly applied under tax law.

Stock could be sold privately or pledged as collateral, as permitted by McDonald v. Comm'r, 764 F.2d 322, 323 n.3 (5th Cir. 1985) and 17 C.F.R. § 230.144(a)(3). An agreement among Aurora's corporate entities and employee members, including Gudmundsson, prohibited public sale of the Stock until July 1, 2000, and allowed transfers only to "permitted transferees," such as family members, who had to agree in writing to the Agreement's terms. Transfers to non-permitted transferees would be considered void, though forfeiture was not a penalty for violations. Gudmundsson was also bound by Aurora's Insider Trading Policy, which mandated waiting periods and consent procedures for trading and allowed disciplinary measures for violations, including termination.

During the period from Gudmundsson's receipt of the Stock to the expiration of the restrictions, Aurora's stock value plummeted due to financial mismanagement and poor earnings reports, dropping from $17.6875 per share on July 1, 1999, to $3.8375 by July 1, 2000. In 2003, plaintiffs filed an amended tax return seeking a refund based on the stock's December 31, 1999, value of $9.25, which the IRS denied in 2006. Subsequently, on March 20, 2008, plaintiffs initiated a refund action under 28 U.S.C. § 1346(a)(1) and 26 U.S.C. § 7422. Both parties agreed that I.R.C. § 83 governed the transaction and that the Stock was “transferred” to Gudmundsson on July 1, 1999, but disagreed on the taxability date. The government maintained that the Stock was correctly reported as income on that date, while plaintiffs argued that the restrictions made it premature to recognize it as taxable income. The district court ruled in favor of the government, affirming the Stock's reportability as of July 1, 1999, and validating the Exchange Price for income measurement, leading to this appeal.

The Court reviews summary judgment decisions de novo, determining if there is no genuine issue of material fact and if the moving party is entitled to judgment as a matter of law. In this case, the facts are stipulated, focusing solely on legal questions. Central to the case is I.R.C. § 83, which governs the taxation of property transferred for services, established to prevent tax deferral through sale restrictions. Under § 83(a), income is recognized when the recipient's rights are either transferable or no longer subject to a substantial risk of forfeiture, with the property's fair market value assessed without regard to certain restrictions.

The plaintiffs argue against the district court's determination that the Stock was recognized as income on July 1, 1999, claiming it remained non-transferable and subject to substantial risk of forfeiture. To counter this, the district court concluded that the Stock was both transferable and not subject to substantial risk on that date. Under § 83(c)(1), property is considered to have a substantial risk of forfeiture if rights to enjoyment are conditioned on future substantial services. The regulations clarify that this determination is based on the specific facts of each case. Examples of substantial risks include conditions requiring return of property based on performance, while risks tied to property value decline or discharge under certain conditions do not constitute substantial risk.

Substantial risks of forfeiture are integral to defining "transferability" under I.R.C. § 83(c)(2), which states that property is considered transferable only if the transferee's rights are not subject to such a risk. The regulations specify that transferable property can be sold or assigned to any person, provided that person does not face a substantial risk of forfeiture. Transferability is established if even one transferee can receive the property free of this risk, even if full marketability is not guaranteed. A special rule under § 83(c)(3) states that if the sale of property given as compensation could lead to a suit under § 16(b) of the Securities Exchange Act, then the rights in that property are considered to have a substantial risk of forfeiture.

Regarding the Stock, the plaintiffs' claims that it faced a substantial risk of forfeiture as of July 1, 1999, were unconvincing. They argued that Gudmundsson's potential termination for not adhering to company policy constituted such a risk, but this is not applicable since § 83 focuses on property interests, not employment risks. A substantial risk of forfeiture must relate to the potential loss of property rights, which was not the case here, as the Agreement did not connect employment termination to the forfeiture of the Stock.

The plaintiffs also contended that Gudmundsson could face a lawsuit under § 10(b) of the Securities Exchange Act if he transferred the Stock, suggesting this created a substantial risk of forfeiture. However, the district court correctly determined that § 10(b) does not align with the substantial risk of forfeiture described in § 83. Civil suits like those under § 10(b) would require Congressional amendment to be recognized as such under § 83, as the statute explicitly references only suits under § 16(b). Thus, the plaintiffs' attempt to incorporate § 10(b) liability into the analysis of § 83 was rejected.

The Stock was not subject to a substantial risk of forfeiture on July 1, 1999, allowing for income recognition under § 83. Plaintiffs argued that the Stock was not transferable due to legal and contractual restrictions. However, the Agreement allowed Gudmundsson to transfer the Stock to "permitted transferees," which included family members. Transferability under § 83 does not solely depend on marketability; even if sales are restricted, property can still be transferable if it can be pledged or assigned. The plaintiffs' analogy to Robinson v. Commissioner was rejected, as the Agreement here allowed some transfers, unlike the mandatory sell-back provision in Robinson which made the stock effectively non-transferable. Furthermore, the Agreement did not provide for forfeiture upon violation of its terms, contrasting with Robinson where the employer could recoup the stock. Therefore, the Stock was recognized as income on July 1, 1999, under § 83(a).

The fair market value of the Stock on that date was also addressed. Section 83(a) states property should be recognized at its fair market value without regard to restrictions that will never lapse. Plaintiffs contended the district court misinterpreted § 83(a) regarding fair market value determination and argued that restrictions imposed by law do not count as "lapse" restrictions. These arguments will be examined further.

Fair market value is defined as the price at which property transfers between a willing buyer and seller, both informed and without pressure to act. This definition, established in Cartwright, is utilized throughout the Internal Revenue Code (I.R.C.) unless a specific statutory rule exists. In the context of I.R.C. § 83, fair market value is determined without regard to any restrictions that will lapse. Plaintiffs argue for a valuation based on the private market due to restrictions on the stock; however, this interpretation is incorrect as § 83 explicitly deviates from the common understanding of fair market value. The valuation under § 83 must ignore restrictions that lapse, which includes both contractual and legal limitations placed on the stock, unless they are considered "nonlapse restrictions." Such nonlapse restrictions are defined as permanent limitations that require property to be sold at a predetermined price and apply to all future transferees. The regulations state that limitations from registration laws do not qualify as nonlapse restrictions. Therefore, the district court rightly rejected the plaintiffs' arguments and calculated fair market value according to § 83's guidelines.

The district court found that both the Agreement and Rule 144 imposed restrictions on stock that lapsed, thus excluding them from the fair market value calculation on July 1, 1999. Plaintiffs contended that since § 83 does not explicitly state that securities laws lapse, such laws should remain in effect. They argued that Treasury Regulation § 1.83-3(h) improperly includes these laws within the statute's scope, contradicting what they believed to be Congress's intent to limit lapse restrictions to contractual ones. The court disagreed, emphasizing that the statute requires disregarding "any restriction" in property valuation, without differentiation based on the restriction's source. The purpose of § 83 was to rectify preferential tax treatment for restricted stock compared to other compensation mechanisms, addressing timing issues with a broad rule that disregards temporary transfer restrictions. Previous case law, including Sakol, supported the IRS's approach of not considering temporary restrictions in fair market value calculations. While plaintiffs noted that contractual restrictions were the primary focus of the statute, it is clear from the statute and its legislative history that § 83's application is not confined to contracts, as it encompasses securities law restrictions as well. The regulation challenged by the plaintiffs effectively aligns with Congressional intent by treating state and federal securities laws similarly to nonlapse restrictions.

All lapse restrictions, whether contractual or statutory, must be ignored in calculating income under § 83. The district court correctly disregarded Rule 144, which restricted the stock's marketability but lapsed on July 1, 2000. Without these restrictions, the stock was treated as unrestricted shares traded on the New York Stock Exchange as of July 1, 1999. The district court appropriately used the Exchange Price to assess fair market value, consistent with standard valuation methods under § 83(a) and supported by precedent cases. Although the application of these rules may seem unfair in specific instances, it is the intended outcome of § 83(a), and taxpayers willingly engage in stock-based compensation plans with knowledge of the tax implications. The plaintiffs' additional arguments were deemed meritless, leading to the affirmation of the district court's judgment.