QinetiQ US Holdings, Inc. v. Comm'r of Internal Revenue

845 F.3d 555

QINETIQ US HOLDINGS, INC. & SUBSIDIARIES, Petitioner-Appellant,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 15-2192

United States Court of Appeals, Fourth Circuit.

Argued: October 26, 2016

Decided: January 6, 2017

ARGUED: Gregory G. Garre, Latham & Watkins LLP, Washington, D.C., for Appellant. Ellen Page DelSole, United States Department of Justice, Washington, D.C., for Appellee. ON BRIEF: Gerald A. Kafka, Benjamin W. Snyder, Nicolle Nonken Gibbs, Latham & Watkins LLP, Washington, D.C., for Appellant. Caroline D. Ciraolo, Acting Assistant Attorney General, Diana L. Erbsen, Deputy Assistant Attorney General, Gilbert S. Rothenberg, Teresa E. McLaughlin, Tax Division, United States Department of Justice, Washington, D.C., for Appellee.

Before KING, KEENAN, and DIAZ, Circuit Judges.

Affirmed by published opinion. Judge Keenan wrote the opinion, in which Judge King and Judge Diaz joined.

BARBARA MILANO KEENAN, Circuit Judge:

This appeal from a decision of the United States Tax Court (the tax court) involves the federal income tax treatment of shares of stock issued to an executive employee of Dominion Technology Resources, Inc. (DTRI), around the time of DTRI's founding. The company's successor in interest, QinetiQ U.S. Holdings, Inc. & Subsidiaries (QinetiQ), contends that the stock was issued in connection with the executive's employment and was subject to a substantial risk of forfeiture until 2008. On this basis, QinetiQ argues that it is entitled to a tax deduction for the value of the stock as a trade or business expense in the tax year ending March 31, 2009.

After reviewing QinetiQ's tax return, the Internal Revenue Service (IRS) issued a Notice of Deficiency concluding that QinetiQ had not shown its entitlement to the claimed deduction. QinetiQ later filed suit in the tax court, raising both a procedural and a substantive argument. QinetiQ argued that the IRS failed to give a reasoned explanation in the Notice of Deficiency for denying the tax deduction. QinetiQ also argued that the stock qualified as a deductible trade or business expense in tax year 2008, because the stock was issued in connection with services and was subject to a substantial risk of forfeiture until that year. The tax court rejected the procedural argument, holding that the Notice of Deficiency provided sufficient explanation. The tax court also held that QinetiQ failed to show that the stock was issued in connection with services and was subject to a substantial risk of forfeiture. Accordingly, the tax court entered judgment in favor of the IRS.

Upon our review, we conclude that the IRS complied with all applicable procedural requirements in issuing the Notice of Deficiency to QinetiQ. We further hold that the tax court did not err in concluding that the stock failed to qualify as a deductible expense for the tax year ending March 31, 2009, because the stock was not issued subject to a substantial risk of forfeiture. We therefore affirm the tax court's judgment.

I.

In March 2002, Thomas G. Hume (Hume) formed "Thomas G. Hume, Inc." as a corporation organized under the laws of Virginia. Hume was the sole shareholder, and served with his wife, Karyn Hume, as the initial directors of the corporation. Hume filed federal tax forms electing for the corporation to be treated as an "S corporation," in order to permit the corporation's profits and losses to be passed through to him individually. See 26 U.S.C. § 1366(b). Thomas G. Hume, Inc. appears not to have engaged in any business before November 2002.

In November 2002, Hume and Julian Chin took certain actions to facilitate Chin's joining the business enterprise. On December 6, 2002, Hume and Karyn Hume, as directors, filed articles of amendment with the Commonwealth of Virginia changing the name of the corporation to Dominion Technology Resources, Inc. and creating two classes of shares, class A voting stock and class B nonvoting stock. The next day, Karyn Hume resigned from DTRI's board of directors, leaving Hume as the sole director. On December 9, 2002, Hume paid a par value¹ of $450 in exchange for 4,500 shares of DTRI class A voting stock, and Chin paid the same par value in exchange for 4,455 shares of DTRI class A voting stock and 45 shares of DTRI class B nonvoting stock.

On December 12, 2002, Hume executed a "Consent in Lieu of the Organizational Meeting of the Board of Directors of [DTRI]" (December Consent), which offered for sale and issuance 4,500 shares of class A stock to Hume, and 4,455 shares of class A and 45 shares of class B stock to Chin. Attached to the December Consent were letters signed by Hume and Chin acknowledging their intent to subscribe to the stated stock shares. Also included in the December Consent was authorization for DTRI to enter into a Shareholders Agreement and employment agreements with Hume and Chin. In a separate paragraph, the December Consent further authorized DTRI to enter into individual employment agreements and restrictive stock agreements with other employees.

The Shareholders Agreement entered into by DTRI, Hume, and Chin stated that the parties

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[.]

To that end, the Shareholders Agreement prescribed provisions for restricting the sale or transfer of stock and for returning stock to the corporation in the event of either Hume's or Chin's death, disability, or termination of employment with DTRI.

The Shareholders Agreement contained provisions for calculating the "Agreement Value" of the shares upon the occurrence of any of these events, and gave the corporation the option of repurchasing Hume's or Chin's shares at the calculated value in the event of such death, disability, or termination without cause. Additionally, in the event of voluntary resignation by the employee, the Shareholders Agreement provided DTRI the option of purchasing the shares at 5% of the Agreement Value for every year of the departing employee's employment, up to a maximum of 100% after twenty years. However, in the event that the employee voluntarily resigned and engaged in competition with DTRI, or that DTRI terminated the employee for cause, the corporation would have the option to purchase the shares at 5% of the Agreement Value for every year of employment, up to a maximum of 25% of the Agreement Value.

Also in December 2002, DTRI entered into stock agreements with other employees that were far more restrictive than the terms of the Shareholders Agreement executed by Hume and Chin. The stock agreements with the other employees contained greater limitations on the transfer of stock and a less generous method for calculating stock value for purposes of DTRI's repurchase of a departing employee's stock. Also, unlike Hume and Chin, the other employees did not receive any voting rights in the stock they received.

DTRI entered into employment agreements with Hume, Chin, and other employees in December 2002. The employment agreements with Hume and Chin bore no reference to stock issued as compensation. In contrast, the employment agreements for the other employees who received stock in December 2002 explicitly referenced, under a contract section labeled "Compensation," nonvoting stock that was issued subject to restrictions.

DTRI, Hume, and Chin filed yearly tax documents treating DTRI as a pass-through entity between tax years 2002 and 2006, with Hume and Chin identified as the shareholders. In DTRI's tax filings from 2002 to 2006, DTRI allocated its net income or loss to Hume and Chin, based on their respective percentage of stock ownership in DTRI in each taxable year. In December 2006, DTRI revoked its S corporation election, effective January 1, 2007. From 2002 through 2007, DTRI did not report the stock issued in 2002 to Hume and Chin as employment compensation, and therefore did not withhold federal payroll taxes on the issued stock. In contrast, DTRI, Hume, and Chin reported as employment compensation shares later granted to Hume and Chin.

In 2008, QinetiQ entered into negotiations to purchase DTRI. On August 4, 2008, QinetiQ, Project Black Acquisition Corp., DTRI, Hume, and Chin entered into a final agreement and plan of merger, with QinetiQ paying $123 million in exchange for all outstanding stock in DTRI. Immediately before the transaction closed, Hume and Chin executed consent agreements waiving DTRI's rights with respect to stock transfer restrictions or partially vested stock. The merger transaction closed in October 2008.

For the tax year ending on March 31, 2009, QinetiQ withheld payroll taxes in accordance with the value of the stock received by Hume and Chin in 2002, and claimed deductions under 26 U.S.C. § 83(h), as wages paid to Hume and Chin for the fair market value of the shares originally issued to them in December 2002. Hume and Chin filed personal income tax returns for tax year 2008 claiming as wage income the 2008 value of their respective shares issued in December 2002.

The IRS transmitted to QinetiQ a Notice of Deficiency stating that the IRS had determined that QinetiQ "ha[d] not established that [it was] entitled" to a deduction "under the provisions of [26 U.S.C.] § 83," and that QinetiQ's taxable income for the year thereby was increased by "$117,777,501." The IRS did not give a further explanation of its decision in its Notice of Deficiency.

QinetiQ filed a petition in the tax court challenging the sufficiency of the Notice of Deficiency, as well as the IRS's substantive determination with respect to Chin's shares.² The tax court ruled that QinetiQ had not demonstrated entitlement to the deduction on two independent bases, namely, that the stock was not property "transferred in connection with the...