In purchase agreements, it is common to see part of the purchase price placed into an escrow account, to be released to the seller at a future date upon the occurrence of some contingency. Buyers often choose to place funds in escrow to guarantee the performance of the seller or to protect themselves from unknown liabilities. For the seller, a properly structured escrow may defer some of the gain on the sale until the escrowed funds are released.
However, a cash basis taxpayer need not actually receive the purchase price for it to be taxable. In fact, the regulations under Section 446 require that a cash basis taxpayer pay tax on income in the year it is actively or constructively received.
The concept of constructive receipts becomes tricky when dealing with escrowed amounts. Generally, when cash or property is placed in escrow and the taxpayer receives no right to control the assets, the courts and the Service have held that the amounts are not taxed until the contingency is met and the funds are released. However, if the taxpayer exercises a considerable degree of domination and control over the assets in escrow, the amounts in escrow have generally been treated as having been constructively received by the seller and taxed accordingly.
This creates a problem for two reasons. First, if the seller is deemed to have constructively received escrowed amounts, he will recognize gain without having the ability to liquidate the escrowed assets and pay the tax. In addition, if the escrowed amounts are not cash, but rather an asset with a fluctuating value like stock, the seller may recognize gain based on the FMV of the stock at the date of the closing, even though the value may be considerably less when subsequently released from escrow.
Last week, the Eleventh Circuit decided U.S. v. Fort, 107 AFTR 2d 2011-739 (Eleventh Circuit, 2011) a case that illustrates the factors the IRS and courts will consider in determining if stock placed in escrow will be treated as having been constructively received by the seller.
In Fort, the taxpayer was a partner in Ernst & Young’s IT consulting business. The partners sold the business to Cap Gemini, a French corporation, in exchange for Cap Gemini stock, and signed an employment agreement to work for a new entity owned by Cap Gemini. Important details relative to the stock proceeds include:
- The stock was placed into an individual account in Fort’s name at Merrill Lynch, effectively acting as an escrow.
- The stock could not be withdrawn from the Merrill account and sold by Fort for four years and 300 days following closing. This was done to prevent all of the E&Y partners from selling the Cap Gemini stock at once and diluting its value.
- During the time the stock was restricted, Fort had full dividend and voting rights.
- The restricted shares would be forfeited upon three conditions: If Fort terminated his employment, violated his employment agreement, or was fired for cause.
- In the event Fort was terminated for “poor performance”, he could forfeit 50% of the restricted shares, but could also receive all of the shares pending a review.
Fort initially reported the value of the stock as having been constructively received in 2000, the year of the sale. After later discovering that some of his former E&Y partners had filed amended returns to remove the escrowed value from the 2000 return, however, Fort followed suit.
The Eleventh Circuit agreed with the District Court that Fort had constructively received the escrowed stock in 2000. Referenced a string of similar cases featuring other selling partners of the E&Y IT consulting group, the Eleventh Circuit cited the following factors in its decision:
- As the stock was paid into a Merrill Lynch account in Fort’s name, Fort was merely postponing unrestricted access to the shares. According to the courts, “a taxpayer’s willingness to defer consumption does not defer taxation…The fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place.”
- Fort bore the risk that the restricted shares would increase or decrease in value. This was an indiciationof control over the escrowed stock.
- Fort had both dividend and voting rights over the restricted stock.
- Since the shares would only be forfeited if Fort quit, violated his contract, or was fired for cause, Fort ultimately had complete control over whether he’d receive the stock.
The Eleventh Circuit dismissed Fort’s argument that he did not have “control” over the restricted stock because he would forfeit them if fired for poor performance. Fort argued that “poor performance” meant “any reason at all,” meaning Fort ultimately had no control over whether he’d get the stock, as Cap Gemini could fire him at their will.
The court saw things differently, arguing that “poor performance” was just that. Since Fort was in control of his performance, he was in control over whether he would be terminated and forfeit the shares.
The lesson here is obvious. The E&Y guys were bright and tax-savvy. They clearly amended their 2000 returns on sound advice that the restricted stock was not constructively received until the restrictions were lifted. The fact that they were wrong reflects just how uncertain the constructive receipt doctrine remains when dealing with escrowed funds. Careful consideration should be given to any escrow arrangement if the goal of the parties is to defer taxation on the escrowed amounts. A seller will obviously want some degree of control over the escrowed funds to protect their proceeds; too much control, however, will accelerate income recognition.