United States

Stock surrender and repurchase transaction lacked economic substance

Taxpayer scheme to avoid compensation income disallowed


The two business owner-employees involved in Austin v. Commissioner, T.C. Memo. 2017-69 sought to avoid tax on the vesting of their stock compensation. The Tax Court agreed with the IRS’ assertion that each employee had taxable income of about $45.7 million at the time their stock vested. Their efforts to avoid tax on this income were ineffective, and they were subject to a penalty due to their negligent failure to report the income.

Stock compensation vesting

An employee receiving stock as compensation is not immediately taxed on the receipt if the stock is subject to a “substantial risk of forfeiture” under the rules of section 83 of the Tax Code.  A condition of continued employment may constitute a substantial risk for forfeiture. Each business co-owner in the Austin case held his stock subject to a provision that he would forfeit 50 percent of its value if he voluntarily terminated their employment. This provision had a five year term and expired in 2004.

The stock therefore “vested” in 2004 (i.e., the rights to the stock were no longer contingent). About $45.7 million (nearly all of the value) of each co-owner’s shares exceeded his tax basis in the shares and represented taxable compensation income to him.

Stock surrender and repurchase

A few months after the co-owners’ stock vested in 2004, each co-owner entered into a surrender and repurchase agreement with the corporation. Each individual would surrender their existing shares and simultaneously repurchase shares in exchange for a promissory note. The repurchased shares were identical to the surrendered shares.

The purposes of the stock surrender and repurchase transaction was to avoid both taxable compensation income on the vested stock, and the resulting income tax and employment tax. The Tax court held that there were two reasons the arrangement did not achieve this purpose. First, the taxable compensation income was triggered before the arrangement was put in place. Second, the arrangement lacked economic substance.  

Taxable compensation income was triggered before the stock surrender and repurchase arrangement was put in place

The co-owners stock vested in January 2004. The stock surrender and repurchase arrangement was put into place in March 2004. The Tax Court found that because taxable compensation was received at vesting in January 2004, the March 2004 agreements could not change this tax result.

The stock surrender and repurchase arrangement lacked economic substance

Further, the court held that even had the March surrender timely addressed the vesting concern, the scheme lacked econoimic substance with no business purpose for the surrender and repurchase other than tax avoidance or profit motive. The court applied the economic substance case law – the Tax Code now contains an economic substance rule, but the transaction at issue predates the statutory rule, so case law governed this issue.

The court applied the two-part economic substance test set out in Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985). The first part involved subjective determination of whether the taxpayers were motivated by no business purpose other than obtaining tax benefits when arranging the surrender and immediate repurchase of their shares. The court found here that the taxpayers’ agreements did not support a valid business purpose and the transaction was solely motivated for the purpose to avoid federal taxes.

The second part of the economic substance test involved an objective determination of whether a reasonable possibility of profit form the transaction existed apart from tax benefits. In essence, the question was whether the co-owners had a reasonable possibility of profiting from the surrender of their shares for zero consideration. Each co-owner surrendered shares he owned free and clear, and repurchased identical shares from the corporation in exchange for a promissory note. The court found that no rational person would incur over $41 million of indebtedness to acquire stock that they already owned; thus, the transaction lacked any reasonable possibility of profit.

Since the court found that the stock surrender and repurchase transaction lacked economic substance under both the subjective and objective tests, it held that the transaction lacked economic substance and should not be given its intended tax avoidance effect.  


The taxpayers here attempted to avoid taxable compensation income though a transaction the Tax Court found ineffective both because it was too late and because it lacked economic substance. As a result, the taxpayers face liability for tax and penalties.

There are straightforward lessons to learn from this case. One is to address potential tax issues before expiration of contract rights or entry into a transaction. Another is that transactions undertaken solely to achieve tax benefits should be approached cautiously if at all. To put these principles into practice, taxpayers should consult with their tax advisors.


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