United States v. Michael Fletcher ( 2009 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 08-2173
U NITED S TATES OF A MERICA,
Plaintiff-Appellee,
v.
M ICHAEL J. and C YNTHIA T. F LETCHER,
Defendants-Appellants.
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 06 C 6056—Ronald A. Guzmán, Judge.
A RGUED O CTOBER 30, 2008—D ECIDED A PRIL 10, 2009
Before E ASTERBROOK, Chief Judge, and R IPPLE and
T INDER, Circuit Judges.
E ASTERBROOK , Chief Judge. Ernst & Young spun off its
information-technology consulting group in 2000. Cap
Gemini, S.A., a French corporation, bought this business
and became Cap Gemini Ernst & Young, a multinational
firm. Today it is known as Capgemini, and we use that
name for the firm after the 2000 acquisition.
2 No. 08-2173
Consulting partners of Ernst & Young received shares
in Capgemini in exchange for their partnership interests
in Ernst & Young. This was not a like-kind exchange, so
it was a taxable event for the partners. Because Ernst &
Young and its partners expected shares in the new busi-
ness to appreciate, they wanted all of the income to be
recognized in 2000. That way any appreciation would be
taxed as a capital gain. But Cap Gemini wanted to
ensure the partners’ loyalty to the new business; a con-
sulting group depends on its staff, and if they left after
taking the stock the business might be crippled. Transfer-
ring the shares in installments might address these sub-
jects but also would make the transfers look like ordinary
income—and, if the shares appreciated in the mean-
time, the partners would receive fewer. Ernst & Young
and Cap Gemini decided that a transfer of all of the
shares in 2000, subject to what amounted to an escrow,
would preserve the tax benefits while serving business
objectives. So the shares received in the transaction were
restricted for almost five years: if a partner quit, was
fired for cause, or went into competition with the new
business, some or all of the shares could be forfeited.
Ernst & Young, Cap Gemini, and the partners agreed by
contract that they would report the transaction as a
partnership-for-shares swap in 2000, fully taxable in that
year. The agreed-on characterization allowed Capgemini
to take depreciation deductions, see 26 U.S.C. §197,
starting in 2000, and ensured consistent tax treatment of
all parties. The Commissioner of Internal Revenue
might have challenged the parties’ characterization, see
26 U.S.C. §269, but decided to accept it. Approximately
No. 08-2173 3
25% of the shares were sold in 2000 to generate cash that
the partners used to pay their taxes; the remainder of the
shares were held by Merrill Lynch subject to instructions
from Capgemini until restrictions lapsed. Each ex-partner
had a separate account for this purpose.
Cynthia Fletcher, one of Ernst & Young’s consulting
partners, voted for the transaction, signed the contract,
moved to Capgemini, and received 16,500 shares in that
business as payment for her partnership interest. The
market value of these shares on the day the sale closed
was about $2.5 million. Only 12,375 shares were
deposited in the restricted account; the rest were sold
for $653,756, which was distributed to Fletcher to cover
taxes. In February 2001 Capgemini sent Fletcher a Form
1099-B reflecting that she had received $2,478,655 in
stock, taxable at ordinary-income rates (save for some
$91,000 attributable to §751 property), from the sale of
her partnership interest. She and her husband Michael
(they filed a joint return) reported this income as re-
ceived in 2000, just as her contract with Capgemini re-
quired. The couple’s gross income for 2000 was reported as
$3,733,180, on which they paid $972,121 in income tax.
Had the market price of stock in Capgemini risen, as
the parties anticipated, that would have been a good
outcome for Fletcher and the other ex-partners. But
although Capgemini traded above €300 a share early in
2001, by 2003 it was below €50, where it has remained.
(So far in 2009 it has traded for about €25.) This made the
deal look bad in retrospect; the partners would have
been better off had distribution of the stock been deferred.
4 No. 08-2173
Fletcher quit in 2003. Although she left before the five
years required by the contract, Capgemini waived its
rights and directed Merrill Lynch to lift all restrictions
on the stock in her account. Fletcher then filed an
amended tax return for 2000. She now took the position
that only the $653,756 distributed from the account was
income in 2000. On her new view of matters, the rest of the
income was not received until 2003, and the amount was
much reduced in light of the lower market price of
Capgemini shares in 2003. Apparently without checking
how other taxpayers affected by the 2000 transaction
had been treated, the Internal Revenue Service paid
Fletcher a refund of about $387,000 plus interest. Con-
tending that this refund had been mistaken, the United
States filed this suit to get the money back. Similar litiga-
tion is pending in many other district courts—some suits
by the United States, some by ex-partners who want
refunds.
The IRS’s principal argument is that Fletcher and the
other ex-partners are bound by their own charac-
terization of the transaction as one in which all shares
were received in 2000. Having adopted this character-
ization with the goal of minimizing taxes, they must
adhere to it even though market movements have made
it disadvantageous, the United States insists. It relies
principally on CIR v. Danielson, 378 F.2d 771 (3d Cir. 1967),
which held just this, and on a Danielson-like remark in
Comdisco, Inc. v. United States, 756 F.2d 569, 577 (7th Cir.
1985): “[A] taxpayer generally may not disavow the
form of a deal.” Some courts have allowed taxpayers to
disregard their own forms when “strong proof” shows that
No. 08-2173 5
the economic reality was something else. See, e.g., Leslie S.
Ray Insurance Agency, Inc. v. United States, 463 F.2d 210, 212
(1st Cir. 1972); Ullman v. CIR, 264 F.2d 305, 308 (2d Cir.
1959). We used the “strong proof” formulation in Kreider
v. CIR, 762 F.2d 580, 586–87 (7th Cir. 1985), though with-
out mentioning either Comdisco or Danielson. The district
court concluded that it was unnecessary to choose
between these approaches (or their variants), because
on any standard the parties set out to ensure that all
income was recognized in 2000—and although the Com-
missioner has some power to recharacterize transactions
so that they match economic substance, taxpayers can’t
look through the forms they chose themselves in order
to improve their tax treatment with the benefit of hind-
sight. See Gregory v. Helvering, 293 U.S. 465 (1935). See
also Joseph Bankman, The Economic Substance Doctrine, 74
S. Cal. L. Rev. 5 (2000); Saul Levmore, Recharacterizations
and the Nature of Theory in Corporate Tax Law, 136 U. Pa. L.
Rev. 1019 (1988); David A. Weisbach, Formalism in the Tax
Law, 66 U. Chi. L. Rev. 860 (1999). So the district court
entered summary judgment for the United States and
ordered Fletcher to repay the refund. 2008 U.S. Dist. L EXIS
3555 (N.D. Ill. Jan. 15, 2008).
Fletcher argues that she didn’t “really” agree to the
structure that Ernst & Young and Cap Gemini (and most of
her partners) wanted in 2000. If she had voted no and
refused to sign, she maintains, she would have been
excluded from the economic benefits and might have
been fired. If this is so, then she had a difficult choice to
make; it does not relieve her of the choice’s consequences.
Hard choices may be gut-wrenching, but they are choices
6 No. 08-2173
nonetheless. Even naïve people baffled by the fine print
in contracts are held to their terms; a sophisticated busi-
ness consultant who agrees to a multi-million-dollar
transaction is not entitled to demand the deal’s benefits
while avoiding its detriments. The argument that
Fletcher can avoid the terms as a matter of contract law
is frivolous. All that matters now are the tax consequences
of the contracts she signed.
That a transaction’s form determines taxation is (or at
least should be) common ground among the parties. If
private parties structure their transaction as a sale of
assets, they can’t later treat it for tax purposes as if it
had been a merger. CIR v. National Alfalfa Dehydrating &
Milling Co., 417 U.S. 134 (1974). Cf. Landreth Timber Co. v.
Landreth, 471 U.S. 681 (1985) (same principle in
securities law). Parties who structure their transaction as
a sale and leaseback can’t treat it as a mortgage loan for
tax purposes—though the Commissioner may be able
to recharacterize it so that the tax treatment matches its
economic substance. See Frank Lyon Co. v. United States,
435 U.S. 561 (1978). If Cap Gemini transfers stock in 2000,
cash-basis taxpayers such as Fletcher can’t treat the
income as received in 2001 or 2003, even though it would
have been child’s play to do the deal so that the
income was received in those years.
The United States treats Fletcher as if she were trying
to report an asset sale as a merger, or income received
in 2000 as if it had been received in 2003. This is not,
however, the sort of argument that Fletcher advances.
She does not want to proceed as if the deal had different
No. 08-2173 7
terms. She argues instead that the deal’s actual terms
have tax consequences different from those that her
contracts with Ernst & Young and Cap Gemini required
her to report in 2000. An example makes this clear. Sup-
pose that Cap Gemini had deposited stock in the Merrill
Lynch accounts in annual installments from 2000
through 2004, and that the parties had agreed to report
that all income from the partnership-for-stock sale had
been received in 2000 because the closing occurred that
year. That agreement would not affect taxation. Private
parties can contract about when income is received, to
be sure, but the tax rules about realization and recogni-
tion are extrinsic. People determine what transactions to
engage in; federal law then specifies how much tax is
due. Because Fletcher does not try to recharacterize the
transaction, doctrines that limit or foreclose taxpayers’
ability to take such a step are beside the point.
What, then, are the tax consequences of the parties’
chosen form? Cap Gemini deposited all of the shares into
individual accounts in 2000; from its perspective, the
consideration had been paid in full. But the accounts were
restricted. Ex-partners received 25% in cash that year,
while the rest of the stock could be reached only as time
passed. From the moment of the deposit in 2000, however,
the ex-partners bore the economic risk: If the stock rose
in the market, the ex-partners stood to reap the whole
gain, and if the stock fell the ex-partners would bear the
whole loss. This makes them the beneficial owners as
of 2000, the IRS contends. For her part, Fletcher stresses
the restrictions and maintains that until she could do with
the stock as she pleased—in other words sell it, not just
8 No. 08-2173
watch nervously as it rose or fell—it did not count as
income.
The Commissioner has the better of this argument, as
can be seen by considering the tax consequences of depos-
iting cash into a blocked account. Suppose that an
inventor sells his patent in 2000 for $2.5 million, all paid
immediately—but by contract the inventor agrees that
$2 million will be put into a trust that will not be distrib-
uted until 2005. From the buyer’s perspective, the full
consideration is paid in 2000. And from the inventor’s, the
full consideration is received in 2000. The inventor
agrees to defer consumption for five years, perhaps as a
spendthrift precaution, but a taxpayer’s willingness to
defer consumption does not defer taxation—for the tax
falls on income rather than consumption. See 26 U.S.C.
§451(a) (any item of gross income is taxed in the year
received). Income is “received” not only when paid in
hand but also when the economic value is within the
taxpayer’s control; this is known as constructive receipt.
26 C.F.R. §1.451–2. It is why a person who earns income
can’t avoid tax by telling his employer to send a pay-
check to his college, or his son, rather than to his bank.
Authority to direct the disposition of income is construc-
tive receipt. In our example, the inventor could have
chosen to receive the $2.5 million in cash. Agreement
with the buyer that $2 million would be sent to a trustee
and held for five years does not avoid the fact that the
inventor had the power to direct what became of the
money; that’s what the contract was about. And much
the same can be said for Fletcher: She agreed by
contract that 75% of the consideration would be held in
No. 08-2173 9
a restricted account for up to five years, but her willing-
ness to accept restrictions and defer consumption does
not eliminate constructive receipt in 2000.
Imagine that, instead of providing for payment in stock,
the contract among Ernst & Young, Cap Gemini, and the
partners had called for some cash in 2000 plus a zero-
coupon bond, handed over to the ex-partner in 2000
and maturing in 2005. That bond is income in 2000, even
to a cash-basis taxpayer, because it is property that can be
sold in the market. Suppose that the partners also made
side agreements with Capgemini not to sell their bonds
for five years. (Equivalently, the ex-partners might have
accepted unregistered securities, with a side agreement
that Capgemini would register them and thus facilitate
sale in 2005 if the ex-partner were still employed.) An
agreement not to sell would not change the nature of the
bonds as property, and thus income, received in 2000. See
Racine v. CIR, 493 F.3d 777 (7th Cir. 2007) (a transaction
involving stock options, but that’s not a material differ-
ence). But deferral of the right to sell would reduce the
value of the bonds, and hence the amount of income,
because an illiquid asset is worth less than a liquid one.
Whether the security is handed over to the ex-partner
with a legend reflecting the limits on sale, or instead is
handed to an intermediary such as Merrill Lynch with
instructions to enforce contractual restrictions on the
sale of an un-legended security, should not matter for
tax purposes. The actual structure of the 2000 transaction
is much like our hypothetical zero-coupon bond, though
because the restrictions on sale were lifted year by year
10 No. 08-2173
it is more like one bond maturing in one year, another
bond maturing in two years, and so on through five years.
Three aspects of the contracts that Fletcher signed are
important to this understanding. First, it matters that
Fletcher and the other ex-partners stood to receive the
entire market gain, and to bear all loss, from the moment
the transaction closed in 2000. That feature of the deal
shows that the stock was in her constructive possession
in 2000. Second, it matters that Fletcher agreed to
postpone her unrestricted access to the stock. This is
why the deal looks like our inventor hypothetical. Third,
it matters that Fletcher agreed to the amount of the dis-
count. The contracts among Ernst & Young, Cap Gemini,
and the partners specified that the restrictions would be
treated as reducing the value of the stock to 95% of its
market price on the closing date. (This reflects not only
illiquidity but also the risk that Capgemini would use
its power over the account in an unauthorized way, or
that Merrill Lynch might fail in its duty as a custodian.)
An ex-partner would be hard pressed in light of this
agreement to argue that the discount should be 10% or
20%; Fletcher does not try. She insists instead that nothing
counts as income in 2000 other than what was actually
put in her hands in cash. And that position is incom-
patible with the examples we have given.
One more complication. The consulting partners agreed
to give back some of the stock if they quit early and went
into competition with Capgemini. If the parties’ goal of
encouraging the ex-partners to remain with Capgemini
had been accomplished by giving the partners immedi-
No. 08-2173 11
ate access to the stock but requiring them to grant
Capgemini a security interest in their homes, so that
repayment would be assured, then all of the income
would be treated as received in 2000. If instead Capgemini
had doled out the stock in installments (say, 50% in
2000 and 50% if the ex-partner remained on its payroll in
2005), then only 50% would be taxable in 2000. The
actual transaction was somewhere in between: 100% of the
stock was transferred to Merrill Lynch in 2000 and the
custodian was to hold it until conditions (such as not
competing) had been satisfied. For reasons we have
covered—principally the fact that the ex-partners
received the entire economic gain and loss from changes
in the price of the securities from 2000 forward—the
transaction looks more like income in 2000 than like a
stream of payments over time. Several courts have held
that, where stock is transferred under a sales agreement
and held in escrow to guarantee a party’s performance
under the agreement, the party “receives” the stock when
it is placed in escrow rather than when it is released.
See Chaplin v. CIR, 136 F.2d 298, 299–302 (9th Cir.
1943); Bonham v. CIR, 89 F.2d 725, 726–28 (8th Cir. 1937);
see also Whitney Corp. v. CIR, 105 F.2d 438, 441 (8th Cir.
1939). That principle applies here.
The more likely it is that the conditions will be
satisfied, and all restrictions lifted, the more sensible it is
to treat all of the stock as constructively received when
deposited in the account. To see this, suppose that the
parties had wanted to defer the recognition of income
and had put $2.5 million in each partner’s account, with
the condition that the whole amount would be forfeited
12 No. 08-2173
if the temperature in Barrow, Alaska, exceeded 80 / F on
January 1, 2005. Would the remote possibility of an Arctic
heat wave enable the partners to defer paying taxes?
Surely not. See Cemco Investors, LLC v. United States, 515
F.3d 749 (7th Cir. 2008). If, on the other hand, the
parties agreed that the ex-partners would receive
$2.5 million only if the temperature in Barrow on Janu-
ary 1, 2005, exceeded 80 / F, then none of the partners
would constructively receive income in 2000; everything
would depend on events in 2005.
The sort of contingencies that could lead to forfeitures
were within the ex-partners’ control. That implies taxabil-
ity in 2000, for control is a form of constructive posses-
sion. And the agreement to discount the stock by only 5%
tells us that the parties deemed forfeitures unlikely.
Fletcher’s acknowledgment that the risk of forfeiture was
small shows that the conditions of constructive receipt in
2000 have been satisfied.
Thus although we agree with Fletcher that the ex-part-
ners are entitled to contest the tax treatment called for
by the 2000 contracts, we hold that the shares are taxable
in 2000 at their value on the date of deposit to the
accounts at Merrill Lynch. Income was constructively
received in that year not because the contract said that
everyone would report it so to the IRS, but because the
parties were right to think that this transaction’s actual
provisions made the income attributable to 2000. That
the price of Capgemini stock dropped in 2001 and later
does not entitle the parties to defer the recognition of
income. Fletcher must repay the refund (and amend her
No. 08-2173 13
returns for later years to reflect receipt of the income in
2000).
A FFIRMED
4-10-09