John M. Larson

United States Tax Court
T.C. Memo. 2022-3JOHN M. LARSON,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 15809-11. Filed February 2, 2022.
—————
Reed J. Hollander, Carl Wells Hall III, Kevin A. Planegger, and Theodore
H. Merriam, for petitioner.
William F. Castor, Vassiliki E. Farrior, and Gerald A. Thorpe, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JONES, Judge: Petitioner, John M. Larson, along with two other
individuals, Robert A. Pfaff and David Amir Makov, promoted a
fraudulent tax shelter transaction known as Bond Linked Issue
Premium Structure (BLIPS). Mr. Larson was convicted of tax evasion
for his involvement in BLIPS, but the central issue in this case concerns
the use of a restricted stock agreement to defer recognition of income
earned from these transactions.
Mr. Larson, Mr. Pfaff, and Mr. Makov organized an S corporation,
Morley, Inc. (Morley), and an Employee Stock Option Plan (ESOP).
They were the trustees of the Morley ESOP and caused it to be a 5%
shareholder of Morley. Simultaneously, they caused Morley to enter
into a three-year employment agreement and restricted stock
agreement whereby they had to forfeit their Morley stock if they were
terminated within that timeframe. All Morley income for the 1999 and
Served 02/02/22
2
[*2] 2000 taxable years was allocated to the Morley ESOP according to
the restricted stock agreements Mr. Larson, Mr. Pfaff, and Mr. Makov
signed. Mr. Larson did not report any income related to the BLIPS
transactions on his tax returns for 1999 and 2000 on the basis that his
Morley stock was not substantially vested for the purposes of section
83. 1
On September 5, 2000, the Internal Revenue Service (IRS or
respondent) issued I.R.S. Notice 2000-44, 2000-2 C.B. 255, which
advised that tax shelters such as BLIPS were not bona fide and that
penalties might be imposed on the promoters of these transactions. On
January 2, 2001, Mr. Larson, Mr. Pfaff, and Mr. Makov voted to
terminate the restrictions on the Morley stock. They did not inform the
members of the Morley ESOP, allow the Morley ESOP to consent to the
removal of the restrictions, or resign as Morley ESOP trustees before
voting to remove the restrictions.
In a notice of deficiency dated April 4, 2011, the IRS disallowed
deferral of Mr. Larson’s distributive share of Morley income, resulting
in deficiencies of $6,867,653, $2,431,749, and $1,253,344 for the 1999,
2000, and 2001 tax years, respectively. The first issue for decision is
whether respondent erred in determining that Mr. Larson’s stock in
Morley was not subject to a substantial risk of forfeiture pursuant to
section 83 for taxable years 1999 and 2000. We must also decide
whether certain expenses incurred and paid by Morley during the 2000
and 2001 taxable years were ordinary and necessary business expenses
deductible under section 162. We resolve these issues in respondent’s
favor.
FINDINGS OF FACT
The parties filed a first stipulation of facts, a first supplemental
stipulation of facts, a second supplemental stipulation of facts, and
accompanying exhibits which we incorporate by this reference. The
parties also filed a stipulation of settled issues which requires
computations under Rule 155. 2 Mr. Larson was incarcerated in El Paso,
1Unless otherwise indicated, all statutory references are to the Internal
Revenue Code, Title 26 U.S.C., in effect at all relevant times, all regulatory references
are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant
times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2In the stipulation of settled issues, the parties agreed that reported interest
income on Mr. Larson’s 1999 and 2000 returns is reduced by $64,896 and $161,680,
respectively.
3
[*3] Texas, at the time he timely filed the petition to commence this
case. His residence immediately before his incarceration was in New
York City, New York.
I. The Presidio and Morley Entities
During the years at issue Mr. Larson was a licensed certified
public accountant (CPA) and a licensed attorney. From around 1986
until August 1997 Mr. Larson was a senior tax manager at the
accounting firm KPMG (formerly known as KPMG Peat Marwick) in the
international tax group. During his employment at KPMG Mr. Larson
was introduced to Mr. Pfaff, a partner in KPMG’s Denver, Colorado,
office working on international tax matters. Mr. Larson also worked
with a KPMG employee named Kerry Bratton, who had been a CPA
since 1993.
In August 1997 Mr. Larson and Mr. Pfaff resigned from KPMG
and formed Presidio Advisors, LLC (Presidio Advisors). In 1997 Ms.
Bratton joined Presidio Advisors as the director of investor relations. In
the fall of 1997 Mr. Larson met Mr. Makov, who specialized in foreign
currency trading. Mr. Makov graduated from Harvard Business School
and held a series 7 National Association of Securities Dealers, Inc.
(NASD), registration. 3 Neither Mr. Larson nor Mr. Pfaff held any
registration with NASD.
On August 10, 1999, Mr. Larson, Mr. Pfaff, and Mr. Makov caused
Morley to form Presidio Advisory Services, LLC (Presidio), as a
Delaware limited liability company. On the same day, Mr. Larson
incorporated Morley, an S corporation for federal income tax purposes
during the years relevant to this case. The certificate of incorporation
of Morley authorized the issuance of 3,000 shares of common stock and
the bylaws stated that each stockholder shall have one vote for each
share of stock. Mr. Larson, Mr. Pfaff, and Mr. Makov were named as
Morley’s managing directors and president, treasurer, and secretary,
respectively. On July 16, 1999, Mr. Larson, Mr. Pfaff, and Mr. Makov
formed Presidio Growth, LLC (Presidio Growth). Mr. Larson, Mr. Pfaff,
3Pursuant to the Financial Industry Regulatory Authority and the North
American Securities Administration Association, a series 7 license is the general
securities representative license, which allows the licensee to sell almost any type of
individual security. See Securities Exchange Act of 1934, ch. 404, 48 Stat. 881 (codified
as amended at 15 U.S.C. §§ 78a–78pp); Fleischer v. Commissioner, T.C. Memo. 2016-
238, at *3 n.2.
4
[*4] and Mr. Makov, through Presidio and Presidio Growth, began
marketing a tax shelter strategy known as BLIPS.
II. BLIPS
Each BLIPS investment involved the formation of a Strategic
Investment Fund (SIF), of which investors owned about 90% and
Presidio Growth owned an interest. The SIF would obtain a premium
loan consisting of a principal amount and a substantial additional
premium with an above-market interest rate. See Shasta Strategic Inv.
Fund, LLC v. United States, No. C-04-04264, 2014 WL 3852416, at *2
(N.D. Cal. July 31, 2014). The premium amount of the loan was set to
equal the investor’s desired tax loss. Id.Presidio used the SIF’s loan proceeds to place a short position
speculating that certain foreign currencies would lose value. For
purposes of calculating the investor’s outside basis, the investor would
treat the obligation to repay the premium portion of the loan as
contingent and not as a liability. All BLIPS investments were designed
to close within 60–90 days. The intended effect of the arrangement, as
described in Keeter v. Commissioner, T.C. Memo. 2018-191, at *5, was
for the investor to claim inflated bases in the distributed assets which
in turn generated tax losses upon the sale of the distributed assets. The
district court in Shasta Strategic Inv. Fund, LLC, 2014 WL 3852416,
at *9, found BLIPS to lack economic substance.
Mr. Larson, Mr. Pfaff, and Mr. Makov sold BLIPS investments to
more than 100 investors in 1999 and 2000.
III. The Morley ESOP
On August 10, 1999, Mr. Larson caused Morley to form an ESOP
and a related trust for its employees and contributed 150 shares of
common stock to the Morley ESOP. 4 The Morley ESOP had four
trustees: Mr. Larson, Mr. Pfaff, Mr. Makov, and Ms. Bratton. In a
determination letter issued on May 25, 2000, the IRS recognized the
Morley ESOP as a qualified plan under sections 401(a) and 4975(e)(7).
Mr. Larson, as president of Presidio, adopted the Morley ESOP on behalf
of Presidio as a “participating employer.” As of December 31, 1999, and
December 31, 2000, there were nine participating employees vested in
4An employee stock ownership plan is “a type of pension plan that invests
primarily in the stock of the company that employs the plan participants.” Fifth Third
Bancorp v. Dudenhoeffer, 573 U.S. 409, 412 (2014).
5
[*5] the Morley ESOP, including Mr. Larson, Mr. Pfaff, and Mr. Makov.
Except for Mr. Larson, Mr. Pfaff, and Mr. Makov, these individuals were
employed by Presidio, not Morley.
IV. The Restricted Stock Agreements
On August 10, 1999, Mr. Larson, Mr. Pfaff, and Mr. Makov each
signed an employment agreement with Morley. Each employment
agreement included a section entitled “restricted stock agreement.”
This section stated that the respective grantor trusts of Mr. Larson, Mr.
Pfaff, and Mr. Makov would receive shares of common stock of Morley
and ownership of said stock would be governed by restricted stock
agreements, effective August 10, 1999. Simultaneously with the
execution of the employment agreements, Mr. Larson, Mr. Pfaff, and Mr.
Makov each signed restricted stock agreements with Morley.
Each restricted stock agreement stated that the shareholder of
Morley stock could not assign, transfer, mortgage, pledge, encumber,
hypothecate, or otherwise dispose of any of the Morley shares without
first obtaining written consent of 100% of the shareholders of Morley.
The restricted stock agreement contained provisions, which, taken
together, stated that if an employee’s employment was terminated with
or without cause before August 10, 2002, he was deemed to have offered
to sell all of his shares of Morley stock at a purchase price determined
by section 5(a) of the agreement. The agreement was effective until
written consent to termination by the holders of 100% of the outstanding
shares of voting common stock. Upon receipt of written notice of consent
to termination, Morley had to promptly deliver copies of such written
notice to all shareholders.
The stated purpose of these agreements was to incentivize
retention of Mr. Makov, who had a history of frequently changing jobs.
Mr. Makov requested that Mr. Larson and Mr. Pfaff also sign restricted
stock agreements so as not to single him out. At trial, Mr. Larson
testified that when they adopted the restrictions, Mr. Larson, Mr. Pfaff,
and Mr. Makov were “in [it] together.” Mr. Larson was aware of the tax
planning opportunity in entering into these agreements.
Several Morley ESOP participants were unaware that Mr. Larson
was an employee of Morley, rather than Presidio. These employees were
likewise unaware that Morley owned Presidio. Furthermore, these
employees never received a copy of Mr. Larson’s restricted stock
agreement, were not advised of their rights as participants of the Morley
6
[*6] ESOP, or were unaware that Mr. Larson’s stock was subject to
forfeiture.
V. Termination of the Restricted Stock Agreements
On September 5, 2000, the IRS issued Notice 2000-44, which
advised that purported losses from tax shelters such as BLIPS were not
bona fide and did not reflect actual economic consequences and that
penalties might be imposed on the promoters of these transactions. As
a result of the issuance of Notice 2000-44, Mr. Larson, Mr. Pfaff, and
Mr. Makov began terminating Presidio’s employees, ceased all new
BLIPS transactions, and wrapped up the deals that were already on the
books. Several months after the issuance of Notice 2000-44, Morley
developed a new deal structure but performed only a limited number of
transactions. Mr. Makov’s work slowed considerably as a result of
Notice 2000-44, and Mr. Larson believed there was no reason to compel
Mr. Makov to stay.
On January 2, 2001, Mr. Larson, Mr. Pfaff, and Mr. Makov
released the forfeiture restrictions on their shares of Morley stocks.
They did not release the restrictions as trustees of the Morley ESOP, nor
did they resign their positions as trustees of the Morley ESOP before
terminating their stock restrictions. 5
Neither the Morley ESOP nor anyone on behalf of the Morley
ESOP provided written consent to the termination of the Morley stock
forfeiture restrictions. The Presidio employees were unaware that Mr.
Larson had released the stock forfeiture restrictions, and they did not
vote to release those restrictions. Mr. Larson did not cause the Morley
ESOP to retain outside counsel to protect its interest. Upon leaving
Presidio, employees received funds from their Morley ESOP accounts
via transfers to rollover individual retirement accounts.
The stock forfeiture restrictions were not enforced, but rather,
were released by Mr. Larson, Mr. Pfaff, and Mr. Makov during the
“earnout” period. Just as they were “in [it] together,” Mr. Larson, Mr.
Pfaff, and Mr. Makov were going to act “as one, unanimously” when
5Mr. Larson objects to paragraphs 153 through 157 of the joint stipulation of
facts dated January 10, 2020, on the grounds that they are not relevant. These are
facts that are of consequence to the determination of the action within the meaning of
Rule 401 of the Federal Rules of Evidence. Under these circumstances we conclude
that paragraphs 153 through 157 are relevant, and we overrule Mr. Larson’s objections
to them.
7
[*7] lifting the restrictions. Mr. Larson further testified that he did not
know he had fiduciary obligations as an ESOP trustee to the Morley
ESOP and its participants. He also testified that he was unaware that
fiduciaries should not engage in self-dealing.
VI. Forms 1120S, U.S. Income Tax Return for an S Corporation:
1999–2001
Morley filed Forms 1120S for the 1999, 2000, and 2001 taxable
years. On Forms 1120S Morley reported income and expenses of
Presidio because it was a single-member LLC disregarded for Federal
income tax purposes. Reported gross receipts consisted of BLIPS fees
paid to Presidio, and reported expenses included the salary expenses of
the six Presidio employees.
Schedules K-1, Shareholder’s Share of Income, Credits,
Deductions, etc., for the Morley ESOP were attached to Morley’s 1999
and 2000 returns and reported that the ESOP owned 100% of Morley.
All Morley income for the 1999 and 2000 taxable years was allocated to
the Morley ESOP according to the restricted stock agreements Mr.
Larson, Mr. Pfaff, and Mr. Makov signed on behalf of their respective
grantor trusts.
The parties were unable to stipulate that the amounts deducted
as business expenses on Morley’s tax returns were incurred. Mr. Larson
believed that the amounts reported would have been incurred and paid.
Mr. Larson also thought that each of the business expenses reported for
the 2000 and 2001 taxable years would have been supported by bank
statements and underlying records but failed to produce such
documentation.
VII. Mr. Larson’s Forms 1040, U.S. Individual Income Tax Return:
1999–2001
For purposes of subchapter S, “stock that is issued in connection
with the performance of services * * * and that is substantially
nonvested * * * is not treated as outstanding stock of the corporation,
and the holder of that stock is not treated as a shareholder solely by
reason of holding the stock.” Treas. Reg. § 1.1361-1(b)(3). Mr. Larson
did not report any pro rata share of passthrough income from Morley for
the 1999 and 2000 taxable years on the basis of his position that his
outstanding stock was subject to a substantial risk of forfeiture and
therefore was nonvested.
8
[*8] On his 2001 return Mr. Larson reported wages and income from
Schedule C, Profit or Loss From Business, relating to director’s fees paid
by Morley. Mr. Larson reported on Schedule E, Supplemental Income
and Loss, passthrough income from Morley for the 2001 taxable year
relating to termination of the purported Morley stock restrictions. Mr.
Larson also reported a Schedule E passthrough loss from Morley
relating to his pro rata share of Morley’s loss claimed on its 2001 return. 6
VIII. Criminal Proceedings and IRS Notice of Deficiency
In December 2008 Mr. Larson and Mr. Pfaff were convicted by a
jury of 12 counts of tax evasion, including evasion with respect to the
BLIPS transactions. In April 2009 Mr. Larson was sentenced to
imprisonment of 121 months, three years of supervised release, and a
fine.
After examination, the IRS issued a notice of deficiency to Mr.
Larson on April 4, 2011. The IRS determined deficiencies of $6,867,653,
$2,431,749, and $1,253,344 for the 1999, 2000, and 2001 tax years,
respectively. The IRS determined that the restrictions on Mr. Larson’s
Morley stock were not respected by the parties and accordingly
disallowed deferral of Mr. Larson’s distributive shares of Morley income.
In the alternative respondent disregarded the Morley stock restrictions
on the basis that the entire arrangement was entered into primarily to
reduce taxes, was a sham, and must be disregarded for income tax
purposes. Accordingly, the IRS increased Mr. Larson’s distributive
shares of Morley income for 1999, 2000, and 2001 from zero to
$8,915,329, $4,265,220, and $2,790,737, respectively (i.e., 33.33% of
Morley’s reported income for the relevant taxable years). 7 The IRS also
6Mr. Larson, through his counsel, filed protective refund claims on Forms
1040X, Amended U.S. Individual Income Tax Return, for taxable years 2002–05.
Copies of these documents were collectively attached to the Joint First Stipulation of
Facts as Exhibit 144–J. Respondent objects to this exhibit on the grounds of relevancy
to the extent Mr. Larson offered the exhibit as evidence of his tax liabilities for taxable
years 2002–05, as those years are not in front of this Court. As Exhibit 144–J and the
protective claims were not discussed at trial, we sustain respondent’s objection.
7On his 2001 return Mr. Larson reported Schedule E passthrough income from
Morley of $8,680,625 on the basis of the termination of the Morley stock restrictions.
On his 2001 return, Mr. Larson also reported a Schedule E passthrough loss from
Morley of $8,515,404 relating to his pro rata share of Morley’s reported loss of
$26,887,918. In the notice of deficiency, respondent did not make a separate negative
adjustment of $8,680,625 to reverse petitioner’s reported Schedule E passthrough
income from Morley of $8,680,625. Rather, respondent adjusted Mr. Larson’s pro rata
9
[*9] determined that all or parts of Mr. Larson’s underpayments of tax
for the 1999, 2000, and 2001 tax years were due to fraud. 8
OPINION
I. Burden of Proof
In general, the Commissioner’s determinations set forth in a
notice of deficiency are presumed correct, and the taxpayer bears the
burden of proving otherwise. See Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115 (1933). A taxpayer must prove his entitlement to any
deductions claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
II. Statutory and Regulatory Framework
A. S Corporations and ESOPs
An S corporation is defined as a small business corporation for
which an election under section 1362(a) is in effect for the relevant tax
year. § 1361(a)(1). Like partnership income, income from an S
corporation flows to its shareholders, resulting in only one level of
taxation. See § 1363(a); Taproot Admin. Servs., Inc. v. Commissioner,
133 T.C. 202, 204 (2009) (quoting Gitlitz v. Commissioner, 531 U.S. 206,
209 (2001)), aff’d, 679 F.3d 1109 (9th Cir. 2012). An S corporation
shareholder generally determines his or her tax liability by taking into
account a pro rata share of the S corporation’s income, losses,
deductions, and credits. § 1366(a)(1).
When qualified ESOPs meet the section 401(a) requirements,
their related trusts are generally exempt from income taxation pursuant
to section 501(a). Effective January 1, 1998, Congress provided that
certain tax-exempt entities, including ESOPs, were permitted to be
share of Morley income (loss) based on a reported amount of zero when in fact
petitioner’s return reported his pro rata share of Morley’s loss to be $8,515,404. The
parties agree that, if respondent prevails on the issue of whether Mr. Larson’s Morley
stock restrictions should be respected, respondent’s adjustment to Mr. Larson’s
Schedule E passthrough income (loss) from Morley for 2001 should be $2,625,516,
rather than $2,790,737 as determined in the notice of deficiency (i.e., respondent would
concede $165,221 of the adjustment, as to amount), subject further to the
determination by the Court as to respondent’s disallowance of Morley entity-level
deductions.
8At trial respondent conceded the fraud penalty for all years at issue.
10
[*10] shareholders of S corporations. 9 Small Business Job Protection
Act of 1996, Pub. L. No. 104-188, § 1316(a), 110 Stat. 1755, 1785–86.
These provisions enacted a framework which allowed all of the
outstanding shares of an S corporation to be owned by an ESOP,
effectively allowing S corporation profits to escape federal income
taxation. See Austin v. Commissioner (Austin II), T.C. Memo. 2017-69,
at *33, aff’d sub nom. Estate of Kechijian v. Commissioner, 962 F.3d 800(4th Cir. 2020). To address concerns about ownership structures
involving S corporations and ESOPs, Congress amended the Internal
Revenue Code in 2001 to require that income or loss that had previously
been allocable to the ESOP be attributable to certain non-ESOP
shareholders of a closely held corporation. See Economic Growth and
Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, § 656, 115 Stat.
38, 131–35. But Congress made the change prospectively and did not
generally apply it to plan years before 2005 for an ESOP (as in the
instant case) that existed before 2001. See id. subsec. (d).
Shareholders of an S corporation could use the above framework
to defer income if they owned “substantially nonvested” stock because it
is considered to be “non-outstanding.” See Austin II, at *13–14, *32–33;
Treas. Reg. § 1.1361-1(b)(3). When shares are “non-outstanding,” an S
corporation can allocate 100% of its income, losses, deductions, and
other tax items to an ESOP. See Austin II, at *14, *32–33.
B. Substantially Vested Stock
Section 83(a) governs the tax treatment of property transferred
“in connection with performance of services.” Upon such a transfer,
section 83(a) generally provides that the value of such property is
taxable in the first year in which the taxpayer’s rights in the property
are “transferable or are not subject to a substantial risk of forfeiture.”
Thus, a taxpayer can defer recognition of income until his rights in the
restricted property become “substantially vested.” Austin v.
Commissioner (Austin I), 141 T.C. 551, 559 (2013); Treas. Reg. § 1.83-
1(a)(1). Shares of stock are subject to a substantial risk of forfeiture if
the owner’s rights to their full enjoyment are conditioned upon the
future performance of substantial services by any individual. QinetiQ
9Such income allocable to an ESOP from an S corporation did not constitute
unrelated business taxable income within the meaning of section 512(a)(1). See
Taxpayer Relief Act of 1997, Pub L. No. 105-34, § 1523, 111 Stat. 788, 1070–71.
11
[*11] U.S. Holdings, Inc. & Subs. v. Commissioner, T.C. Memo. 2015-
123, at *24, aff’d, 845 F.3d 555 (4th Cir. 2017).
The requirement that an employee render future services as a
precondition for obtaining full enjoyment of restricted property is often
referred to as an “earnout” restriction. Austin I, 141 T.C. at 559–60
(citing Campbell v. Commissioner, T.C. Memo. 1990-162, aff’d in part,
rev’d in part, 943 F.2d 815 (8th Cir. 1991)). The regulations provide that
“a substantial risk of forfeiture exists only if rights in property that are
transferred are conditioned, directly or indirectly, upon the future
performance (or refraining from performance) of substantial services by
any person.” Treas. Reg. § 1.83-3(c)(1). Whether a substantial risk of
forfeiture exists depends on the facts and circumstances. Id.The regulations provide five factors to consider when determining
whether an employee’s interest in transferred property is subject to a
substantial risk of forfeiture in instances where an employee of a
corporation owns a significant amount of stock of the employer
corporation:
(i) the employee’s relationship to other stockholders
and the extent of their control, potential control and
possible loss of control of the corporation, (ii) the position
of the employee in the corporation and the extent to which
he is subordinate to other employees, (iii) the employee’s
relationship to the officers and directors of the corporation,
(iv) the person or persons who must approve the employee’s
discharge, and (v) past actions of the employer in enforcing
the provisions of the restrictions.
Id. subpara. (3).
Thus, in order for section 83 to apply to Mr. Larson’s Morley stock
for the 1999 and 2000 taxable years, the facts and circumstances must
show that it was subject to a substantial risk of forfeiture during that
period.
C. Substantial Risk of Forfeiture
In Austin I, 141 T.C. at 553, two taxpayers worked together in the
distressed debt loan portfolio business. Before 1998 the taxpayers were
original shareholders of a group of related companies called “the UMLIC
Entities.” Id. The taxpayers formed an S corporation and, in a section
351 transaction, the taxpayers transferred their interest in the UMLIC
12
[*12] Entities to the S corporation in exchange for common stock. Id.Concurrently, the S corporation issued shares of its common stock in
exchange for a note to an ESOP for its employees, including the two
taxpayers. Id. As part of this exchange, the taxpayers executed
employment agreements and restricted stock agreements almost
identical to those in the instant case. See id. at 554. In particular, the
taxpayers would receive less than full fair market value upon forfeiture
of their stock if they did not perform substantial services for the S
corporation until the expiration of their initial term of agreement. Id.
at 556. Thus, the employment agreement in conjunction with the
restricted stock agreement constituted a classic “earnout restriction.”
Id. at 567.
The Court considered whether there was a sufficient likelihood
that the earnout restrictions would be enforced. Id. at 568. Finding that
an employee’s inability or disinclination to work for the agreed-upon
term was not a remote event unlikely to occur, the Court held that the
relevant earnout restriction could give rise to a substantial risk of
forfeiture within the meaning of section 83. Id.
In Austin II, at *24, the Court found that the taxpayers credibly
testified that they understood their fiduciary obligations to the ESOP.
The ESOP had retained outside counsel to protect its interest when
called upon to vote on the sale of the S corporation’s assets. Id.
Furthermore, the Court stated,
[b]ecause approving removal of the forfeiture
provision affecting either petitioner’s shares would have
been directly contrary to the economic interest of the
ESOP, it would have been a grotesque conflict of interest
for petitioners to have acted as ESOP trustees for such a
vote. We are confident that petitioners in such
circumstances would have resigned as trustees, as they in
fact did in 2003, rather than face the consequences of a self-
dealing charge. The ESOP used a pass-through voting
system whereby participants voted confidentially through
a third party, who directed the trustees to vote in
accordance with the participants’ majority vote. The
participants would thus have been uninhibited in voting
their economic interest, which would plainly have dictated
a vote against waiver of the forfeiture provision.
Id. at *24–25.
13
[*13] The Court thus held that the stock held by the taxpayers was
subject to a substantial risk of forfeiture and remained subject to that
risk until the forfeiture provisions lapsed. Id. at *28–29.
III. The Parties’ Arguments
Mr. Larson argues that the Morley stock issued to him on August
10, 1999, was subject to a substantial risk of forfeiture and therefore did
not vest until the employment-related restrictions were released on
January 2, 2001. Mr. Larson contends that he entered into the
restricted stock agreement in conjunction with Mr. Pfaff and Mr. Makov
as an incentive to retain Mr. Makov as an employee because he had a
history of frequently changing jobs.
Respondent counters that the Morley stock was substantially
vested when Mr. Larson received it in 1999 because the forfeiture
conditions were unlikely to be enforced. Alternatively, respondent
argues that the restrictions lacked economic substance because there
was no nontax business purpose for the restricted stock agreements and
employment agreements.
IV. Analysis
Mr. Larson failed to demonstrate that the Morley stock was
subject to a substantial risk of forfeiture in the 1999 and 2000 taxable
years. The facts and circumstances support this conclusion.
Mr. Larson, Mr. Pfaff, and Mr. Makov, through their respective
grantor trusts, owned 95% of Morley’s common stock, with the Morley
ESOP owning the remaining 5%. In situations in which restricted
property is transferred to an employee “who owns a significant amount
of the total combined voting power or value of all classes of stock of the
employer corporation,” Treasury Regulation § 1.83-3(c)(3) directs us to
consider several factors. The regulation emphasizes the importance not
just of stock ownership percentages, but of the de facto power to control.
See Austin II, at *21.
Mr. Larson, along with Mr. Pfaff and Mr. Makov, formed Morley
and promoted the BLIPS business together. They had a close working
relationship and were “in this together.” We acknowledge that only Mr.
Makov had the necessary registration for securities trading; but after
the IRS issued Notice 2000-44, his work slowed to a halt. Rather than
allow Mr. Makov to leave and implement the stock restrictions, Mr.
Larson and Mr. Pfaff collectively released their restrictions. This lack
14
[*14] of enforcement aligns with Mr. Larson’s testimony that they were
going to act “as one, unanimously” when lifting the restrictions. When
the arrangement was no longer beneficial, they terminated it. Mr.
Larson did not show that there was sufficient likelihood that the earnout
restrictions would be enforced. Rather, his relationship to the officers
and directors of the corporation and their actions revealed an effort to
collectively avoid enforcement of the restrictions. See Treas. Reg. § 1.83-
3(c)(3).
Furthermore, removal or waiver of the forfeiture provision
required the consent of the holders of 100% of the company’s shares. As
a holder of a 5% interest, Morley had to obtain the consent of the Morley
ESOP before lifting the stock forfeiture restrictions. Mr. Larson did not
cause it to do so. These facts show that Mr. Larson, along with Mr. Pfaff
and Mr. Makov, had complete control over Morley. See id. Mr. Larson
did not put forward any convincing evidence that he could possibly lose
control over the S corporation. See id.Mr. Larson’s casual treatment of his fiduciary duties is
particularly telling. Under the Employee Retirement Income Security
Act of 1974 (ERISA), 29 U.S.C. §§ 1104(a)(1) and 1106(b), the plan’s
trustees were required to refrain from self-dealing in the plan’s assets
and to “discharge [their] duties . . . with the care, skill, prudence, and
diligence . . . that a prudent man acting in a like capacity . . . would use.”
A trustee of an ERISA-qualified plan has a fiduciary duty to inform
participants and beneficiaries of their rights under the plan as a result
of general fiduciary standards of loyalty and care borrowed from the
common law. See §§ 401(a), 4975(e)(7); Cent. States, Se. and Sw. Areas
Pension Fund v. Cent. Transp., Inc., 472 U.S. 559, 571–72 (1985);
Petersen v. Commissioner, 148 T.C. 463, 475–76 (2017), aff’d and
remanded, 924 F.3d 1111 (10th Cir. 2019).
Mr. Larson’s handling of his fiduciary responsibilities is
distinguished from the way in which the taxpayers in Austin II handled
similar duties. See Austin II, at *24. Despite having been both a CPA
and an attorney, Mr. Larson testified that he was unaware of his duties
as a fiduciary of the Morley ESOP. We do not find his testimony credible
on these points. Further, Mr. Larson did not resign as a Morley ESOP
trustee before voting on the stock forfeiture restrictions. Unlike the
taxpayers in Austin II, Mr. Larson did not retain outside counsel to
protect the Morley ESOP’s interest when voting to lift the stock
forfeiture provisions. See id. Although using an ESOP to defer income
was a well-known tax planning strategy at the time, Mr. Larson was not
15
[*15] free to override the basic fiduciary requirements that were
fundamental to the documents that he signed. We find Mr. Larson’s
actions to be a “grotesque conflict of interest.” See id.Finally, the record does not show a pattern of open and fair
dealing with regard to the Morley ESOP participants. The Morley ESOP
participants were woefully ill-informed of their rights and seemed
oblivious to the existence of stock forfeiture restrictions. Consequently,
it was unsurprising that they were unaware that Mr. Larson had
released the restrictions or that they had the right to vote upon such a
release. The Morley ESOP participants would have had a strong
economic incentive to enforce the forfeiture clauses, but they were not
given the opportunity to do so. Mr. Larson’s actions with regard to the
Morley ESOP participants make it evident that he, Mr. Pfaff, and Mr.
Makov had complete control of Morley. See Treas. Reg. § 1.83-3(c)(3).
Therefore, the facts and circumstances compel the conclusion that the
stock forfeiture restrictions were never likely to be enforced.
Accordingly, we hold that the Morley stock was not subject to a
substantial risk of forfeiture under section 83, and we sustain
respondent’s determination on this matter. We therefore need not
address respondent’s alternative argument that the entire Morley
restricted stock strategy was a sham and should be disregarded for
income tax purposes.
V. Ordinary and Necessary Business Expenses
As mentioned above, generally the Commissioner’s
determinations in a notice of deficiency are presumed correct, and the
taxpayer bears the burden of proving that those determinations are
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. at 115. To deduct
an expense under section 162, a taxpayer must establish that the
amount was an ordinary and necessary expense paid or incurred in
carrying on a trade or business. § 162(a); see also INDOPCO, Inc. v.
Commissioner, 503 U.S. at 84.
Taxpayers bear the burden of substantiating the amount of any
claimed deduction by maintaining the records needed to establish
entitlement to such a deduction. See § 6001; Hradesky v. Commissioner,
65 T.C. 87 (1975), aff’d, 540 F.2d 821 (5th Cir. 1976). “A taxpayer’s self-
serving declaration is generally not a sufficient substitute for records.”
Fine v. Commissioner, T.C. Memo. 2013-248, at *4 (citing Weiss v.
Commissioner, T.C. Memo. 1999-17).
16
[*16] Mr. Larson failed to present any credible evidence showing that
Morley’s business expenses in tax years 2000 and 2001 were ordinary
and necessary pursuant to section 162. Mr. Larson relies on internal
documents he generated purporting to substantiate the expenses;
unreliable hearsay; and his own self-serving, uncorroborated testimony.
We are not required to accept such testimony, nor do we here. See
Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). Taxpayers are
required to maintain the records needed to establish entitlement to a
deduction, and Mr. Larson has not done so. See § 6001. Mr. Larson has
failed to introduce sufficient and credible evidence, and therefore did not
meet his burden of proof on this issue.
When a taxpayer establishes that he has paid a deductible trade
or business expense but is unable to adequately substantiate the
amount, the Court may estimate the amount and allow a deduction to
that extent. Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930).
To apply the Cohan rule, the Court must have a reasonable basis upon
which to make an estimate. Vanicek v. Commissioner, 85 T.C. 731, 742–
43 (1985). Otherwise, an allowance would amount to unguided largesse.
Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957). As Mr.
Larson failed to properly establish that Morley incurred ordinary and
necessary business expenses, application of the Cohan rule would be
inappropriate.
VI. Conclusion
We hold that respondent did not err in determining that Mr.
Larson’s stock in Morley was not subject to a substantial risk of
forfeiture pursuant to section 83 for taxable years 1999 and 2000. We
further sustain respondent’s determination to disallow Morley’s
ordinary and necessary business deductions for taxable years 2000 and
2001.
We have considered all of the arguments made by the parties and,
to the extent they are not addressed herein, we deem them to be moot,
irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.