This article is reprinted with permission from the
November 12, 1996
edition of

New York Law Journal.

1996 NLP IP Company.


'Theophilos' -- A Pandora's Box for Section 83?

By Joseph E. Bachelder.


SECTION 83 of the Internal Revenue Code of 1986 imposes income tax on the transfer of property in connection with the performance of services. 1 The issue of what constitutes "property" for purposes of 83 can be critical in determining the application of that section. Treasury Regulation 1.83-3(e) defines "property" for purposes of 83. The first sentence of the regulation reads:

For purposes of Section 83 and the regulations thereunder, the term "property" includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future.

Based on Treasury Regulation 1.83-3(e) it has been assumed (at least by the author) that a promise to pay compensation at a future date is not taxable at the time of the promise even if the promise is embodied in a written (but unsecured) agreement. The Court of Appeals for the Ninth Circuit has cast doubt on this assumption.

Contract to Buy Employer's Stock

In Theophilos v. Commissioner, 85 F3d 440 (9th Cir. 1996), rev'g and rem'g 67 TCM (CCH) 2106 (1994), the Ninth Circuit addressed this issue in the context of an executory contract to purchase stock of the employer. In early 1985 the taxpayer and Greater Suburban Mortgage (GSM), a California corporation engaged in the mortgage banking business, began negotiations that led to the taxpayer's leaving his law firm on Oct. 1, 1985, and soon after becoming president and chief executive officer of GSM.

While there was an apparent understanding as to the extent of the equity interest in GSM to be acquired by the taxpayer (40 percent) there was still no written agreement regarding the specific terms of that acquisition when taxpayer joined GSM in October 1985.

Further discussions followed throughout 1985 and into early 1986. The parties, with assistance from accountants for GSM, agreed that there would be a recapitalization of GSM and that the taxpayer would purchase one of two classes of stock resulting from it.

In April 1986 the taxpayer and George Beegle, who was the sole shareholder of GSM, executed various documents, including a shareholder's agreement. As part of these arrangements, it was agreed that upon the effectiveness of the recapitalization the taxpayer would purchase 1,020 shares of Class B common stock of GSM for $10,200 (evidently the parties considered this to be the fair market value of the stock at the time the agreement was entered into).

On Oct. 1, 1986, GSM filed amended articles of incorporation with the State of California. On Dec. 10, 1986, Beegle transferred all 1,020 shares of Class B stock to taxpayer in exchange for a promissory note. Taxpayer and GSM did not report this transaction in their respective returns, as originally filed, for 1985, 1986 and 1987. 2

In late 1987 taxpayer resigned as president of GSM after disagreements with Beegle and asked GSM to repurchase his stock pursuant to the shareholders agreement. GSM refused, claiming the shareholder agreement was invalid. In April 1989 a settlement was reached pursuant to which GSM agreed to pay taxpayer $1.75 million, and taxpayer agreed to a rescission of the December 1986 purchase.

After the settlement just noted, GSM received a financial report from a firm called the Newport Group, which valued the stock purchased by taxpayer at $3,526,320 on Dec. 31, 1986 (approximately the date on which purchased). GSM issued a new W-2c statement for 1986 indicating the taxpayer received wages in the amount of $3,516,230 and claiming a deduction of like amount in an amended tax return for 1986. (It so happens that the tax benefit of GSM's deduction on its amended tax return, if it had been sustained, would have been about equal to the $1.75 million settlement between GSM and taxpayer in 1989.)

In the ensuing tax dispute between the taxpayer and the Internal Revenue Service:

(1) The IRS claimed the taxpayer received $3,516,320 of income on Dec. 10, 1986, in connection with his purchase of the 1,020 shares of GSM stock.

(2) The taxpayer asserted he owed no taxes, on the theory that the net effect of the negotiations in the spring of 1985 was that he acquired his 40 percent equity interest at that time at its then fair market value.

The Tax Court agreed with the IRS and held that the taxpayer was taxable, under Code 83, at the time of the purchase of the stock on Dec. 10, 1986.

The Ninth Circuit concluded that the taxable event occurred in April 1986 when the taxpayer entered the executory agreement to purchase the stock of GSM.

All parties agreed that GSM went through a very significant increase in value from 1985 through December 1986 (although they disagreed as to what that value was). This included a significant increase in value from April 1986 when the executory agreement was signed to Dec. 10, 1986, when the purchase of the stock took place.

In reversing the Tax Court, the Ninth Circuit remanded the case to the Tax Court for determination of value as of April 1986 when the executory agreement was signed.

The essence of the Ninth Circuit's holding is in its response to Treasury Regulation 1.83-3(e):

A contractual right to acquire stock is not unsecured or unfunded if it is a binding obligation secured by valuable consideration. Thus, we hold that a contractual obligation to acquire stock, as well as an acquisition of stock itself, is "property" within the meaning of IRC 83, and if the contractual right to acquire stock is taxable under 83, the subsequent purchase is not.

This contrasts with the Tax Court holding that only when the taxpayer purchased the stock of GSM in December 1986 did he "convert any executory contract right into a beneficial interest in GSM" so as to become taxable. 3

The Precedents Used

The Ninth Circuit cites two cases as primary support for its holding. In Estate of Ogsburg v. Commissioner, 28 T.C. 93 (1957), aff'd 258 F2d 294 (2d Cir. 1958), a case decided before the enactment of 83, the Tax Court decided that the exercise of an option (in 1945), which obligated the taxpayer to pay for the stock, was the taxable event and not payment for and receipt of the stock in a later year (1948). Estate of Ogsburg is doubtful precedent, for two reasons. First, it predates enactment of 83. Second, it represents a purchase of stock by exercise of an option -- the only steps remaining were payment for and delivery of the shares.

The second case is Montelepre Systemed Inc. v. Commissioner, 61 T.C.M. (CCH) 1782 (1991), aff'd, 956 F2d 496 (5th Cir. 1992). In that case the Tax Court held that a right of first refusal constituted property within the meaning of Code 83. A hospital's operator sold the right of first refusal to the buyer of the hospital for $1.5 million.

The issue before the Ninth Circuit in Theophilos was not whether a right of first refusal may constitute property (it obviously can under certain circumstances). The issue was whether a promise by an employer to deliver stock in the future, embodied in an executory contract entered in connection with employment, is excluded by Treasury Regulation 1.83-3(e) from being property taxed under 83.

Question of Security

As quoted above, the Ninth Circuit states that the executory contract before it was "not unsecured or unfunded" within the meaning of Treasury Regulation 1.83-3(e). According to the court, the contract was "a binding obligation secured by valuable consideration." (Emphasis added.) 4

Where is the security? Ordinarily one thinks of security for a promise to pay to be in a form such as a pledge, a mortgage, a separate fund or a third-party assurance of performance. In connection with deferred compensation it often is a separate trust fund. The Ninth Circuit evidently finds the binding obligation of the taxpayer to purchase stock pursuant to an executory contract to be "security" within the meaning of Treasury Regulation 1.83-3(e). That, certainly, is not a customary meaning of "security," at least in the context of an executive compensation arrangement.

The Ninth Circuit indicates that if continued rendering of substantial services represented the consideration the result might have been different. It cites Treasury Regulation 1.83-3(c)(1):

[a] substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance . . . of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied.

The court concluded that the contract was not conditioned on future performance of substantial services and also found that there was no condition related to the "purpose of the transfer" that would represent a substantial risk of forfeiture within the meaning of the Treasury Regulation.

Import of 'Theophilos'

On the one hand, Theophilos, if correct, suggests that employers must be careful in assuming that an executory agreement relating to executive compensation does not, under 83, constitute property that is being transferred at the time the agreement is executed. If the transaction is subject to 83, the employer is obligated to file an information tax return regarding the transaction. Failure to do that results in loss of deduction to the employer. 5

Theophilos also represents a planning opportunity (again, if the Ninth Circuit is correct). As one example, a traditional stock unit award might, in certain circumstances, qualify as a property transfer under the Theophilos rationale.

To illustrate, assume that an employer wants to make an award of "X" units to an executive (each unit representing a share of stock to be delivered five years later). The stock price today is $20. The executive contracts today to buy at the lesser of $20 or 90 percent of the fair market value for the 20 consecutive trading days preceding the fifth anniversary of the award. The risk is limited but the contract obligates the executive to purchase the stock at a price that cannot be treated as nominal. The award is fully vested.

Instead of an option, with ordinary income to the executive at the time of exercise, this arrangement under the rationale of Theophilos would seem to produce a long-term capital gain opportunity for the executive on any gain over the purchase price, taxable at the time the executive disposes of the stock. The employer, of course, would forgo any deduction on the transaction beyond the excess, if any, of the value of the award at the time of grant over what the executive contracted to pay for the stock.

What if the executory contract represented by the stock unit award were subject to continuing services until it "vested" after the five years? Applying the logic of Theophilos, this should make no difference. There has been a transfer of property, the executory contract, supported by valuable consideration, the promise to purchase the stock. The fact that the property transferred (the executory contract) is subject to a substantial risk of forfeiture should only postpone the applicability of the tax under Code 83 until the risk of forfeiture lapses.

Alternatively (and this is the point), the executive might elect to be taxed under Code 83(b) at the time of the transfer notwithstanding the substantial risk of forfeiture, thereby qualifying for long-term capital gain when the executive ultimately disposes of the stock.

Carrying Theophilos one step further, does the Ninth Circuit's logic create a taxable transfer under Code 83 for a customary stock unit award (that is, one without any purchase price required of the executive) if it is granted in consideration for a promise by the executive to continue in employment for the next five years or, if his employment terminates, not to work for a competitor for a specified period after termination of employment? Certainly the executive has made a binding obligation in consideration for the promise to deliver the stock. This may be a logical extension of Theophilos, but the result would not seem to be within the intent of Treasury Regulation 1.83-3(e).


1 A transfer is not subject to tax under 83 if it is subject to a substantial risk of forfeiture at the time of transfer unless the employee elects to be taxed at the time of transfer. Code 83(a) and (b).

2 Both the Tax Court and the Court of Appeals treat the purchase of stock by the taxpayer from Beegle as a transfer from the employer (GSM) to the taxpayer pursuant to Code 83. [While neither decision discusses its theory,] presumably each court concluded that the transaction was in substance between GSM and the taxpayer. The Treasury Regulations under 83 contemplate a transfer from a shareholder to an employee of the corporation and its treatment as a contribution to the capital of the corporation by the shareholder followed by a transfer from the corporation to the employee. Treas. Reg. 1.83-6(d).

3 Theophilos v. Commissioner, 67 TCM (CCH) 2106, 2116 (1994).

4 Theophilos v. Commissioner, 85 F3d 440, 444-445 (9th Cir. 1996).

5 Treas. Reg. 1.83-6(a)(2).